The Japanese market has recently been witnessing greater activity in the issuance of hybrid securities by the financial and non-financial sectors, the latter having been less common in the past.
Hybrid securities, generally defined as securities with characteristics of both debt and equity, have been popular since the nineties among Japanese financial institutions as a tool for raising regulatory capital. They are still active issuers of hybrids for their capital needs, particularly in connection with the recent capital crisis.
In the past few years, however, non-financial firms have been also active in issuing hybrid securities. For example: ¥31 billion ($333 million) by AEON Co, Ltd in September 2006, ¥300 billion by Nippon Steel Corporation in November 2006, ¥120 billion by Sumitomo Realty & Development Co, Ltd in February 2008 and ¥300 billion by JFE Holdings, Inc in March 2008.
In addition, leveraged buyouts are one of the principal fields where hybrid securities are used. A well-publicised management buyout of World Co, Ltd in July 2005 is one example of where multiple tranches of mezzanine financing were used for acquisition financing.
Basic understanding
There is no legal definition of hybrid securities under Japanese law. It is generally understood, however, that hybrid securities are securities with characteristics of both debt and equity. Rating agencies view the following as being equity rather than debt features: (i) no maturity; (ii) no ongoing payment that could lead to default; and (iii) loss absorption in the case of a bankruptcy.
Given the above, hybrid securities can be defined in several ways. Firstly, in their broadest sense, hybrid securities can include convertible securities in the sense that they become both debt and equity before and after conversion. Secondly, in contrast, securities can bear characteristics of both debt and equity at any given time. For example, redeemable preferred stock lacks the equity feature of no maturity but still bears other equity features. Included in this category are conventional preferred stock and subordinated debt. Thirdly, in their narrowest sense, hybrid securities only refer to securities that are treated as debt for tax purposes but as equity for other purposes.
Perpetual subordinated debt
Perpetual subordinated debt is, as its name suggests, an instrument that has no set maturity date for the return of principal. The payment of interest can or must be deferred, subject to certain terms and conditions. Step-up of interest spread is typically built in, providing the issuer with an incentive to pay off the principal, even though it is not required to do so. Voluntary prepayment of the principal requires approval by a governmental authority when issued by banks and certain other financial institutions. The payment of the principal and interest are subordinated to senior debt in the case of the bankruptcy of the issuer.
J-TPS
In a typical scheme for Japanese Trust Preferred Securities (J-TPS), a Japanese corporation (the borrower) sets up a wholly-owned special purpose subsidiary in the Cayman Islands. Investors contribute capital to the subsidiary in exchange for preferred securities. The conduit then lends all of its capital to the borrower by way of termed or perpetual subordinated debt. The terms and yield of the loan are substantially identical to those of the preferred securities, so the loan provides the cash to make the distribution payment to investors. Contrary to their name, Japanese trust preferreds have rarely used a trust as a conduit.
Economic features
From the issuer's perspective, the weighted cost of capital can be reduced by issuing hybrids instead of equity where the cost of capital of equity exceeds that of debt, as is often the case. Some hybrids are also useful for raising funds without diluting earnings per share. For investors, hybrids may carry a higher yield than straight debt, in response to the higher risk involved. Investors in hybrids issued by highly-graded issuers can enjoy high yields from companies that are less likely to default than lower-grade issuers. Investment opportunities in those products add the alternatives available to investors' portfolio management.
Rules and regulations
Hybrid securities are not merely something economically in-between equity and debt. By being treated as debt for tax purposes and as equity for other purposes, hybrids are advantageous for issuers and, through the more favourable terms available, for investors as well.
Taxation
As is the case in most other jurisdictions, Japanese issuers generally design hybrids to be treated as debt for tax purposes because interest paid to debt holders may be deducted, while dividends to stockholders must only be paid out of after-tax income. The issue lies in debt-versus-equity characterisation for tax purposes.
Many European countries treat perpetual or long-maturity debt as debt while in the US, under the Internal Revenue Service's IRS Notice 94-47, together with case law, perpetual debt would likely be recharacterised as equity for tax purposes. Because the recharacterisation risk of perpetual debt seems more remote in Japan than in the US, practitioners tend to assume that perpetual debt would be viewed as debt for tax purposes. In this sense, Japan takes a more European than American approach. No case has been publicly reported where debt treatment of perpetual subordinated debt was denied by the tax authority or courts. As for J-TPS, because the subsidiary is not consolidated with the borrower for tax purposes, the same applies for the intercompany subordinated loan, and the borrower's interest payment to the conduit is tax deductible.
However, that is not to say that Japanese hybrids are completely free from tax recharacterisation risk. Participating bonds are commonly discussed products (whereby interest is calculated by reference to the profits or dividends of the issuer). Some suspect that these products can be too equity-like to enjoy debt treatment for tax purposes, depending on the security structure. As a protective measure against tax risks, many Japanese hybrids include in their terms a tax event as one of the prepayment events.
Accounting
Japan does not have a special accounting principle that provides a standard for recharacterisation of hybrid securities for accounting purposes. Accounting treatment of financial instruments under Japanese Generally Accepted Accounting Principles (GAAP) is therefore generally based on their corporate law characterisation.
Because the intercompany loan is eliminated in the consolidation, J-TPS is presented as a minority interest in subsidiary companies, a class of quasi-equity that is a separate line item between liabilities and shareholder's equity, on the borrower's consolidated balance sheet. This can be viewed as an advantage over US TPS issuers, who usually have to report TPS as debt on the consolidated financial statements due to FAS 150, announced by the Financial Accounting Standards Board (FASB) in May 2003. As for perpetual subordinated debt, it appears as debt on issuers' balance sheets, and a footnote to a balance sheet often indicates the amount of long-maturity or subordinated debt included in debt items.
Again, Japanese hybrids are not completely free from accounting risks. Many Japanese hybrids include an accounting event as one of the prepayment events.
Credit rating
Credit ratings treatment can be a key consideration for issuers, as evidenced by the worldwide boom in hybrid issuance immediately following Moodys' liberalisation in their rating methodology in February 2005.
There are two different rating issues involved. One is the bond ratings of hybrid securities themselves. In this regard, according to the rating agencies active in Japan, including international agencies such as S&P and Moody's and Japanese agencies such as R&I and JCR, the general principle is that hybrids are rated one to three notches (depending on the structure of the hybrids) below the senior debt issued by the same issuer where senior debt is investment grade.
The second issue is how corporate credit rating is affected by the issuance of hybrids. Rating agencies do not take a black or white approach. Instead, they attribute what is called equity credit to each hybrid in accordance with the degree to which it is equity-like. Equity-likeness is scored in terms of each of the following features of equity: (i) no maturity; (ii) no ongoing payments; and (iii) loss absorption. Then an overall evaluation will be made based on such scores. Perpetual subordinated debt and J-TPS are treated as equity-like because of their long or unlimited maturities, deep subordination and dividend deferral option. For example, it has been reported that a perpetual subordinated loan borrowed by Sumitomo Realty in February 2008 was granted 75% equity credit, and a J-TPS issued by NSC in October 2006 was granted 50%-75% equity credit.
Among Japanese local rating agencies, R&I and JCR announced their view of hybrids in mid-2000. They basically follow the approach of Moody's and S&P.
Regulatory capital
Issuing hybrids is an important alternative to issuing common equity for Japanese financial institutions that are subject to a capital adequacy requirement.
Japanese banking regulations set forth a positive list of hybrids that may be regarded as regulatory capital. J-TPS qualifies as Tier 1 capital up to a certain maximum and subject to certain conditions, such as the condition that securities should be non-cumulative, subordinated, perpetual and with interest step-up within a certain level. Perpetual subordinated debt qualifies as Upper Tier 2 and termed subordinated debt qualifies as Lower Tier 2, subject to certain limitations and conditions.
Japanese legal issues
Legal forms of conduit entities
J-TPS usually uses a foreign entity as a conduit. The most heavily used are Cayman corporations. In November 2001, NEC Corporation used a Delaware business trust. Domestic conduits have rarely, if ever, been used. In contrast, in the US, TPS usually use a trust or limited liability corporation (LLC) established in Delaware or other states within the US. Japanese issuers may wonder why they cannot use a domestic vehicle, which would likely reduce transaction costs and the risk of the occurrence of tax and accounting events.
The practice of using a Cayman corporation is connected to Japanese capital adequacy regulations. Japanese banking regulations are not clear, if not clearly negative, on whether J-TPS using a domestic conduit can be counted as regulatory capital in connection with the non-consolidated basis regulation. Some practitioners have cast doubt on the legitimacy of such regulation, but the regulators have not changed their position.
Now that non-financial companies are seeking to use J-TPS schemes, there is a possibility that domestic vehicles would be used in a J-TPS scheme. However, the Japanese version of an LLC (godo kaisha) is not feasible for J-TPS purposes because it is not eligible for pass-through taxation, unlike a US LLC. A statutory special purpose company (tokutei mokuteki kaisha, TMK), statutory special purpose trust (tokutei mokuteki shintaku) or general trust (shintaku) might be alternatives to Cayman corporations. The feasibility must be considered from the perspectives of, among other things, taxation, accounting, credit ratings, duration of the vehicle and voting rights arrangements.
Perpetuity
Japanese corporate law requires issuers of bonds to set forth the repayment date of the principal of bonds. In addition, Japanese debtor-creditor law deems a contract void if the contract is subject to a condition precedent that is totally dependent on the debtor's intent (a debt that is payable only if and when the debtor wants to pay is void because the debtor of such debt is deemed not to have an intent to be legally bound). In this regard, the legality and validity of perpetual debt used to be at issue. However, as a practical matter, these doubts have been cleared ever since governmental authorities and a leading scholar expressed their positive views.
Subordination provision
One of the indispensable legal tools in structuring hybrid securities is the use of subordination provisions. Japanese subordination provisions can take several forms.
One category is the statutory subordination agreement. Bankruptcy laws expressly recognise the enforceability of certain types of subordination agreements. However, a statutory subordination agreement is not always used, partly because multiple tranches cannot be structured.
The other category is the non-statutory subordination agreement. The first sub-category is an intercreditor agreement scheme. Subordinated debt holders agree on a subordinate payment and to deliver to the senior debt holders any amount received in violation of the agreement. One of the disadvantages is that, because agreements need to be made with all senior debt holders, this method does not work when there are too many actual or potential senior debt holders, which is often the case.
The second sub-category is a condition precedent scheme. The subordinated debt holder and the issuer agree that the subordinated debt becomes, upon the occurrence of subordination events (typically the commencement of a bankruptcy procedure), subject to a condition precedent of full repayment of senior debt. One of the disadvantages, which is common to the statutory subordination agreement, is that such provisions can theoretically be amended without the consent of the senior debt holder, because the agreement between the issuer and the subordinated debt holder does not directly grant the senior debt holders enforceable rights.
Some might wonder why an issuer and a subordinated debt holder do not simply agree to grant senior rights for the benefit of senior debt holders. One of the constraints is section 537 of the Civil Code, which governs contracts for the benefit of third parties. Section 537 provides that the third party beneficiaries would not be granted enforceable rights until they express their intent to benefit from such contracts. Given that there can be many senior debt holders, ensuring that all of them express their intent is often practically impossible. In this regard, discussion is now underway to amend Japanese contract law. A commentator has suggested that Section 537 should be amended to the effect that third party beneficiaries do not need to express their intent to enjoy such rights. If this amendment is enacted, the Japanese practice of subordination arrangements might change.
Replacement capital covenants
There is also the issue of enforceability of replacement capital covenants (RCC) under Japanese law. An RCC is an issuer's covenant to replace a hybrid security upon its call, redemption or repurchase with an instrument with specified characteristics. Having an RCC to replace with an equally or more equity-like instrument in the terms of hybrids enhances the equity credit for ratings purposes in some situations. S&P have expressed their view that, though the enforceability of an RCC is admitted in many jurisdictions, Japanese law would not recognise the enforceability (without senior debt holders' express intent) due, again, to section 537 of the Civil Code. This issue may also be resolved if the section is amended.
Other issues
Japanese legal issues associated with hybrid securities are not limited to those discussed above. Disclosure and other issues under the Financial Instruments and Exchange Law are also important. Corporate law would be at issue where stock acquisition rights are issued in combination with, or as part of, hybrid securities. These areas of Japanese law have been substantially revised in the past few years and there is only a short history of issuance of Japanese hybrids under this relatively new legal framework. Thus, there will likely be further developments in the Japanese hybrid market.
| Author biography |
Hiroki Aoyama
Mori Hamada & Matsumoto
Hiroki Aoyama is an attorney with Mori Hamada & Matsumoto. His areas of practice are corporate and financial transactions, with a particular focus on structured finance, banking, acquisition finance and other debt and equity financings. Hiroki was admitted to the Bar in 2002 in Japan and in 2008 in New York. He graduated from the University of Tokyo (LLB, 2001) and Harvard Law School (LLM, completed international finance concentration, 2007). He worked at Debevoise & Plimpton LLP in New York from 2007 to 2008. |