The Japanese project finance market has grown rapidly in recent
years. It has typically involved private finance initiative (PFI)
projects, but more recently private sector projects such as
independent power producer projects, telecommunications
infrastructure and theme parks have been financed. Changes in
financing methods have not, however, matched the innovation in the
use of project finance. Bank loans remain the only tool available
for financing projects in Japan.
Yet some market participants have begun to recognize the need to
use bonds in addition to bank loans to finance projects. The
attraction is that project bonds can supply a large amount of
long-term capital.
Using the capital markets
A number of efforts have been made to expand the role of the
capital markets in Japanese project financing in recent years. In
2000, for example, the Osaka Securities Exchange established the
PFI market to help project companies raise funds by offering debt
or equity securities. But not a single project company has listed
securities on the PFI market.
In 2004, bankers and lawyers active in PFI published a report
identifying the need for capital market financing and related legal
reform. The Committee for the Promotion of PFI, an official
advisory body set up under the PFI Promotion Act, has also
published a report identifying the need for capital market
financing for PFI projects and has asked the Ministry of Justice to
make the necessary legal reforms.
Given the strong support for more project-related capital market
financing it is inevitable that project bonds will be issued in
Japan soon. However, a number of legal and practical hurdles must
first be overcome.
Security interest
No floating charge
A typical English law-governed project finance loan or bond is
secured by a floating charge over all the assets of the project
company. Japanese law has a similar security interest called an
enterprise mortgage (kigyou tanpo), which covers all of the
assets of a company. However, an enterprise mortgage ranks junior
to a security interest established over specific assets and also
ranks junior to other security interests for the purpose of
insolvency proceedings. In practice, this makes it highly unlikely
that the holder of an enterprise mortgage will recover much in
insolvency proceedings.
Japanese law also has a security interest called foundation
collateral (zaidan teitou) that covers all of the assets
identified in a list of assets. However, foundation collateral is
only available over certain specific types of real property,
including factories and hotels. As a result, foundation collateral
is not available to many businesses. The asset list also must be
registered and updated periodically; a burdensome procedure. So as
a matter of practice, bondholders cannot rely on these blanket
security interests and have to establish security interests on an
asset-by-asset basis.
Historically, it was difficult to perfect a security interest
over receivables and personal property. To address this problem, a
law creating a receivables assignment registration system was
enacted in 1998 to enable the perfection of an assignment of
receivables by making a simple filing. In November 2004, the law
was amended to enable the perfection of an assignment of
receivables from an unspecified obligor (for example, the
assignment of receivables from an unspecified ticket buyer). The
amended law also established a filing system perfecting assignments
of personal property. These reforms make it is possible to
establish and perfect security interests over almost all the assets
of a project company, provided those assets are identified
individually.
Security trustees
Because project bonds will be held by a large number of
bondholders and frequently traded, it is necessary for one entity
to hold the security interest in the collateral for the benefit of
all bondholders. This entity (often referred to as a security
trustee or security agent) is a familiar concept in common-law
jurisdictions. However, under Japanese law only a creditor can hold
a security interest in collateral; a security interest held by a
security trustee on behalf of others is void. The only statutory
exception to this general rule is a security trustee established
under the Mortgage Debentures Trust Law (Tanpotuki Shasai Shintaku
Hou).
However, the Law, enacted in 1905, does not allow much
flexibility in structuring. It has many limitations as a tool for
issuing project bonds. First, the types of permitted security
interests are limited. For example, a security assignment is not
permitted. Secondly, to change or amend the security interest
approval, a meeting of the bondholders is required. This means that
every time a project company sells or buys assets, the project
company must seek the bondholders' approval. Thirdly, the security
trustee is obliged to enforce the security interest without delay
when the bond is accelerated. This means that there is no room to
negotiate a restructuring with the project company's creditors.
Finally, the only permitted method of enforcing the collateral is
compulsory execution or auction in accordance with the Civil
Enforcement Act. This means that the security trustee cannot sell
the entire business of the project company on mutually negotiated
terms. These four factors make it difficult to issue project bonds
under the Mortgage Debentures Trust Law.
The Committee for the Promotion of PFI has requested that the
Ministry of Justice reform the Mortgage Debentures Trust Law. The
Ministry has expressed its readiness at least to abandon the
restriction on the types of security interest that are permitted,
but it is not clear whether, or when, all of the limitations
outlined above will be addressed by the reform. It is still
unclear, therefore, whether it will be possible for project bonds
to be issued in accordance with the Mortgage Debentures Trust
Law.
Possible solutions
One possible way to overcome the Law's limitations would be to
use the structure illustrated in diagram 1. In this simple
structure, a special purpose company (SPC) established solely for
financing issues unsecured bonds and uses the proceeds to make a
secured loan to the project company. The bonds issued by the SPC
are not legally secured by payments under the project finance loan,
to avoid the application of the Mortgage Debentures Trust Law. It
is not clear, however, whether the market would accept this type of
unsecured project bond.
A second possible solution would be to use a trust to secure the
bonds. In this structure, the project company would assign all of
its assets to a trustee. The trust agreement would provide that,
until a default event occurs, the trustee would hold the assets for
the benefit of the project company and would grant the project
company a contractual right to continue using those assets for the
purpose of its business. However, if a default event occurs, the
trust agreement would provide that the beneficial interest in the
assets would be transferred to the bondholders.
An advantage of this scheme is that it allows secured bonds to
be issued virtually free of the restrictions of the Mortgage
Debentures Trust Law. The Government Housing Loan Corporation has
already used the scheme to issue residential mortgage-backed
securities. However, under the Trust Business Act, a trustee is
prohibited from being entrusted with assets other than money,
securities, receivables, personal property, real estate and certain
leasehold interests. Other assets, such as intellectual property,
cannot be transferred to a trust, although this limitation will be
abolished when amendments to the Trust Business Act come into
effect in February 2005.
Although perfecting security interests is still a legal hurdle
to issuing project bonds in Japan, thanks to recent law reform it
seems that this issue can now be overcome to a considerable extent
by using the trust structure described above. However, this
structure has only ever been used to securitize financial assets so
practical and legal problems will be encountered when first
applying it in the context of project bonds. For example, the
contractual arrangements giving the project company the right to
possess and use the trust assets to operate its business will need
to be carefully structured. In addition, Japanese trustees may be
reluctant to become involved in such a complicated trust with no
existing precedents to guide them in its proper administration.
| Diagram 1 |
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| Diagram 2 |
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Monitoring
Monitoring refers to activity by an agent of lenders or
bondholders to oversee the compliance by the project company of its
obligations under the terms of the loan or bond. This sometimes
includes discretion to consent to certain actions by the project
company and to waive minor breaches of the loan or bond
covenants.
Some lawyers and other market players argue that a person who
monitors compliance with the terms of a project bond ought to have
broader discretion and flexibility than one who monitors compliance
with the terms of a project finance loan because of the practical
difficulty of obtaining prompt and appropriate consent from a
potentially large number of bondholders. Project bonds issued in
the Euromarket sometimes give the trustee broad discretion to
consent to amendments of the bond covenants. However, trustees in
Japan are reluctant to exercise such discretion because of the risk
of increased liability. So another practical hurdle for project
bonds in Japan is finding someone to monitor compliance with the
terms of the bonds.
Exemption from liability
Before a trustee will accept such a risky role it is important
to make clear in what circumstance the trustee will be released
from liability to bondholders. Project bonds issued in the
Euromarket sometimes exempt the trustee from liability if it
exercises discretion to consent to an amendment to the bond terms
based on advice from a third party or if the amendment does not
trigger a downgrade. If similar exemptions from liability are valid
under Japanese law then trustees may be more willing to accept a
greater role in monitoring compliances with bond covenants.
Under Japanese law, a bond trustee is given two types of
authority to act on behalf of bondholders. One is a statutory
authority under the Commercial Code, including authority to receive
money from, and to make inspections of, the issuer. The other
authority is granted by the agreement, including authority to
consent to certain action by the issuer or to trigger acceleration
when the issuer breaches bond covenants.
Most of the authority that is unique to project bonds would be a
similarly agreed authority. Under Japanese law, a trustee is
obliged to act in accordance with the duty of due care of a good
manager when exercising statutory authority. A trustee cannot
contract out of this obligation. On the other hand, an exemption
from liability when exercising an agreed authority would be valid.
Therefore, it is legally possible to exempt the trustee from
liability in the exercise of the type of discretion required for a
project bond.
However, a proposed amendment to the Commercial Code would
require a trustee to act in accordance with the duty of due care of
a good manager when exercising an agreed authority as well as a
statutory authority. If this amendment is approved, it is not clear
whether the trustee could be exempted from liability even if it has
acted in accordance with agreed procedures or standards.
Monitoring by lenders or monoline insurers
Because of the historical reluctance of Japanese trustees to
exercise their discretion and the uncertainty relating to the
proposed amendment to the Commercial Code, it may be more realistic
for a party other than the trustee to monitor compliance with the
terms of a Japanese project bond.
There are two possibilities. One is monitoring by lenders (or an
agent of the lenders) when both bonds and loans are used to finance
the project. In this case, bondholders will not be given discretion
except for certain material judgments and the lenders will decide
most other matters. The other possibility is monitoring by a
monoline insurer when the bond is guaranteed by that insurer. In
this case, a monoline insurer who takes the risk of the project
would have discretion over all matters relating to the terms of the
bonds.
To persuade lenders or monoline insurers to monitor compliance
with bond covenants they would need assurance that they would not
be liable to bondholders for the reasonable exercise of their
discretion. The statutory liability under the Commercial Code
described above applies only to a trustee. However, general agency
principles will apply and the agency agreement will need to be
carefully structured to exempt the lender or monoline insurer from
liability for the reasonable exercise of their discretion.
Another practical issue is whether bondholders would agree to
allow bank lenders or monoline insurers to exercise discretion on
their behalf because they may well have different interests from
bondholders if the project company breaches the bond covenants.
Overcoming these practical problems will probably involve
negotiating appropriate commercial terms to compensate the various
parties for the risk they are exposed to.
In spite of the proposed amendment to the Commercial Code it
should be possible to use a structure where a party other than the
trustee monitors compliance with the terms of the project bonds. So
it seems that the monitoring issue is basically a commercial issue,
and one that can be resolved soon.
Whole-business securitization
In the UK, if a project company (together with a project
sponsor) enters insolvency proceedings, a secured creditor of the
project company can maintain control over the business of the
project company by appointing an administrative receiver who acts
solely for the benefit of the secured creditor. This scheme is
known as a whole-business securitization. A significant benefit of
this scheme from the perspective of the project company's creditors
is that it helps to insulate the project company from the credit
risk of the project sponsors. This semi bankruptcy- remoteness
allows the project company to obtain a slightly higher credit
rating (and so slightly cheaper financing) than the project
sponsors.
In Japanese insolvency proceedings, a trustee appointed by the
court or insolvency debtor-in- possession must act for the benefit
of all the creditors and the rights of secured creditors will be
affected by the insolvency proceedings. If a project sponsor goes
into corporate reorganization (kaisha kousei) proceedings,
secured creditors of the project company can only receive payment
in accordance with the reorganization plan. As a result, the rating
of the project company will be affected by the rating of the
project sponsors, which could result in higher financing costs than
the project would receive as a standalone company.
Because of this, some market participants have recently been
calling for the development of a Japanese whole business
securitization scheme. One possible way to insulate the project
company from the credit risk of its sponsors would be to establish
a security interest over the assets of the project company and then
use a corporate governance structure that limits the ability of the
project sponsor to avoid insolvency proceedings commencing against
the project company.
For example, the project company could issue a special share to
a third party with veto rights over significant actions, such as
making a petition for the commencement of insolvency proceedings or
the power to appoint directors of the project company after certain
credit events. This type of structure together with appropriate
financial covenants by the project company could help to make it a
semi bankruptcy-remote vehicle acceptable to rating agencies and
the market. If a Japanese whole business securitization scheme is
successfully established, Japanese project companies could achieve
financing on more attractive terms.
The sooner the better
There are significant hurdles to successfully launching project
bonds in Japan. However, with careful structuring, all of these
hurdles will be overcome soon. The sooner that happens the sooner
Japanese project companies will be able to enjoy access to a new
source of long-term capital.
Author
biography
Takeshi Mukawa
Mori Hamada &
Matsumoto
Takeshi Mukawa is an attorney with Mori Hamada & Matsumoto.
He was admitted to the bar in 1998 in Japan after being educated at
the University of Tokyo (BAg, 1996) and the University of
California, Davis School of Law (LLM 2002). He worked at Morgan
Lewis & Bockius in New York from 2002 to 2003. His practice
covers every legal aspect of finance, including project financing
and securitization. He is a member of the Tokyo Bar
Association.
Mori Hamada & Matsumoto
Marunouchi Kitaguchi
Building
1-6-5 Marunouchi, Chiyoda-ku
Tokyo 100-8222
Japan
Tel: +81 3 5223 7777
Fax: +81 3 5223 7666
www.mhmjapan.com