Banks see the benefits of syndicating risk

Author: | Published: 24 May 2005
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Companies in Japan have traditionally maintained a long-term relationship with a single main bank. The main bank is typically the company's largest lender, providing financing on an as-needed basis. The relationship is such that the main bank has essentially taken the role of the company's financial adviser, arranging comprehensive financial services and sometimes even owning a small equity stake. As Japan's period of post-bubble economic recession and stagnation has dragged on, the main bank system has begun to weaken. Many banks have sold their equity stakes in their borrowers and decreased their willingness to extend credit solely on the basis of a long-term relationship with the borrower. They have also begun to spread their credit risk by lending in syndicated loan transactions where both domestic and foreign lenders make a commitment to the borrower. In these transactions, it has become common practice for the main bank to act as arranger and agent of the syndicated loan.

Syndicated loans became much more attractive when the Commitment Loan Agreement Law was adopted in 1999. It made it clear that commitment and facility fees under commitment loan agreements with certain types of borrowers are not to be regarded as interest for purposes of Japanese usury laws. After this legislative clarification, lenders were no longer as reluctant to join syndicates to provide loan commitments where the economics of transaction rely on charging fees on the amount committed in addition to interest on the amount borrowed.

Standard documentation

As a sign of the development of a Japanese syndicated loan market, the JSLA (Japan Syndication and Loan-trading Association) was formed on January 1 2001 as a consortium of Japanese and non-Japanese financial institutions with the purpose of expanding the market for making and selling syndicated loans. The JSLA has sought to help borrowers, lenders and assignees in the secondary loan market by reducing transaction costs through the development of standardized loan documentation and procedures. The model revolving credit facility agreement and syndicated term-loan agreement developed by the JSLA are now widely used as standard forms in the industry.

Complications

Syndicated loans in Japan were initially limited for the most part to unsecured loans for a borrower's working capital needs. However, they are used more and more in structured and project finance transactions and acquisition financings and are thus being increasingly structured as secured loans. Unfortunately, some unique aspects of Japanese law make structuring secured syndicated loans more complicated than in other jurisdictions.

Perhaps the most difficult hurdle to overcome when structuring a secured syndicated loan in Japan is the absence of the concept of a security trustee under Japanese law. Two aspects of Japanese law make the typical security trustee concept unworkable. First, under Japanese law, the named secured party must be the obligee of the secured obligation. Second, there is no clear authority under Japanese law that a secured party can act as the sole named secured party as trustee for other secured parties. So, in general, a third-party custodian that is not a lender could not act a security trustee for the lenders. Furthermore, it is not established under Japanese law that even a lender can act as security trustee for other lenders. Part of the uncertainty in this regard stems from Japanese laws that essentially prohibit any third party taking legal action to enforce a lender's rights against a borrower, other than a lawyer or a qualified loan servicer. In order to solve this issue, some secured syndicated loan agreements authorize appointment of a qualified servicing company or a lawyer to take necessary legal action against the borrower.

In the absence of a security trustee, the obvious option is for each of the lenders to be named as a secured party, but this can often be burdensome, particularly where the creation and/or perfection of the security interest requires registration in the name of each of the secured parties. Security interests in Japan typically take the form of a mortgage in respect of real property and a pledge in respect of other types of property. Each of these types of security interests is explicitly provided for in the Japanese Civil Code. In addition, the concept of a security assignment has developed through case law and is now as commonly used as a mortgage or a pledge.

Mortgages and certain pledges typically require the payment of higher registration fees (as a percentage of the secured amount) than the generally fixed fees required to register security assignments. Use of mortgages and pledges in secured syndicated transactions can be particularly burdensome if each of the lenders is named as a secured party and the registration fees (or a pro rata portion thereof) have to be paid in connection with each transfer of the loan in the secondary market.

Security assignments present other issues and complexities, however, because actual title to the collateral is transferred to the secured parties. Banks are often reluctant to take a security assignment, particularly in the case of real property, as it is arguable that they thereby immediately become subject to the liabilities and obligations as owner of the property. Other types of collateral present other issues. In the case of intellectual property, for example, a security assignment may be particularly burdensome because each of the lenders would become registered owners of the collateral and would have the burden of maintaining and administering the registration of the intellectual property at the Patent Office. A security assignment of equity interests may also present issues where the borrower is a closely held corporation. Such corporations in Japan generally contain provisions in their articles of incorporation requiring transfers of shares to be approved by the board of directors. In such cases, initial board approval of granting the security assignment would not cover a subsequent foreclosure in which the shares are to be transferred to a third party. So lenders may insist that the articles be amended to remove the director-approval requirement for share transfers.

In some syndicated transactions involving large and complex security packages, structures have been devised to avoid having multiple secured parties in an effort to minimize some of these problems. For example, in one transaction, a single purpose finance entity was established. The syndicate of lenders made a syndicated loan to the finance entity that was secured mainly by a pledge of the finance entity's shares to each of the lenders. The finance entity then made a mezzanine level loan to the borrower that was secured by the assets of the borrower.

Confidentiality is another issue that frequently arises in both secured and unsecured syndicated loan transactions. The confidentiality of information pertaining to the borrower is protected under Japanese case law. Lenders in syndicated transactions are therefore uncomfortable sharing information - such as their risk assessment of the borrower, for example - with other lenders or prospective transferees in the secondary market. This issue could be largely resolved with language in the documentation of the original loan making express the ability of the lenders to share information concerning the borrower. But this is often a contentious issue with borrowers.

Positive developments

In 2001, the Commitment Loan Agreement Law was amended to broaden the scope of borrowers with respect to whom the payment of commitment and facility fees is not regarded as payment of interest for purposes of the usury laws.

Amendments to the Japanese Civil Code that became effective in April 2004 also contain some positive developments for the Japanese syndicated loan market. For example, the amendments clarified the cases in which creation of a pledge on a claim requires delivery of the documents evidencing the existence of that claim. It is now provided that delivery of such documents is not required to create a pledge on a claim unless delivery is otherwise legally required to transfer ownership.

The Code amendments also provide for specific procedures to crystallize (kakutei) the type of so-called bracket security interest (ne-tampoken) that is used in revolving loan transactions. Under Japanese law, a revolving loan is generally secured by a bracket security interest so that it will cover the full amount of the secured claim, which may change over time. A peculiarity of bracket security interests, however, is that they do not automatically transfer to an assignee of the secured obligation. In the case of a revolving loan secured by a bracket mortgage on real property, for example, if the lender transfers the revolving loan to another lender, the new lender will not obtain the benefit of the mortgage unless it has been crystallized and thereby converted to a non-bracket mortgage, or unless the lender-assignor, the lender-assignee and the borrower agree to certain matters relating to a corresponding assignment of mortgage. Before the amendments to the Code, it was not always easy to tell when a bracket mortgage had been crystallized. Generally, crystallization occurred when the amount of secured principal became definitively fixed, such as through acceleration of the loan. The amendments to the Code together with amendments to Japanese registration law now provide a procedure whereby the lender can crystallize the bracket mortgage by fixing the principal amount at its discretion and then registering it.

Prospects

The primary and secondary market for syndicated loans has increased over the past few years. Mizuho Corporate Bank estimates that the domestic market for syndicate loans grew from being nonexistent in 1997 to being a ¥15.4 trillion ($140 billion) industry by 2002, and projects that it will eventually reach ¥70 trillion by 2007. While there remain aspects of Japanese law that continue to create legal issues in structuring syndicated loans, Japan has been in the process of deregulating the financial services industry since 1996 with the aim of improving the Japanese financial markets and the competitiveness of Japanese financial institutions. As a result, Japan's financial institutions have begun to offer a more comprehensive range of services, and it is hoped that continuing movement toward deregulation will further foster the development of Japan's syndicated loan market.

About the authors

Akira Marumo

Akira Marumo is a partner of Mori Hamada & Matsumoto, practising in the area of banking, IT laws, mergers and acquisitions finance, and structured finance. He represents many banks and financial institutions in lending transactions and assisted the Japan Syndication and Loan-trading Association (JSLA) in preparation of the model loan documentation.

He graduated from the University of Tokyo (LLB) and was admitted to practise law in Japan in 1993. He also graduated from Columbia University School of Law (LLM, 1997) and was admitted to practise law in New York in 1998.

He is the co-author of Multimedia Business and Laws (1995), Providers' Liability Law (2002) and Syndicated Loan Practice (2003).


Mitsue Tanaka

Mitsue Tanaka is an associate of Mori Hamada & Matsumoto, practising in the areas of corporate finance, banking, securitization and structured finance.

She graduated from the University of Tokyo (LLB, 1998) and was admitted to practise law in Japan in 2000. She will pursue her LLM at Columbia University School of Law from August 2004.

She is the author of "Legal Issues regarding Securitization of Housing Loans" (Kikan Saiken Kanri, Vol 97, 2002).