Using declarations of trust

Since the enactment of the amended Trust Law (New Trust Law) in September 2007, the use of a business trust (meaning a whole property that is organised for certain business purposes and functions as an organic unity, which could include both assets and liabilities arising from the business, notwithstanding that the trust law generally prohibits the entrustment of negative property) has drawn attention and references have been made in articles concerning the New Trust Law. A business trust would be quite useful if used in conjunction with declaration of trust (as a trust declaration as a declaration of trust, even if done repeatedly, cannot be said to be undertaken as a business, it is considered that a declaration of trust does not fall under the definition of trust business, and registration will not be required, except when more than 50 persons can obtain beneficial interest). Previously, if an operating company (a company that conducts business other than financial business) wanted to raise funds by securitising the profitability of a specific business division, it needed to undertake measures such as a corporate split or business transfer. However, by using a business trust and declaration of trust, a company can raise funds by creating a declaration of trust with its relevant business division and selling beneficial interests to investors while continuing direct management of the business division, thus avoiding employee issues, concerns over disclosure of confidential information and the costs of a spin-off or business transfer.

The declaration of trust system commenced on September 30 2008, enabling the use of a scheme that combines a business trust with declaration of trust. However, because the system is new, it is not entirely clear what kind of scheme will actually be possible. It is expected that if a model that sufficiently covers matters such as protection of creditors, safety of transactions and protection of beneficiaries can be developed upon further discussion in working groups we will see such a business trust/declaration of trust structure in the near future.

Matters to be discussed

Potential methods

• Securitisation of business (use as a vehicle to raise funds).
• Use in place of tracking stock (a stock the value of which is linked only to the achievements of specified wholly-owned subsidiaries or business operation sections, among others, owned by the company).
• Use in business collaboration.
• Use in limited period M&A for the restructuring of an existing business.
• Use in commencing a new business (especially high-risk business).
• Use as the means for a hostile takeover, going private or management buyout.
• Avoidance of servicer risk.
• Use for succession of a business in the civil trust field.

Advantages

• Transfer of business contracts and creditor-debtor relationships are not required.
• Succession of employment relationship is not required.
• Decline in business value due from separation of the business from a company will be small (the credit of the company can be used and confidentiality of know-how maintained).
• There is a restriction on the amount that can be distributed when issuing class shares for a company split, for example, but it is possible to plan distribution of dividends for beneficial interests more flexibly, provided (in the case of a trust with limited liability) the distributable amount is limited to protect creditors (Article 225 of the Trust Law).
• Protection of the interests of investors can be achieved through the rights of beneficiaries to supervise the trustee (rights to inspect accounting books, demand indemnification of losses from an illegal act or rescind any act exceeding trustee authority, for example).
• A trust business licence is not required because declaration of trust does not fall under the definition of trust business.
• New approval or licence is not required.

Disadvantages

• If 50 or more beneficiaries are envisioned, even in the case of a declaration of trust the trustor-cum-trustee must be registered every three years pursuant to the Trust Business Law and, in principle, regulations similar to those applicable to trust companies will be applied. Depending on whether the financial condition is sound, restrictions on dual business could apply (Article 50-2 of the Trust Business Law, Article 51-8 of the Ministerial Ordinance for Enforcement of the Trust Business Law).
• Provisions on business transfer under the Company Law, among others, will apply to the creation of declaration of trust (Article 266.2 of the Trust Law). Therefore, if a declaration of trust is created on all or any material part of a business, a special resolution of the general meeting of shareholders will be required, as in the case for a transfer of business to a third person.
• Another beneficiary is necessary.
• Article 163(2) of the Trust Law provides that a trust will terminate when a trustee has held all the beneficial interests in its account continuously for one year. Therefore, another beneficiary holding at least part of the beneficial interest is required.

Whether to use limited liability trusts

A limited liability trust means "a trust in which the trustee shall be liable for the performance of obligations only to the extent of the trust property" (Article 2.12 of the Trust Law), allowing a limited liability trust to remove unlimited responsibility from the trustee. Though the limited liability trust might be indicated in the case of a high-risk venture, in other cases the credibility of the company itself may be needed to ensure favourable pricing on beneficial interest sales.

From the perspective of protecting creditors, it will become necessary to stipulate certain matters at the time of creation of a limited liability trust (Article 216 of the Trust Law) and also to register the fact that it is a limited liability trust (Articles 216 and 232 of the Trust Law). In addition, from the perspective of protecting creditors, the following provisions also apply.

• Limitation on naming (Article 218 of the Trust Law).
• Obligation to express the fact that it is a limited liability trust (Article 219 of the Trust Law).
• Obligation to prepare and keep accounting books, among others, creditor right to demand inspection and copying of accounting books, among others (Articles 222 and 223 of the Trust Law).
• Trustee responsibility to third persons in the case of wilful misconduct and gross negligence (Article 224 of the Trust Law).
• Restriction on distribution to beneficiaries (Article 225 of the Trust Law).
• Special exceptions in the case of liquidation (Articles 229 to 231 of the Trust Law).

In administering the above obligations, the procedures connected with them (including a possible limitation on the amount available for distribution) may impose burdens that could have the effect of reducing the value of the limited liability trust vehicle.

Protection of trustor shareholders and general creditors

Protection of creditors

When using a declaration of trust, the trustor (and the trustee) would usually acquire the beneficial interest, sell it to a third person and receive the sale consideration into the trustor property. Therefore, the aggregate property of the trustor will not decrease and, in general, the trustor creditors will not be harmed by the creation of a declaration of trust.

Note that in the case of right of avoidance of fraudulent acts or under the Bankruptcy Law, though there is some argument regarding replacement of property with money (which is easily consumed), as a general rule, if a reasonable amount of consideration is obtained, the creditor will not be found to be harmed and the creation of a declaration of trust will not be subject to avoidance.

Alternatively, if no consideration is obtained through the declaration of trust, the protection of creditors' provisions in the Trust Law could apply.

Provisions for prevention of abuse

In order to verify the function and effect of relevant provisions and harmonise the interests of trust creditors and beneficiaries with the protection of trustor shareholders and general creditors, it will be preferable to establish a new system, including the enactment of appropriate regulations, for matters not dealt with under the Trust Law, the Trust Business Law or other current laws.

Special regulations

Declaration of trust must be created by notarised deed or electronic record, in which the purpose of the trust, matters necessary to identifying trust property and certain other matters are described (Article 3.3 of the Trust Law). A notarised deed will confirm the date of creation and other matters in a recorded (though not public) document and prevent the trustor (and the trustee) from using a backdated declaration of trust to avoid being subject to execution by creditors. Which provisions to stipulate in the notarised deed must be considered. Because notarised deeds are not open to public view, a registration or record system for the declaration of trust to which third persons would have access may be a useful system to enhance the security of transactions.

Creation of a trust registration or record system

In order to assert against a third person that a property that needs to be registered or recorded to assert gaining/losing/changing a right to assert that such property belongs to trust property, the fact must be registered or recorded (Article 14 of the Trust Law). In the case of declaration of trust, for properties for which a registration or record system exists (real property, vehicles and vessels, among others), the fact that the property is trust property may not be asserted against third parties without a registration or record that the property is subject to a declaration of trust (patent rights and copyrights also require registration). For movables and claims, the trust registration or record system under the Special Exception Law on Movables and Transfer of Claims has not been developed, and a registration under Article 14 of the Trust Law is not yet possible.

In order to use declaration of trust and a business trust as a means of raising funds, it is desirable to have a way of clarifying that the relevant property is trust property. For the protection of creditors, registration of trust for property where such method is available and, in a case where no registration is available, a degree of specificity must be ensured through separate management (what constitutes separate management will need to be considered).

Restrictions on compulsory execution against trust property

If a trustor creates a trust knowing that it will harm a creditor who has a pre-existing claim, the creditor may immediately commence compulsory execution of the trust property in accordance with the title of obligation of its claim without filing an action for cancellation of a fraudulent trust (Article 23.2 of the Trust Law). However, this may not apply in a case where beneficiaries, in whole or in part, did not know that a creditor would be harmed, and the trustor and/or beneficiaries who have an objection must file an action for third party objection in accordance with Article 23.5 of the Trust Law. The trustor, when making such an objection, will need to assert and prove that the assets are trust property, against which the creditor will need to prove fraud in the establishment of the trust and the trustor intent of fraud, and the trustee will need to prove the good faith of beneficiaries.

Protecting interests of employees and/or shareholders

A company that is trustor and trustee will be subject to the relevant provisions of the Company Law and other laws regarding a business transfer of a legal entity, so a declaration of trust structure will not be less protective of shareholders and employees. If a declaration of trust is established for all or a material part of a business, a special resolution by a general meeting of shareholders will be required.

Creation of declaration of trust registration system

In a case where 50 or more people may acquire a beneficiary interest in a declaration of trust, registration is required (Article 50-2 of the Trust Business Law) and restrictions under the Trust Business Law will apply (Article 50-2.12 of the Trust Business Law). Matters such as specification of trust property by a qualified third person, an investigation of trust property prices and others will be required (Article 50-2.10 of the Trust Business Law and Article 51-7 of the Ordinance for Enforcement of the Trust Business Law), although the details are not yet fixed.

Securing the independence of trust property upon bankruptcy of a trustee

Bankruptcy-remoteness of trust property will be desirable in a scheme that separates a specific business of a company from the other property of that company and implements fundraising and other activities focused on the specific business. For the use of declaration of trust and a business trust, it is essential to clarify the rules to specify trust property.

Specification of trust property

Trust property means property stipulated as belonging to the trust upon creation of the trust (Article 16, Introductory Clause of the Trust Law). Therefore, it is necessary to examine the following matters upon establishment of a trust by a declaration of trust.

What should be indicated in a notarised deed

• Whether inclusion in the declaration of trust of a claim that prohibits transfer is possible (whether consent of the obligor is necessary for a declaration of trust).
• In order to perfect against third persons, what specificity is needed for property without a registration or record system (movables, money and claims).

Change of trust property by business activities

In the case of a business trust, the trust property may change daily from the initial trust property and increase or decrease as a result of the business activities of the trustee. It is necessary to consider the degree to which such property will become trust property.

Scope of trust property provisions

• What degree of specificity is needed to assert against a third person that the property is trust property with respect to property without any registration or record system?
• Which method is appropriate as a method of segregation of trust property? Note that segregation under the Trust Law is a duty of a trustee and is different from requirements to perfect against a third person that a property is a trust property, but in order to assert against a third party (a creditor or a bankruptcy administrator) that the property is trust property, segregation or a specificity of trust property will be required.

Article 34 of the Trust Law deals with the duty of segregation as follows. Except for trust property that may be registered or recorded, it is possible to stipulate a different segregation method in creating the trust (Article 34.1, Proviso and Article 34.2 of the Trust Law).

• Property of the trust that may be registered or recorded (Article 34.1(1) of the Trust Law).
• Registration and record of a trust.
• Movable property other than money (Article 34.1(2)(a)).
• Maintaining objective segregation.
• Money and property (Article 34.1(2)(b)).
• Method for clarifying calculation.
• Property for which indication and recordation of trust property is a requirement for assertion against a third party (Article 34.1(3) of the Trust Law, Article 4 of the Ordinance for Enforcement of the Trust Law).
• Method of clarification and a record or indication that the property belongs to a trust.

Succession of employment relationship

The dominant view is that succession of the employment relationship is possible without obtaining individual consent from employees as a general rule, which is an advantage of using declaration of trust. This is because the company establishing a declaration of trust for a specific business will continue to carry out that business as is and no impact on individual employment contracts will occur. That is, provided that employee consent may become necessary in certain situations where terms of employment may become disadvantageous for an employee (such as a limited liability declaration of trust), where the stability of the position of the employee might arguably be reduced. This issue necessitates a case-by-case consideration.

Self-transactions, conflicts of interest transactions and competitive acts

The Trust Law prohibits self-transactions, conflicts of interest transactions and competitive acts as a general rule (Article 31.1 and Article 32.1 of the Trust Law). Adjustments of interests can be made by the application of general provisions, such as a duty of due care of a trustee under the Trust Law (Article 29.2 of the Trust Law and Articles 50-2.12 and 28.2 of the Trust Business Law), a duty of loyalty (Article 30 of the Trust Law and Articles 50-2.12 and 28.1 of the Trust Business Law), supervision by a beneficiary, such as filing for dismissal of a trustee (Article 58.4 of the Trust Law), filing for the appointment of an inspector (Article 46 of the Trust Law), a request for the inspection of books, balance sheets and income statements (Article 38 of the Trust Law), directors' duty of due care under the Company Law (Article 330 of the Company Law and Article 644 of the Civil Code), a duty of loyalty (Article 355 of the Company Law) and a resolution of the board of directors for disposal of and acceptance of assignment of important assets (Article 362.4(1) of the Company Law). For a declaration of trust, stipulation with respect to a certain range of matters that are envisaged to occur (for example, matters pertaining to composition of officers, borrowing policies, management policies and a management plan for important assets) at the time of creation of the trust (the Trust Law stipulates this in some detail) will be necessary.

Securing the continuity of a business upon insolvency of a trustee

For a spin-off, a switching of specific business by a company into a declaration of trust, it is necessary that the deterioration of other business activities of that company, and even its insolvency, does not affect the continuity of the spun-off declaration of trust business.

Task of a trustee upon bankruptcy

The task of the trustee will terminate (Article 56.1(4) of the Trust Law) and a bankruptcy trustee will retain the trust property until the appointment of a new trustee and perform the actions necessary for a handover of the trust affairs (Article 60.4 of the Trust Law). A new trustee will be appointed in accordance with the stipulations for the act of creating the trust (if any) and if there is no stipulation regarding the act of creating the trust, or if a person designated in accordance with the stipulation of the act of creating the trust does not assume the trust, the trustor and a beneficiary will make the appointment upon mutual agreement (Article 62.1 of the Trust Law). In a case where a new trustee is not appointed, a court may order a disposition of management by a trust property administrator, upon filing by an interested person, and appoint a trust property administrator (Articles 63.1 and 64.1 of the Trust Law).

To cover this situation, stipulations should be made for the appointment of a new trustee in the act of creating the trust. First, a new trustee (such as a back-up operator) can be stipulated. In addition, in a case where continuation of the business by terminating the trust and transferring the trust property to another company upon bankruptcy of the trustee may be more realistic, it will be necessary to consider including a provision for such a situation in the act of creating the trust.

Task of a trustee upon civil rehabilitation and corporate reorganisation proceedings

Unless provided in the act of creating the trust, the task of a trustee will not terminate (Articles 56.5 and 56.7 of the Trust Law). An administrator or provisional administrator has the right to perform a trustee's business duties and to manage and dispose of property that is trust property (Articles 56.6 and 56.7 of the Trust Law). However, if there is any provision in the act of creating the trust that the tasks of a trustee will terminate, a new trustee will be appointed in accordance with that provision (Article 56.5, Proviso and Article 56.7 of the Trust Law).

Possible cancellation of the act of creating the trust

Even where a trustor-cum-trustee becomes subject to commencement of insolvency procedures, a trust will not naturally terminate in principle. However, if there is a provision to that effect in the act of creating the trust, the trust will terminate (Article 163.1(9) of the Trust Law).

To be included in a business trust Instrument

To be included under the law

• Purpose of the trust.
• Matters necessary for specifying property of the trust.
• Name and address of the person who will create a declaration of trust.
• Provision for beneficiary (including manner of stipulating beneficiary).
• Method of management or disposal of trust property.
• When setting conditions or a deadline for the act of creating the trust, a provision regarding the conditions and the deadline.
• Events under Article 163.1(9) of the new law (events of termination for a trust stipulated in the act of creating the trust).
• Other terms of a trust.

Matters generally indicated in a trust

• Purpose of trust.
• Establishment of trust (establishment of trust, trust property, name of the trust and any additional trust).
• Trust period.
• Public notice of trust and requirements for perfection.
• Representations and warranties.
• Beneficiary and beneficiary interest.
• Transfer, succession and pledge of beneficiary interest.
• Management, operation and disposal of trust property.
• Entrustment of trust operations.
• Duty of care of a prudent manager and trustee's duty of loyalty.
• Self-transactions and competitive transactions, among others.
• Trust expenses.
• Remuneration for trust.
• Calculation of trust (principal, trust profits, trust expenditures, calculation of a trust and delivery of profits).
• Report on trust.
• Change of trustee.
• Termination and liquidation of trust.
• Change, consolidation and division of trust.
• Provisions regarding the bankruptcy of trust property.
• General provisions.

As outlined above, the declaration of trust and business trust combination that has become possible under the New Trust Law promises to be a useful and efficient vehicle for companies. We will no doubt see the first example of an actual structure using declaration of trust and a business trust in Japan in the next few months.

Author biography

Yutaka Sakai TMI Associates Yutaka Sakai has been a partner at TMI Associates since 2007. His practice area includes securitisation, project finance, ship financing, aircraft leasing and syndicated lending. Yutaka received his LLB from Keio University in 1980, studied at the Research Institute of the Supreme Court of Japan between 1983 and 1985, and received his LLM from the University of London in 1990. He was admitted to the Japanese Bar in 1985. Yutaka has written articles for various publications on subjects including real estate, syndicated lending and emissions-trading schemes. He is fluent in Japanese and English.