Japan

In the past few years, Japanese domestic and cross-border asset securitization markets have experienced significant growth. Various factors such as the emergence of new asset classes, innovation in legislation and regulation as well as the adoption of newly innovated structures have extended the issuance of asset-backed securities in Japan, reportedly up to ¥2 trillion in 1999. In particular, while securitization of equipment lease receivables, auto loan receivables and installment credit receivables have enjoyed steady growth, expansion of real property related securitization has swept the Japanese asset-backed securities markets within the past year.

The Japanese government initially established a foundation for a vibrant asset-backed securities market by promulgating a number of legal and regulatory initiatives as part of Japan's wider financial deregulation programme. The government has supported the further development of the market by promulgating amendments to the so-called SPC Law and to the so-called Investment Trust Law, both of which will become effective no later than November 23, 2000.

Recent Innovations in Japanese Securitization

New structures

As the securitization of lease receivables, auto loan receivables and installment credit receivables has matured, these products have evolved structures that allow more cost-efficient, time-reducing and attractive investment, such as:

(i) the first domestic master trust structure (publicly offered issuance) – this structure has many features unique to the Japanese market and it allows serial issuances to occur more quickly with the benefit of the shared credit/liquidity enhancement. However, for certain legal and business reasons, such as procurement of the structure being isolated from the application of the so-called Specified Claims Law (tokutei saiken ho) which, if applied, would impose certain restrictions (eg restrictions on sales and resales of the trust certificates), trust beneficiary interest (or trust certificate) has been repackaged into an ABS issued by a TMK (or tokutei mokuteki gaisha, an SPC incorporated under the SPC Law);

(ii) issuance in the euro-market using a TMK – allows the originators to choose the then-attractive markets for the issuance. However, a potential Japanese withholding tax risk has, amongst other factors, restricted the introduction of the structure to off-shore investors;

(iii) direct sales of trust beneficiary interests (trust certificates), with the increased recognition of asset-backed transactions, certain domestic investors have matured enough to directly purchase trust beneficiary interests that have not been repackaged into securities under the Securities and Exchange Law of Japan (SEL). (In the earlier stages, Japanese domestic investors would only invest in instruments which would then be regarded as securities); and

(iv) various asset-backed commercial paper (ABCP) programmes – as is the case in the United States and in the European markets, Japanese banks tend to shift from fully-supported programmes to partially-supported programmes; and a multi-seller partially supported programme with joint sponsors, an arbitrage ABCP programme and a domestic ABCP programme using a TMK as a CP conduit have been introduced to the Japanese ABCP market within the past year.

New asset classes

Besides real property securitization (which is described more fully below), perhaps the most notable new asset class securitized in the past year was non-performing mortgage loans. The second securitization of non-performing Japanese mortgage loans was completed in the United States this summer, after the first successful securitization that took place last year.

Another new asset class that attracted peoples' attention was residential mortgages. Several unique features of Japanese residential mortgages, impacted upon their securitization, including mortgages being created by obligors for the benefit of guarantee companies rather than lenders, variations in the contracted interest rates and difficulties arising from the tax treatment of residential mortgages. Nonetheless, several commercial banks such as The Mitsubishi Trust and Banking Corporation, The Dai-ichi Kangyo Bank, and The Fuji Bank, and non-bank financial companies such as The Dai-ichi Mutual Life Insurance Company have succeeded in securitizing residential mortgage portfolios in the Japanese domestic market. In addition, with the necessary amendment to the Government Housing Loan Corporation Law being effected this April, the Government Housing Loan Corporation (GHLC), a Japanese governmental financial corporation which generates a significant portion of residential mortgages in Japan, has officially announced its intention to issue its first mortgage backed securities using a new structure intended to take advantage of the fact that GHLC is not a joint stock company to make the structure bankruptcy remote (in fact, there is an argument that GHLC would not be subject to insolvency proceedings). Securitization by GHLC of its residential mortgages is anticipated to be the start of a further development of the Japanese asset-backed securities market, as was the case with GNMA, FHLMC and FNMA in the United States markets.

Securitization of other new asset classes, such as future cash-flow trade receivables, health care receivables, ship building receivables, small-sized business loans and convertible bonds have been carefully structured and introduced to the Japanese asset-backed securities market. Further so-called CAT bonds or insurance securitization have succeeded as well.

New players

In the course of Japan's fiscal reformation of governmental authorities or government-owned special corporations (ko-hojin) , the government has encouraged governmental corporations to obtain financing from sources other than the government budget. In response, certain governmental corporations such as GHLC (as described above) are beginning to show interest in asset-backed securitization.

The Japanese government has involved itself as one of the new players in the market with the Ministry of Finance selling some government-owned real properties through an auction procedure on condition that the properties are securitized through the use of a TMK. In addition, the Tokyo Metropolitan Government has become indirectly involved in the securitization of small business loans (ie, loans made to small-sized companies) as part of its policy of encouraging small-sized businesses in the prefecture.

In relation to the securitization of real properties, real property development and management companies and life insurance companies are also entering the scene.

Real Property Related Securitization

Securitization related to real property was successfully brought to the public markets beginning in June 1999, notwithstanding certain practical difficulties. These include difficulties in evaluating real property, cumbersome enforcement procedures under Japanese law, the perceived involvement of organized criminal groups in the distressed property market and Japanese domestic tax issues which had restricted most of the transactions to private issuance.

Basic structure and features

Many real property securitizations in Japan have adopted a sale and lease-back structure where an SPV acquires real property held by the originator and leases it back to the originator. This typical Japanese structure differs from the typical CMBS structure in the United States. Despite the difference within the structures, the feature whereby securities are backed by the value of real properties remains common.

The other significant features of real property securitization in Japan are that: (i) almost every structure uses a real property trust as an SPV primarily to avoid imposition of relatively high tax rates on the transfer of ownership of the real property; (ii) one of the main purposes of the securitization is for the originator to enjoy off-balance-sheet treatment in respect of such real property and to acknowledge profit at the level of the originator (mainly for accounting purposes as current market value accounting principles will become applicable shortly); and (iii) in a number of transactions, exit strategies are designed to provide the originator with the opportunity to repurchase the real property before transfer to third parties.

Types of securitized real properties vary from the originator's main office building, commercial office buildings, condominium buildings, department stores, hotels, shopping centres to gas stations. Of course, each type of real property involves different kinds of legal, business and practical issues, so careful structuring, due diligence and satisfactory disclosure to the investors are needed.

Credit enhancement and liquidity enhancement have been provided by the originator in most cases by retaining subordinated beneficiary interests in the aforementioned real property trust or by using a tokumei kumiai contract, an unique Japanese limited partnership contract, entered into by the issuer of the asset-backed securities and the originator under which profits and losses in relation to the real property would be distributed and absorbed by the originator.

Change in accounting principles

Despite the increasing recognition and desire on the side of potential originators, real property securitization in Japan may be materially affected by a recent change in Japanese accounting principles. The Japanese Institute of Certified Public Accountants recently published its Practical Principles Concerning Accounting Treatment of Assignor in Liquidation of Real Property Using Special Purpose Companies which would be applied to new securitization transactions completed on or after August 1, 2000. These principles provide that, amongst other things, the so-called risk/reward approach would be applied to a sale and other disposition (including entrustment) of real properties and that an assignor (originator) could remove any real property from its balance sheet only if the risks/benefits associated with such real property retained by it fall within the range of approximately 5%. The reasoning is that, under such an approach, an assignor of real property should only be able to enjoy the off-balance treatment where almost all the risks/benefits of such real property are transferred to the assignee.

Prior to the application of this new accounting principle, there was no specific rule for off-balance treatment by an assignor of real property, and only certain loose criteria in relation to "sale and lease-back" transactions (which almost all securitization transactions would automatically fulfill) were applied. Therefore, in certain transactions, the subordinated portion or equity portion held by the originator accounted for up to approximately 50%. or more.

Under the new accounting principle, potential originators are now seeking sophisticated investors willing to invest in the (high yield but high risk) equity portion or subordinated interests in the transaction in order for the transaction to enable the originator to enjoy the off-balance-sheet treatment of the real property upon securitization. In this context, J-REITs as described below are anticipated to function as one type of such investor.

The new accounting principle could raise a new legal issue in respect of the true sale issue as well. Japanese legal counsel may need to opine on whether a transaction could still be determined to be a true sale of real property even when the originator would not be permitted to remove such real property from its balance sheet under the new principle.

Tax treatment

Another important subject in the context of real property securitization in Japan is the tax issues. As indicated above, relatively high tax rates are imposed in relation to the transfer of real property. Registration tax, real property acquisition tax and consumption tax are applicable to the acquisition of real property, on top of capital gain taxation (if any), and land value tax, fixed asset tax and city planning tax are applicable to the holding of real property. This restricts flexible structuring and disadvantages both the originator and the investors.

There have been and probably will continue to be demands from the Japanese asset-backed securities markets for amendment to the relevant tax laws.

New Legislation and Regulations to Come

The Japanese government has significantly contributed to the development of the Japanese asset-backed securities market by passing new legislation and amending various existing laws. This continuing evolution in the legal and regulatory landscape has made issuance in both the Japanese domestic and cross-border securitization markets significantly easier (although there still remain a number of legal difficulties in securitizing any type of asset class).

As described above, the Japanese government has made a further contribution to this evolution, encouraging the Japanese asset-backed securities market to move to a more sophisticated level. On May 23, 2000, the Japanese Diet passed and promulgated an amendment to the SPC Law and concurrently, within the same bill, an amendment to the Investment Trust Law facilitating further development of the market.

Amendment to SPC law

The SPC Law was initially enacted in June 1998 (and became effective in September 1998) in an attempt to facilitate the use of a domestic SPV. For this purpose, the SPC Law includes the following features with about fifty transactions to date using a structure within the act:

(i) the law decreases the cost of formation compared to other types of domestic corporations that could be utilized as SPCs by having a minimum capital requirement of only ¥3 million (as compared to ¥10 million for joint stock companies (kabushiki gaisha)) and by requiring appointment of only one director (as compared to three for joint stock companies);

(ii) it allows a TMK to issue three different types of asset-backed securities to investors, ie, ABS, ABCP and preferred shares (yusen shusshi);

(iii) it allows a TMK to purchase and acquire different types of assets, ie, monetary payment obligations, ownership rights in real property and trust beneficiary interests with any of the foregoing types of assets being the trust assets;

(iv) for the purpose of providing protection to investors, the law requires certain procedures to be taken, eg, registration of the TMK itself and of the TMK's "asset securitization plan" (shisan ryudoka keikaku) with the government, filing of the TMK's "assets securitization implementation plan" (shisan ryudoka jisshi keikaku) and restriction of amendment to the TMK's asset securitization plan;

(v) it grants general liens (ippan tanpo) to the holders of an ABS issued by a TMK on the assets of such TMK for the purpose of securing such holders' rights;

(vi) it provides a framework to ensure the isolation of a TMK from bankruptcy, eg, prohibition both on disposition of assets backing its securities and on borrowing, except as otherwise specified in such TMK's asset securitization plan, and prohibition also on engaging in any business activities other than those activities in connection with the securitization in accordance with its asset securitization plan; and

(vii) it grants certain tax benefits – eg, reduction in real property-related taxes, ie, registration tax and real property acquisition tax.

However, despite such features, practitioners and scholars have complained that the law has a number of limitations and difficulties that limits its use. One practical difficulty is that formation and registration of a TMK takes too much time. The SPC Law requires an asset securitization plan to constitute a part of the articles of incorporation of a TMK and the registration procedure with the government authority takes up to approximately two months from the application. A second difficulty is the uncertainty regarding the legality and validity of incorporating a limited recourse clause to the terms and conditions of an asset-backed securities (ABS) issued by a TMK. This is due to the fact that the holders of such ABSs are granted general lien on the TMK's assets under the SPC Law, and such difficulty results in restricting a TMK from serial issuance of securities. Another similar difficulty is that it is currently practically impossible to find a swap counterparty to engage in a swap agreement with a TMK due to the fact that holders of such securities would be prioritized in receiving payments from such TMK over any swap counterparty. Thirdly, under the framework provided by the SPC Law, satisfactory bankruptcy remoteness could not be achieved. The law does not eliminate or reduce to an acceptable level the possibility that an originator-related director be appointed, and a holder of preferred shares (yusen shusshi shain), which are usually issued and subscribed by the originator in a real property securitization, has the right to remove a director and elect a replacement. Due to such reason, rating agencies require specified shares (tokutei mochibun) in a TMK to be held by an off-shore vehicle (such as Cayman Islands companies the shares of which are in turn held in a charitable trust). Such arrangement could be cumbersome and expensive. Fourthly, the rules under the SPC Law lack flexibility with respect to the redemption of equity share. Finally, restrictions on assets that could be purchased by a TMK continue to be regulated limiting the situations in which a TMK could be used.

The Japanese government, having realized the limitations and difficulties, has promulgated amendments to the SPC Law. Although the amendments have not been effected to date, and a significant part of the regulatory framework is to be more precisely stipulated in the ministry ordinances which have not been promulgated, the amendment includes the following features:

(i) the minimum capital requirement will be reduced from ¥3 million yen to ¥100,000;

(ii) registration system would be abolished and only prior filing (as opposed to registration) of a TMK would be necessary, and an asset securitization plan would not be a part of a TMK's articles of incorporation. However, an asset securitization plan is required to be filed with the government authority concurrently with the filing of a TMK;

(iii) assets that could be purchased and acquired by a TMK will be expanded, eg, a TMK could be used in a collateralized bond obligation (CBO) deal or equity securitization deal;

(iv) although there remain certain legal issues in connection with other regulations (eg regulations relating to the Anti-monopoly Law of Japan), a stronger framework will be provided to ensure bankruptcy remoteness by allowing elimination of voting rights of a holder of preferred shares by providing to that effect in the articles of incorporation and by introducing a new concept of entrustment of specified shares which are designed to eliminate or reduce the influence of a holder of a specified share attempting to facilitate purely domestic deals without the need for use of off-shore SPVs (eg, the entrustor of a specified share would be prohibited from giving instructions to the trustee regarding the trust assets and the trust could not be terminated during the term of the instruments issued by such TMK);

(v) preferred shares may be redeemed prior to the expiration of the asset securitization plan – giving more flexibility to structuring;

(vi) a general lien may be eliminated if so stated in the asset securitization plan – this may allow issuance of limited recourse asset-backed securities and may make it easier to find swap counterparties. The amendment allows a TMK to issue its convertible (asset-backed) securities or (asset-backed) securities with warrants in an attempt to facilitate flexible structuring; and

(vii) finally, in addition to a TMK structure where a TMK will be utilized as an SPV, the amendments provide for a new so-called special purpose trust structure, where a trust will be utilized as an SPV (instead of TMK) and trust certificates under such structure will also be treated as securities under the SEL. The amendment might allow master trust structures to be arranged more easily.

J-REIT

Concurrently with the passage of the amendment to the SPC Law, an amendment to the Investment Trust Law has also passed the Japanese Diet and was promulgated on May 23, 2000.

Although the current Investment Trust Law (as amended in 1998) authorizes both an "investment trust structure" and an "investment company structure", the law was not designed for real property investments as the law contemplated investment to be "primarily" in securities, which means 50% or more of the overall investments. Thus, market participants and practitioners sought further amendments of the law to allow the structure to invest primarily in real property so that they could form a Japanese version of a real estate investment trust (J-REIT). When the amendment promulgated in May becomes effective, investment trusts and investment companies may be formed under the law to invest primarily in securities, real properties and other assets to be stipulated in the ministry ordinance (which has not yet been promulgated).

Under the investment trust structure, investors will purchase trust certificates (which will be treated as securities under the SEL) that represent trust beneficiary interests in the real properties which consist of the trust assets held and administered by the investment trust. Under the investment company structure, investors will purchase equity shares (which will also be treated as securities) in an investment company which invests the proceeds of such equity shares in real property. Concurrently, the amendment allows investment trusts and investment companies to borrow or issue debt instruments (also treated as securities under the SEL) in an attempt to allow more flexible structuring and management. However, unlike REITs in the United States, in both the investment trust structure and the investment company structure third parties must be appointed to manage the real properties, and investment decisions must be made by external investment managers which must be licensed by the Japanese governmental authority. In addition, the amendment incorporates certain provisions that would protect investors, eg, an obligation upon such investment managers to enforce the standard of care of a prudent manager and a restriction imposed on the same not to engage in transactions in conflict with the interests of the investors. The amendment will also introduce another trust structure under which trust banks are allowed to act both as an investment manager and an asset custodian (administrator). In this case no external investment manager will be required.

Since daily evaluation of real property is not practical and the liquidation of real property on a day-to-day basis is simply impossible, it is likely that all the funds established will be closed-ended (as opposed to open-ended) and therefore, from the investors' perspective, the need for the immediate founding of infrastructure for secondary markets is prominent (it is reported that the stock exchanges in Japan are preparing to set necessary guidelines for the listing and trading of such funds).

Various securities houses, real property development companies and real property management companies are seriously engaging in attempts to form J-REITs, which are expected to raise hundreds of billions of yen.

Outlook

The Japanese asset-backed securities market has grown through the securitization of new asset classes, and still others await to be securitized. It is expected that the Japanese government will adopt further legislation and regulations in an attempt to stimulate further securitization.

Although real property securitization might experience a decline due to the significant changes in accounting principles, the continued vibrance of the Japanese asset-backed securities market seems to be assured and may continue to grow with support from investors who are hungry for asset-backed securities, and with increased recognition of the availability of such products, these should be further emergence of new asset classes and further evolution in legislation and regulations.

Nishimura & Partners

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General Email: mail@jurists.co.jp

Masaru Ono Email: m_ono@jurists.co.jp

Hajime Ueno Email: h_ueno@jurists.co.jp