On April 28, 2022, the Financial Services Commission (the “FSC”) announced the Guideline for New Securities Business, including Fractional Investment (the “Guideline”) which focuses on the recently emerging fractional investment instruments.
Fractional investment is an innovative financial investment methodology that broadens access to investment products by enabling investors to make small fractional investments in various assets or property rights. Fractional investments are being offered in various industries. For instance, recently, Musicow Co., Ltd. (“Musicow”) experienced rapid growth as a platform operator that sells the “right to claim participation in copyright fees” to investors, where the right to profits generated from copyrights of certain music sources were sold in fractionalized units for purchase and sale amongst investors.
There have been concerns that fractional investments may circumvent regulations applicable to traditional financial investment products and that they lack investor protection measures due to their unclear legal nature and applicable legal regime.
On April 20, 2022, the Securities and Futures Commission (the “Commission”) determined that the right to participate in copyright fees issued by Musicow is an investment contract security under the Financial Investment Services and Capital Markets Act (the “FSCMA”), and is thus, subject to the regulations promulgated under the FSCMA for securities. However, given it is the first application of the FSCMA to fractional investments of this nature, the Commission has decided to postpone imposing sanctions on Musicow for violation of the public offering regulations under the FSCMA on the condition that Musicow establishes systematic investor protection measures.
The FSC on April 28 issued the Guideline as a follow-up measure to provide guidance on the FSCMA’s applicability to fractional investment products and considerations required for their commercialization. The Guideline sets out the criteria to determine whether a fractional investment product is a security under the FSCMA and discusses issues to consider when dealing with fractional investment products that are classified as securities.
1. Whether a Fractional Investment Product is a Security
There have been ongoing debates on the legal nature of fractional investments with particular focus on whether a fractional investment is a security which would be regulated under the FSCMA. Importantly, the Guideline presents the criteria for determining whether a fractional investment product would be classified as a security under the FSCMA.
According to the Guideline, fractional investment products are highly likely to be categorized as an investment contract form of security when the expertise and the business of the entity that operates the business which is the subject of the fractional investment product (the “Business Operator”) significantly influence the investors’ return on investment. Detailed examples of such significant influence include the cases (i) where the role of the Business Operator is pertinent to the profit or loss on the fractional investment, (ii) when the success of the secondary trading market for the fractional investment product operated by the Business Operator critically impacts the profit and loss of the fractional investment and (iii) when it can be reasonably expected by the offerees of the fractional investment product at the time of investment, that the price of the fractional investment product would be correlated to the effort and capability of the Business Operator. On the other hand, when the fractional investment product does not fall under the above criteria and if an investor can fractionalize the investment it holds on its own and or is able to independently utilize, generate profits or dispose of the fractionalized investment, such fractionalized investment product is less likely to be categorized as a security.
2. Considerations Prior to Applying for the Financial Regulatory Sandbox
When a business plans to offer a fractional investment product that constitutes a security (“Fractional Investment Business”) it may apply for a provisional exemption from the FSCMA and related securities regulations, via the financial regulatory sandbox regime, pursuant to the Special Act on Support for Financial Innovation which has been in effect since 2019 (“Provisional Exemption”). The financial regulatory sandbox regime provides a special provisional regulatory exemption for certain financial services recognized for their “innovation” and “necessity”. “Innovation” can be demonstrated by the fractional investment product’s proposed contribution to the financial market, convenience to investors and growth of the market underlying the fractional investment product. “Necessity” can be demonstrated by the fact that securitization is a necessity to commercialize the market for the assets and rights derived from the assets which are the subject of the fractional investment product.
In the application for Provisional Exemption, a Fractional Investment Business must include a business plan that incorporates a system for investor protection such as (i) preparing appropriate explanatory materials and advertising standards/procedures to ensure that investors do not misunderstand important matters that can influence their investment decisions, (ii) depositing or placing in trust investor’s funds with an external financial institution so as to segregate the investors’ funds from the fund of the Fractional Investment Business and implementing measures to secure the return of investors’ funds in the event of bankruptcy of the Fractional Investment Business, (iii) implementing legally enforceable bankruptcy remote measures to protect the assets and related rights underlying the fractional investment product and the cash flow arising therefrom from insolvency of the Fractional Investment Business, (iv) prepare a ledger akin to a securities deposit ledger to clearly identify the rights among the investors of the fractional investment product, (v) establishing facilities and personnel necessary for investor protection, response to disruptions, information security, etc., and (vi) adopt policies for dispute resolution and a plan for compensating investors for any damages caused by the negligence of the Fractional Investment Business.
In addition, Fractional Investment Businesses, in principle, are not permitted to operate a secondary market for trading of fractional investment products offered by them. However, if they have an appropriate system to prevent conflicts of interest and operate a secondary market for fractional investment products, such Fractional Investment Businesses may be permitted to operate a secondary market for their fractional investment products on an exceptional and temporary basis until a broader secondary market for such products supported by an adequate operating system and rules develops.
3. Issues and Implications
The FSC has not only laid the groundwork for broadening the application of the securities regulation by utilizing the concept of an investment contract, but has also made clear its intentions to regulate the secondary trading market for investment contract securities. The Guideline is expected to not only expand the reach of securities regulation to new investment vehicles such as fractional investments but also bring about significant changes in the securities regulation itself.
On the other hand, the FSC has stated that investment contract securities are a type of securities that are not suitable for investor protection because investors’ rights are closely linked to the success or failure of the Business Operator. Thus, the FSC has encouraged Business Operators to establish a business plan that offers other types of securities, such as trust beneficiary certificates that ensures bankruptcy remoteness of the investor’s funds from the Business Operator’s insolvency (which itself is a requirement to obtain the Provisional Exemption). As the FSC’s intention is to apply the existing regulatory framework to broader types of securities products through the Guideline rather than adopt a new regulatory system for new types of investment products, it would be necessary to carefully monitor future amendments to the laws, regulations and supervisory policies.
In addition, the FSC’s principle is to separate issuance and secondary trading of securities. For early stage of Business Operators, the separation of issuance and secondary trading of new investment products is not easily achievable. In fact, most platform operators are in charge of both issuance and secondary trading of fractional investment products. Therefore, the effect of the Guideline on the market will not be small.
While the Guideline has clarified that capital markets laws and regulations are applicable to fractional investments, whether or not a fractional investment should be treated as a security will be determined on a case-by-case basis due to the wide variety of forms and transaction structures of fractional investments. Therefore, anyone engaged in, or intending to engage in, a fractional investment business should thoroughly review and assess whether the investment meets the criteria for categorization as a security. In instances where such a review does not clearly resolve whether the business model qualifies the investment as a type of security product, it is advisable to explain the business model to the financial supervisory authorities and obtain guidance on whether the fractional investment would constitute a security product.
In particular, if the business model of a Fractional Investment Business is deemed consistent with categorization as a security, the entity may be required to submit a securities registration statement. In such an instance, as seen in the Musicow case, many practical difficulties arise in making efforts to comply with existing regulations on the issuance of securities. Therefore, many Fractional Investment Businesses may be expected to apply for a Provisional Exemption. However, in order to establish the investor protection system prerequisite to applying for a Provisional Exemption, changes to the business model, entry into a business alliance with an external company, or attraction of larger scale investment may be required. To this end, it may be timely and necessary to thoroughly review the FSCMA and related regulations with the aim to devise creative alternatives.
In addition, the Guideline is expected to have a significant impact not only on fractional investments, but also on various rights and related businesses classified as new types of securities, such as NFTs, virtual assets, and securities tokens. In such case, considerable confusion in the market is expected to prevail in the near term as strict regulations under the FSCMA, such as public offering regulations, will apply to many businesses that have not previously been subject to securities regulations. Fractional Investment Businesses already engaged in potentially relevant businesses are advised to review the current status of their businesses, including whether the relevant business will remain sustainable and whether any additional legal issues pertaining to the business must be assessed if the investment would be considered as a security.
