TOKYO -- Chinese tech group Tencent Holdings' investment in wireless carrier Rakuten has revealed what some see as the limits of new Japanese investment rules meant to ensure such deals are vetted on national security grounds.
Japan amended its Foreign Exchange and Foreign Trade Act to tighten oversight on foreign investment into critical industries. When the revised law went into force in May last year, with China seen as the major impetus, it lowered the minimum stake requiring prior screening to 1% from 10%.
Yet a Tencent subsidiary gaining a 3.65% stake in Tokyo-based Rakuten in a share issue announced in March, which should have been a test case for the new rules, was not subject to a prescreening.
"It was a shock that Chinese capital was injected into a critical Japanese corporation with so little fuss," said a Japanese government source.
Tencent's investment in Rakuten caught Washington's attention. Shortly after the announcement, the U.S. embassy in Tokyo asked Japan's National Security Secretariat, as well as the finance, communications and economy ministries, on how the deal would be handled under the foreign investment rules.
In the end, the 65.7 billion yen ($604 million) share purchase by Tencent subsidiary Image Frame Investment, part of a 242.3 billion yen fundraising round, was not met with scrutiny.
The law provides for exemptions for such cases as investments that do not grant access to nonpublic technology. Investments that meet additional conditions, such as no board representation, are exempted from a prior notification requirement.
Whether an investment meets the exemption criteria is left up to investors to self-report. The Tencent group maintains the deal is a purely financial investment that is exempt from prior notification.
"Tencent's explanation that this is a purely financial investment is not entirely clear," said a Japanese government source.
This episode highlights the difficulties of prescreening foreign investment.
On top of lowering the minimum ownership threshold for triggering capital controls, Japan's government expanded the list of applicable Japanese investment targets to roughly 2,100, a majority of listed companies. At the same time, the government inserted broad exemptions in response to concerns by international investors that the new rules would disrupt normal transactions.
"These provisions were necessary to prevent a retreat from Japanese equities," said a source at a U.S.-invested brokerage. But they left room for entry by investors that present a real threat.
This contrasts with the oversight practiced by the Committee on Foreign Investment in the United States, which brings together experts from the Treasury, Defense and Energy departments. If a foreign investor is deemed to pose a significant threat, CFIUS is empowered to order the sale of the acquired shares after the fact.
CFUIS also conducts unofficial consultations prior to investment deals. Most foreign investments in the U.S. above a certain level require dealing with the committee.
Although Japan has the means to order divestments after the fact, its foreign investment rules lean more toward preliminary screenings. The reasoning is believed to be that the government lacks strong intelligence.
"The U.S. is uniquely placed to get away with heavy-handed measures," a senior Japanese industrial policy official said.
Masahisa Ikeda, a lawyer at Shearman & Sterling's Tokyo office, says strengthening only quantitative rules on foreign investment leads to loopholes.
"It is also effective to have measures to address threats, such as how the CFIUS requires companies to disclose the details of contracts," Ikeda said.
The Japanese government plans to monitor whether Tencent is complying with the exemption criteria, and whether Rakuten is safeguarding sensitive information from breaches, officials said. But it is unclear whether there are enough staffing and other resources in place.