Domestic and international private equity funds have played a
key role in triggering leveraged buyout (LBO) and management buyout
(MBO) transactions in Japan. With the advent of such players in
Japanese M&A, several commercial banks have emerged as
providers of debt finance to funds in search of new business
opportunities. Yet while the number of equity players has
increased, the number of debt financiers remains static and
limited.
In a number of transactions in 2004, equity investors sold their
shares in a target company to another investor. The buyer then
refinanced the company's debt, often before the debt obtained in
the original LBO/MBO had been repaid. The consequences of a
strategy built on conformity to scheduled repayments were not
always hedged against. Given this experience, financial
institutions seeking to provide finance for an LBO or MBO should
formulate an early exit strategy when structuring financial
schemes.
Capital/debt structures
Different share classes
The capital structure of a company is one of the main concerns
for equity investors in LBOs/MBOs. Recent amendments to the
Commercial Code of Japan allow a company to issue different classes
of shares, so that the company can grant greater control to certain
investors. The amendments allow equity investors, including the
emergent Japanese private equity funds, to create flexibility in
the equity component of the capital structure of a borrowing
vehicle by having that vehicle issue several different classes of
shares. These different classes might carry such disparate rights
as a priority to dividends or residual rights on liquidation.
Multiple layers of debt finance
To meet the desire of equity investors to leverage against the
financial condition of the borrowing vehicle, a financing party may
offer multiple layers of debt finance, such as senior or
mezzanine/subordinate debt. These layers are created by agreement
between the borrower and financiers, and between the financiers
themselves (through an inter-creditor agreement). These agreements
mitigate the potential conflicting interests of creditors.
There have been many financing schemes for LBOs/MBOs that have
involved absolute subordination of debt. Here, the parties seek to
subordinate a creditor to all of a borrower's other creditors and
to perfect that subordination agreement against third parties,
including the bankruptcy trustee. Examples include those agreements
created by Japanese banks in the 1990s to cope with the
requirements of the Bank for International Settlement (BIS).
In structuring schemes for absolute subordination of debt, the
right to repayment under such agreements was expected to be
characterized by the former Bankruptcy Law (hasan-ho) as a
conditional claim. This structure intended to allow a financing
party to perfect its subordinated loan against all creditors and
the bankruptcy trustee. Despite the number of such schemes, the
validity of the absolute subordination of debt remained
uncertain.
However, the subordination of debt created by contractual
agreement based on the understanding that subordination may not be
perfected against a third party, is generally legally valid.
Subordinated creditors will be obligated to deliver any funds they
receive under a bankruptcy procedure to senior creditors, based on
the inter-creditors agreement.
Bankruptcy law amendments
In the context of a subordinated debt structure and, in
particular, an absolute subordination of debt scheme, amendments to
the Bankruptcy Law, the Corporate Reorganization Law
(kaisha-kose-ho) and the Civil Rehabilitation Law
(minji-saisei-ho), effective January 1 2005, will likely
impact the structure of future transactions.
From the perspective of a financing party seeking to provide
multiple layers of debt finance, one of the most material
amendments is the promulgation of Article 99(2) of the New
Bankruptcy Law, which intends to give legal support to multiple
layers of debt finance. Article 99(2) explicitly permits financing
agreements (made before a bankruptcy procedure begins) that would
subordinate claims on the commencement of a bankruptcy procedure by
a debtor petitioner. The Corporate Reorganization Law and the Civil
Rehabilitation Law have similar provisions. These articles give a
financing party more assurance in structuring an absolute
subordination of debt finance scheme and, as its derivative, a
debt-debt-swap.
The amendments are also expected to motivate senior financiers
by giving assurance as to their validity to invite mezzanine
financiers to enter into absolute subordination of debt
transactions.
Types of debt, lien and assets
Debt finance
A joint stock company (kyumin-kaisha) is commonly used as
an acquiring vehicle or borrowing vehicle in an M&A asset deal
or stock deal respectively. It is a special purpose company and
neither holds assets nor enters into any significant transactions.
However, a financing party enters into LBOs/MBOs secured against,
or as an investment in, the value of an acquisition as a going
concern, rather than the value of the acquisition's assets.
Accordingly, LBO/MBO financiers seek to acquire management and
disposal rights over the stand-alone future cash flows that the
borrower generates out of the acquisition and contractual
relationships to which the borrower is a party.
To ameliorate any risk an LBO/MBO poses, the financing party
typically secures its position by two means. First, it obtains
security over the assets to be purchased by the lent funds.
Secondly, it obtains a pledge, exercisable on default under the
loan, of enough shares in the borrowing vehicle to give the
financing party not only a security interest on it but also,
sometimes more importantly, a controlling interest in the
vehicle.
The essence of a well-tailored LBO/MBO finance structure is the
creation of a valid security interest in the acquisition or
acquisition vehicle - specifically focusing on the cash-flow assets
that the vehicle generates. There are several means by which a
financier may be granted a security interest; which of these are
most suitable will vary according to whether the financing has been
by way of bonds or loans.
Bonds
Bonds issued to obtain debt financing may be secured against
collateral, subject to the terms of the Law Concerning Secured
Bonds Trust (tanpotsuki-shasai-shintaku-ho). That law
regulates the issuance of bonds used for secured transactions,
stipulating that such bonds must be subject to a trust agreement
between the issuer and a trust company. The trust company must have
authority over management of the bonds for the benefit of the
bondholders.
There have been few cases in Japan where a secured LBO financing
has been effected in this manner. This appears to be mainly because
of the rigid requirements of the Law Concerning Secured Bonds Trust
in respect of the formality of the trust deed, the narrow range of
liens and collateral that it permits and the costs involved.
For investors seeking capital gains upon a bond issuer going
public, as well as interest accrued from the bonds, one of the
viable financing options in an LBO/MBO is the issuance of bonds
with stock acquisition rights (shinkabu-yoyakuken-
tsuki-shasai). In these cases, the bondholders have an option
to subscribe for shares in the issuer company pursuant to the
conditions previously agreed between the issuer and the
bondholders.
Loans
Loans are the most common form of debt financing in an LBO/MBO,
mainly because lenders are not subject to any extraordinary
requirements to create a security interest.
In an LBO/MBO, a borrower frequently has several different
financial needs. Revolving credit facilities, often called
commitment lines in Japan, and term loan facilities are commonly
used to satisfy those needs. Commitment lines are especially
suitable for providing working capital to the borrower. Under such
facilities, advances are made available to the borrower on
satisfaction of certain conditions precedent.
Term loan facilities may be divided into several categories
according to the use of the proceeds. Straight lending is provided
to fund purchases of a business, shares, or other types of assets,
which are usually purchased with lump sum payments. Multi-step
loans, which operate by advancing funds to the borrower each time
it executes an acquisition agreement with a seller, make several
drawdowns possible and are especially suitable for funding separate
purchases of several assets.
Typically, the loan facilities in an LBO/MBO are large. Given
that few banks that will expose themselves to such a credit risk
welcome such a large exposure, a borrower usually seeks finance
from a syndicate of lenders. However, it is sometimes difficult for
a borrower to attract a sufficiently large syndicate of banks,
partly because of the tight timeframe in which financing must be
provided in conjunction with an M&A. The trend is for a lead
arranger bank to underwrite the facility and later assign parts of
the loan to other financial institutions, except for those
transactions where the amount of loan facility is too large to
underwrite. The arranger bank thus enjoys higher fees on the
closing than those realized in situations where syndication is
formed at closing.
Security package
It is commonly accepted that for a financing party in an LBO/MBO
to secure the financing as well as monitor the management of the
company, the financier should be granted a priority security
interest over all, or substantially all, of the assets of the
target company, such as inventories, receivables, promissory notes,
bills of exchange, bank deposits, real property, intellectual
property and securities.
In Japan, however, there is no statute allowing a borrower or a
third party to grant to a financier a security interest over all of
the target company's assets, except for corporate collateral as
discussed below.
Possibility of corporate collateral
For a financing party hoping to be granted a security interest
over all of a borrower's assets, one viable option (modelled on the
concept of a floating charge) is corporate collateral
(kigyo-tanpo-ken). This, however, remains unpopular in
Japan.
One reason for this is that it is only available to bond issuers
and bondholders, not lenders. Also, the Commercial Code allows only
a joint stock company (kabushiki kaisha) to issue bonds.
Consequently, any vehicle providing corporate collateral must be a
joint stock company, restricting the parties' choice of company to
raise funds. Another concern is the lack of strength over
perfection of corporate collateral, which may not be as inviolable
as other types of collateral stipulated in the Civil Code of Japan.
For example, if a borrower grants corporate collateral to an
investor and subsequently grants creditors a security interest over
particular assets of its business, the investor will be subordinate
to such creditors; that is, the general grant will be subordinate
to the specific grant. However, this lack of strength might be
useful when creating secured corporate collateral for the benefits
of mezzanine creditors.
Given these difficulties, the Ministry of Economy Trade and
Industry is discussing whether changes to the law addressing
corporate collateral should be made. The specifics of those
amendments have yet to be discussed.
Creating security
Based on the foregoing, a financing party in Japan can only
obtain security similar to a floating charge by obtaining from a
borrower, and any other party with an interest in the borrower's
assets, progressive pledges over each asset the borrower owns. This
results in extra time and costs involved in completing the loan and
security documentation.
Liens
Since 2003, there has been a surge in new legislation relating
to security interests in Japan, including an amendment of the Civil
Code relating to collateral and civil enforcement; the
establishment of a registration system for assignment of movable
assets (dosan-joto-ni-kakaru-koji-seido); and an amendment
of the Special Exceptions Law on Assignment of Loan Receivables
(saiken-joto-toki-toku-rei-ho).
A key purpose of these changes has been to encourage commercial
banks to extend debt finance to small and medium-sized companies.
The government hopes that funds will become available to such
companies at lower interest rates in exchange for reduced risk
resulting from the ability to obtain security interests over
receivables and movables.
The legislative changes will have a significant impact on legal
practice in creating security interests generally, and in LBOs and
MBOs specifically.
Collateral over movable assets
In Japanese banking practice, the creation and perfection of a
security interest over movables (do-san) used to be
completed by delivery by way of a declaration of possession
(senyu-kaitei-ni-yoru-hikiwatashi). This practice was based
on the Supreme Court of Japan's interpretation of the meaning of
delivery in Article 178 of the Civil Code. Article 178 sets
out the means to perfect a transfer of a right in movables. Those
means include four types of delivery, one of which is delivery by
way of a declaration of possession. Such delivery creates a
security interest over a moveable asset by way of assignment
(joto-tanpo).
In addition to delivery under the Civil Code, registration under
the system of registration for the assignment of movables may be a
further means by which lenders may perfect assignment of, or
security over, movables. Accordingly, the existence of an
assignment of or security over a movable will be easier to
determine from the registered record than those created by delivery
under the Civil Code.
However, it is likely that the legislation for the new
registration system will not give the system the capacity to
perfect; at least not to the extent that it will supplant the
current system of perfection by delivery under the Civil Code.
Therefore, because the risk of security interest being created by
delivery before registration still exists, the prudent lender
should check, before entering into a financing transaction, whether
the movable to be used as security for the lender had at any time
been assigned by the borrower to a third party by delivery.
Including representations and warranties from the borrower to this
effect in the loan and security agreements may to a certain extent
reduce the risk posed by an earlier transfer.
Collateral over receivables
A series of judgments handed down by the Supreme Court of Japan
has strengthened the legal basis for creating security interests
over receivables by way of assignment. In those judgments the
Supreme Court declared that the common practice of assigning
present and future receivables, including healthcare, lease and
consumer loan receivables, is permissible under Japanese law and
that such assignment may be perfected. The only qualification is
that validity can only occur if the assigned receivables can be
distinguished, by description under the loan and/or security
agreement, from other receivables that the subject borrower owns or
will own.
Following these decisions, the amendment to the Special Law on
Assignment of Loan Receivables seeks to broaden the range of
funding tools available to borrowers by removing the requirement to
record the name of the debtor in the register. The consequences of
this are greater than a simple reduction in the information that
must be recorded.
A security interest may be created over receivables for the
benefit of lenders even if, at the time, no underlying transactions
exist that could originate receivables to which the borrower is a
creditor. (The Supreme Court has declared that the contingent
nature of such receivables is irrelevant to the creation and
perfection of a security interest over them.) With this amendment,
the borrower may obtain finance backed by future receivables more
extensively.
Rise of the security trustee
Although there are a lot of secured syndicated loan transactions
in Japan, judicial decision appears to clearly adopt or approve a
security trust arrangement that is structured in the same manner as
those typically used in the UK. Legal practitioners in Japan have
long understood that whether security trusts are permissible under
the current legal system is dependent on a broad interpretation of
the Civil Code.
The main benefits available to lenders from introducing a
security trustee are: a simpler method of creating security
interests; easier management and maintenance of collateral;
reduction in registration expenses and other transaction costs; and
revitalization of the loan trading market.
These benefits seem attractive to LBO/MBO financiers given that
loans are frequently syndicated and secured and, under the current
law, rights and obligations among syndicate members, are
complicated.
There have been some ambitious discussions on whether Japanese
law supports concepts of security trusts and security trustees and
several issues remain, including the treatment of a security
trustee in the real estate registration system and in a civil trial
procedure, and the treatment of a security trust for lenders in a
bankruptcy procedure. These issues must be resolved before the
security trust and security trustee are accepted in the legal
system.
Author
biographies
Minoru Ota
Nagashima Ohno &
Tsunematsu
Minoru Ota is a partner of Nagashima Ohno & Tsunematsu
(admitted to the Bar in Japan in 1987). He specializes in banking,
environment and corporate finance.
Kentaro Suzuki
Nagashima Ohno &
Tsunematsu
Kentaro Suzuki, is an associate of Nagashima Ohno &
Tsunematsu, and a graduate of Keio University (LLB 2000). Suzuki
joined the firm in October 2001, and has since practised mainly in
the field of finance.
Nagashima Ohno & Tsunematsu
Kioicho
Building
3-12, Kioicho, Chiyoda-ku
Tokyo 102-0094, Japan
Tel: +81 3 3288 7000
Fax: +81 3 5213 7800
Web site:
http://www.noandt.com/