The number of insolvency cases is increasing in Japan, as has been demonstrated by large-scale insolvencies occurring one after another in the real estate industry (among others) due to a capital crunch caused by the subprime problem. As a result, the demand for an understanding of insolvency proceedings is also growing. Overseas companies that have executed contracts with Japanese companies are also likely to be concerned about how such contracts will be treated if the Japanese company becomes insolvent. Situations where securitisation projects are affected by the insolvencies of parties involved in such transactions (such as servicers and asset managers) have also become a reality.
Key insolvency proceedings
These include bankruptcy proceedings (hasan tetuzuki) pursuant to the Bankruptcy Law (hasan ho), corporate reorganisation proceedings (kaisha kousei tetuzuki) pursuant to the Corporate Reorganisation Law (kaisha kousei ho) and civil rehabilitation proceedings (minji saisei tetisuki) pursuant to the Civil Rehabilitation Law (minji saisei ho). A bankruptcy proceeding is a liquidation-type insolvency proceeding with the aim of paying as much as possible to creditors by monetising the insolvent debtor's properties into cash. Corporate reorganisation and civil rehabilitation are rehabilitation-type insolvency proceedings with the aim of enabling the debtor to recover economically, paying its debts by way of restructuring the claims of creditors (such as reduction or exemption of claims and extension of due dates). Such restructuring must be in accordance with a reorganisation plan or rehabilitation plan approved by creditors and authorised by the court.
Under bankruptcy proceedings, a court-appointed bankruptcy trustee (hasan kanzainin) will monetise the assets of the debtor into cash and distribute it among the bankrupt party's creditors in the form of dividend distributions. Among rehabilitation-type insolvency proceedings, corporate reorganisation is a proceeding intended only for corporations (kabushiki kaisha), where a reorganisation trustee (kousei kanzainin) appointed by the court takes the initiative in reorganising the business of a kabushiki kaisha. On the other hand, civil rehabilitation is a proceeding intended for both individuals and corporations. Though the Civil Rehabilitation Law was initially envisaged for the rehabilitation of small and medium-sized companies, it is actually used for listed companies and large companies due to the simplicity of proceedings and the possibility of a speedy outcome. Civil rehabilitation differs from corporate reorganisation in that management of the company is not necessarily undertaken by a rehabilitation trustee but can be continued by the existing management (debtor in possession). However, the court can appoint a trustee if it determines such is necessary, and even where there is no such appointment the former management often resigns upon filing a petition for civil rehabilitation proceedings.
Bankruptcy and civil rehabilitation proceedings have one thing in common. Claims secured by certain types of security, such as mortgages and pledges, among others, do not have to be enforced as part of the proceedings. In civil rehabilitation proceedings, certain secured creditors can, in principle, enforce their claims independently of the creditor-approved and court-authorised rehabilitation plan. In bankruptcy, certain secured creditors could, in principle, enforce their claims independent of the dividend distribution process overseen by the trustee. Thus, in both types of proceedings, the trustee has relatively less control over the process than in corporate reorganisations, where the creditors have no similar recourse to claim enforcement outside the proceedings.
Consequences
Where a Japanese company becomes insolvent, an overseas company should note that the contractual relationship with the Japanese company does not always follow general principles of contract law applicable outside bankruptcy. Under a contract, the parties generally bear contractual obligations towards one another (bilateral contract), and a relationship to secure mutual performance (a relationship of simultaneous performance, for example) is guaranteed under contract law as such obligations of the parties are closely correlated to one another. However, this special kind of relationship does not always apply in cases of insolvency.
If the counterparty to a bankrupt party has performed its obligation fully while part of the obligations of the bankrupt party remains, the counterparty's claims against the bankrupt party are treated as so-called bankruptcy claims, and such claims must be enforced in bankruptcy proceedings. This means that counterparties to the bankrupt party can only receive an amount distributed fairly from the assets held by the bankrupt party to bankruptcy creditors in the order stipulated by law. On the other hand, if the bankrupt party has fully performed its obligation but part of the counterparty's obligation remains to be performed, the bankruptcy trustee may request that the counterparty fully perform such remaining obligations. Although this may seem unfair, under Japanese law, where the counterparty has already performed their obligations, the party is likely to be deemed not to have the right to take advantage of what is known in Japan as the defence of simultaneous performance from the beginning (under the defence of simultaneous performance, a party to a bilateral contract does not have to perform its contractual obligations until the other party has performed) or to have waived such defence, and therefore such claimants are in no position to expect more than payment from the general assets of the estate.
If both parties to a bilateral contract have not yet fully performed their obligations, the Bankruptcy Act grants a bankruptcy trustee the right to request performance of the obligations of the bankrupt party under the contractual relationship and request that the counterparty performs its obligations or to extinguish the contractual relationship by exercising its right of termination. This means that if a Japanese company goes bankrupt and neither party to an affected contract has performed all of their obligations then, in the absence of any other termination causes, the bankruptcy trustee will be able to determine whether or not the contract continues to exist. However, many exceptional treatments are also provided by law from the viewpoint of fairness to the parties, and it is therefore necessary to confirm the contract's content in each case. For instance, a contract in relation to a commodities trade for which there is market rate may, by its nature, inflict unpredictable damages to the counterparty if the bankruptcy trustee selects either performance or termination. Therefore, if bankruptcy proceedings are commenced against one of the parties before the due date, it is deemed that the contract has been automatically terminated.
As stated above, contractual relationships in bankruptcy proceedings are peculiar to bankruptcy law and do not always follow the general principles of contract law. This also applies to civil rehabilitation and corporate reorganisation proceedings.
Securitisation transactions and bankruptcy proceedings
In the case of a securitisation transaction, investors invest in the value or cash flow of the assets that are isolated from the creditworthiness of the originator and other parties to the transaction. Thus, a structure is used under which investors will not be affected by the insolvency of the originator or any other party to the transaction. However, if the originator or any other party to the transaction actually commences insolvency proceedings, problems may arise in various situations, causing concern about influences on investors, including overseas companies.
Insolvency of the originator and servicer and commingling risk
In a receivables securitisation, receivables are transferred from the originator, which is the original creditor, to a special purpose vehicle (SPV), but because the SPV does not have a collection capacity in most cases, the originator and servicer generally manage and collect receivables subject to securitisation on behalf of the SPV and receive a servicing fee as compensation. In this case, if the originator and servicer commence insolvency proceedings without delivering collections to the SPV, the SPV to which assets have been transferred from the originator would not have the right to recover such collections, and the rights to claim delivery of collections that have arisen before the insolvency proceedings will be handled as ordinary bankruptcy claims, reorganisation claims or rehabilitation claims, which involves a risk that the collections may not be fully recovered. This risk is the so-called commingling risk.
To reduce the commingling risk, the following measures are available: (i) to remit the collections directly to the SPV from the original obligors; (ii) to shorten the interval between delivery from the servicer to the SPV as much as possible; (iii) to add credit enhancements such as cash collateral or external guarantees; and (iv) to segregate the collections into an exclusive bank account in the servicer's name. Among these measures, measure (i) is problematic in that it requires the customer's cooperation to change the bank account, and it is difficult for the SPV, which functions merely as a conduit, to manage the default of original obligors without the involvement of the servicer. As for measure (ii), there exist servicer risks, though for a short term, even if the servicer remits the collections to the SPV promptly after collection. As for measure (iii), although at the time of structuring measures (such as reserving funds) are taken to reduce the commingling risk, there is the disadvantage of a higher cost for structuring the securitisation instrument. As for measure (iv), there is a problem regarding the attribution of deposit claims in an exclusive collection account separately managed, and identification of the depositor becomes a problem. Regarding this aspect, according to judicial precedent with regard to the attribution of deposit claims (Supreme Court Judgment of February 21 2003, Minshu Volume 57, No 2, Page 95, Supreme Court Judgment of June 12 2003, Minshu Volume 57, No 6, Page 563), it is considered that even if the originator opens and separately manages an exclusive collection account, there still remains a possibility that the deposit claims in the account would be attributed to the originator.
Termination of the servicing agreement
If any insolvency proceeding is commenced with respect to the originator and servicer, there may be a case where the SPV terminates the servicing agreement in order to transfer its right to collect to a backup servicer. In this case, termination events may include: (i) termination pursuant to insolvency provisions under the servicing agreement, which provides as a termination event a petition for commencement of legal insolvency proceedings of the originator and servicer; (ii) termination without cause under the delegation agreement; and (iii) termination due to default. Regarding the termination event described in (i), the Supreme Court has ruled in one case involving a sales agreement where the owner or seller retained an ownership right and the agreement included a provision stating that the occurrence of an event that allowed the purchaser (or one of its creditors) to petition to commence reorganisation proceedings with regard to the purchaser was a termination event. The Supreme Court invalidated the provision to allow corporate reorganisation proceedings to proceed under the rationale that the reorganisation sought to preserve and rehabilitate the purchaser while coordinating interests among relevant parties (Supreme Court Judgment of March 30 1982, Minshu Volume 36, No 3, Page 484). Although there are various opinions, a widely accepted opinion is that the scope of the precedent does not extend to this case and termination is valid in light of the fact that the situations differ between the sales agreement with ownership reservation, which functions as substantial collateral, and the servicing agreement (mentioned below) with the nature of a delegation agreement, and as servicing is not necessary for the business continuity of the originator and servicer. As for (ii), termination under the delegation agreement, there is the opinion to allow legal termination without cause even after the commencement of insolvency proceedings because the servicing agreement is a delegation agreement or a quasi-delegation agreement. However, according to the opinion in (i) to restrict termination pursuant to insolvency provisions, termination under the delegation agreement may also be restricted. As for (iii), if the originator delays the performance of its obligation to deliver collections and the right of termination has arisen before the issuance of a provisional administration order (hozen kanri meirei), the SPV may terminate the servicing agreement due to a delay in performance even after the issuance of a provisional administration order. On the other hand, as the company may not perform its obligations if the obligations become due after the issuance of a provisional administration order, it is considered that the servicing agreement may not be terminated merely due to delay in performance.
The problems arising in cases of the insolvency of the originator and servicer in the course of securitisation transactions have only been briefly mentioned above with a focus on commingling risk and the feasibility of the SPV terminating a servicing agreement. There are many other issues to be taken into account when assessing bankruptcy risk, such as true sale, exercise of right of avoidance and the termination of pending contract by a trustee in connection with the insolvency of the originator and servicer in a securitisation transaction.
Recommendation
Considering the present circumstances, in which petitions for corporate insolvencies are becoming more frequent, it is necessary for lawyers and companies in Japan to gain more understanding than ever before of the issues in insolvency proceedings. The issues mentioned above are only a few of those related to insolvency proceedings in Japan. However, we hope that this will contribute to your understanding.
| Author biographies |
Saori Hanada
Atsumi & Partners
Saori Hanada is a member of the finance and litigation/insolvency practice groups of Atsumi & Partners. She holds a master of arts degree from Waseda University. After completing her training at the Legal Training and Research Institute of the Supreme Court of Japan, she was admitted as an attorney in 2000. She handles securitisation and project finance matters based on structured finance, as well as general corporate law, commercial transactions, contracts, litigation and general financial transactions.
Miki Ono
Atsumi & Partners
Miki Ono is a member of the corporate/IP and litigation/insolvency practice groups of Atsumi & Partners. She has a bachelor of arts degree from Kyoto University. After completing her training at the Legal Training and Research Institute of the Supreme Court of Japan, she was admitted as an attorney in 2005. She principally handles general corporate law, finance, commercial transactions, contracts, international transactions and litigation.
Eiichiro Hata
Atsumi & Partners
Eiichiro Hata is a member of the finance and corporate/IP practice groups of Atsumi & Partners. He holds an LLB degree from The University of Tokyo. After completing his training at the Legal Training and Research Institute of the Supreme Court of Japan, he was admitted as an attorney in 2005. He handles securitisation, project finance, investment fund-related matters, general corporate law, commercial transactions, contracts and general financial transactions with an emphasis on structured finance. |