Japan: Project finance needs know-how

Author: | Published: 1 Oct 2008
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The first project finance loan agreement in Japan was executed in 1998. It served as the basis for the first independent power producer (IPP) project in Japan. Since then, the number of project finance transactions in Japan has increased each year, mainly involving IPP projects.


One reason why project finance has become popular in Japan is the deregulation of the power industry. Historically, as Japan had many good domestic quasi-governmental bodies with ample sources of finance for power generation projects, there was no need for (and therefore there were no) pure private industry entities involved in and also no private financing for such projects. However, as awareness of the advantages and benefits of deregulation spread, private industry entities started to enter the Japanese power supply business. As mentioned above, the power purchase agreement for the first IPP project in Japan was executed in 1997, and the project finance loan agreement for this IPP project was executed in 1998. A few other relatively large Japanese IPP projects followed, including a 1,400 MW IPP project in Kobe, Japan, following which Japanese regional power companies, which had exclusively supplied power to Japanese end-users, agreed to purchase electricity from the IPP on a long-term basis. Financing for that IPP was provided on a project finance basis.

However, there has been little progress with respect to such deregulation. There are several reasons for this. One reason is the continuing dispute as to whether the faults of deregulation outweigh its merits, not only with respect to the power business but also with respect to other industries. Regarding this issue, Japanese regional power companies, which are in essence competitors of the new power producers, do not have an incentive to increase PPA-type transactions. On the other hand, potential newcomers do not hesitate to start up their power businesses in Japan. Another reason might be that people are now more interested in the reduction of greenhouse gases. In most of the IPP projects in Japan, coal-fired or gas-fired power plants are used. The costs of reducing greenhouse gases generated by such plants seem to be unknown.

Instead, the number of wind power plants in Japan has increased. In fact, there are several wind power projects financed through project financing schemes. However, there are few policies intended to promote wind generated electricity. For example, unlike some other countries, Japanese regional power companies are not legally obliged to purchase electricity generated by wind power plants.


Some people might point out that the introduction of private finance initiative (PFI) in Japan has led to the increased popularity of project finance. Following the success of PFI efforts in the UK, the so-called PFI Law of Japan (the Law Concerning the Promotion of the Design and Construction of Public Facilities through the Utilisation of Private Funds) was enacted in 1999. Since then, more than 200 PFI projects have been launched in Japan. It is said that most of such PFI projects are financed through project financing schemes.

However, project financing for most of PFI projects does not follow a genuine project financing scheme. In PFI project finance in Japan, any and all risks of the Special Purpose Company (SPC), that is, the borrower of the project financing, must be passed onto either the subcontractors that enter into contracts with the SPC or the SPC's sponsors without limitation of liability. This means that the SPC is free from any risk and the project finance lenders do not bear any risk associated with the project. The only risk that the project finance lenders incur is the risk regarding the creditworthiness of such subcontractors and sponsors. There are several reasons for this. One reason is the structure of the PFI projects. Only the design, construction and maintenance, and not the operation, of the project are included in most of the PFI projects in Japan. The operation is included in only some of them. However, in those PFI projects, the operation portion is merely ancillary to the primary operations of the project. This means that PFI projects in Japan are, by their nature, unsuitable for project financing schemes. Another more prevalent reason might be the lack of understanding of the nature of PFI and project financing. Simply stated, the nature of project finance is that: (i) the project finance lender assumes some amount of the operation and maintenance risk of the project; and (ii) the project should emphasise the primary operations to be carried out by the private sector. Incredibly, many of the PFI and project finance specialists in Japan believe that project financing is financing through which any and all project risks are passed onto the other companies involved in the project. Regrettably, PFI has failed to substantially affect the actual perception of project financing schemes. Rather, it has negatively affected the progress and development of project financing schemes and structures in Japan.

Legal issues

Initially, it was envisaged that a legal structure supporting project financing in Japan would be introduced to the extent possible under Japanese law, so that legal issues arising from project financing could be clearly addressed under principles of existing Japanese law and applicable Japanese law would be promoted. What actually occurred was that, because the initial stage of project financing proceeded with the execution of agreements, many people in Japan believed that project financing could be done under Japanese law. This is another example of the fact that there is, in fact, no legal specialist who has a complete understanding of the nature of project financing in Japan.

Legal issues related to project financing often arise under the laws of other countries. There are, however, more issues relating to project financing that arise under Japanese law that are critical from the perspective of genuine project finance: they are addressed below.

Real estate mortgage foreclosure

As project finance legal specialists are well aware, the purposes of granting a security interest over the assets of a project in cases involving project financing are: (i) to exclude any risk of disposal or attachment of the assets of the project by a third party so that the cash flow of the project is protected; and (ii) to give the lenders the right to have the assets of the project transferred to a third party (or its SPC) so that the third party can continue to carry out the project and the project will generate enough money to repay loans made through the project finance. These purposes are different from those related to corporate financing.

The security interest that is typically granted over the real estate included in the assets of a project in Japan is a mortgage and not an assignment as security interest of the real estate. The foreclosure procedure for a mortgage on real estate under Japanese law is a legal enforcement proceeding resulting in the public auction of the collateral real estate by a Japanese court. This means that there is no legal assurance that real estate included in the assets of the project will be transferred to a third party selected by the lenders to, among other things, carry out the operations of the project. In addition, sometimes it takes more than a year to consummate such foreclosure procedures in Japan. This means that the project cannot be transferred in a timely manner. A project will be transferred to a third party if the then-current sponsors do not carry out the operations of the project in accordance with their agreement with the offtaker of the project and the SPC is in default of such agreement. If the project is not transferred in a timely manner, the project will be terminated by the offtaker and the third party will not be able to continue the project.

There may be provisions in the mortgage agreement providing for the right of the lenders to sell the collateral real estate. In order to do so, however, the lenders must obtain a power of attorney from the SPC to sell the real estate and register the sale in the public real estate registry. However, whether or not such sale by power of attorney is practically workable is uncertain.

A security interest over the real estate might also be granted in the form of an assignment as security interest of interest in such real estate. However, such an assignment is not commonly used in Japan and its legal effects are not clearly established.

Land and buildings as separate real estate

Unlike in most other countries, in Japan a building is recognised as being a separate real estate interest from the land on which it stands. This means that even if a security interest is granted over the land for a project, the legal effect of such security interest does not cover the building on that land. In addition, a mortgage over a building cannot be validly created before the building is constructed. This means that if project finance loans are made before the completion of a relevant project, the loans will not be secured by a mortgage over a building in the project that is under construction.

In cases where the project finance loans are made before construction of a project-related building has been completed, if only the SPC owes an obligation to grant a mortgage over such building, there is no legal assurance that the project finance lenders will obtain a security interest over such building because the borrower's violation of said obligation would merely result in an event of default under the project finance loan agreement. The sponsors should owe such obligation with respect to this point.

Assignment of contractual status

As mentioned above, the most compelling reason for creating a security interest over the assets of a project is to enable the project finance lenders to force an assignment of such assets from the SPC to another entity by enforcing rights arising from its security interest. This means that a security interest should be granted over all of the SPC's contracts that relate to the project. Under Japanese law, as is the case with most civil law systems and unlike common law, contractual status as a party to a contract is recognised separately from the rights and obligations under the contract. This means that not only the rights and obligations but also the contractual status as a party to a contract should be the subject of a security interest secured by a project finance lender. On the other hand, the prevailing legal viewpoint in Japan is that no security interest can be granted over a contractual status as party to a contract. A current practical scheme to resolve this issue is for the SPC to grant an option to the project finance lenders that allows such lenders to acquire or have a third party acquire the SPC's contractual status as party to a contract. However, it has not been conclusively determined whether this option is enforceable or how such a transfer would be effected.

Another method by which project finance lenders may have a third party succeed to a contract is through novation. However, novation is rarely used in Japan. The novation of a contractual obligation is provided for in the Civil Code of Japan, but not the novation of a contract. Therefore, the conditions to effect a novation of a contract under Japanese law remain uncertain and it is not clear whether such a novation of a contract is workable from the viewpoint of project finance in Japan.

Validity of a security interest over future rights

The validity of a security interest over a future right to receive money is not clearly established under Japanese law. If a company is to receive a payment, e.g., on an annual basis, and the amount of the payment is not fixed at the time of the creation of the security interest, the company's right to receive payment is classified as a future right. A security interest over an SPC's right under a long-term project agreement with the offtaker is also classified as a future right and the validity of the security interest on such future right remains unclear under Japanese law. Recent judicial decisions have established that a security interest can be granted over future rights that extend for a period of nearly seven years from the time the security interest is granted. Current practice in Japan to establish and maintain a valid security interest over a future right is to re-execute the security agreement every few years to ensure that this seven-year limit is not breached. Considering that a security interest is created to enable the lender to compel the assignment of the whole project to a third party, the current structure for providing a security interest over future rights is not adequate, regardless of however many times the security agreement is re-executed.

In addition, the project finance lenders will bear the risk that the SPC may not re-execute the security interest to maintain the security interest over the future right. To hedge this risk, the sponsors should owe obligations to the project finance lenders, which would ensure that such security interest will be maintained or the lenders' interests will be protected.

Validity of a security interest over bank accounts

The validity of a security interest over a bank account is also not clearly established under Japanese law. The rights of an accountholder are not clearly recognised under Japanese law because the amount of the money deposited with a bank account may vary. This is the reason why such validity is not perfectly clear. However, there have been many articles written on this issue by law professors and legal practitioners, none of which state that a security interest over a bank account is unenforceable.

Sponsor guarantee

Naturally, an SPC is used as the vehicle to carry out the project finance projects. As is the case in other countries, the reason an SPC is used for such projects is to attempt to insulate all other parties apart from the SPC from any liability that may arise from a project and therefore limit the liability exposure of the operator to the assets of the project held by the SPC. One of the most problematic issues is that a Japanese offtaker will sometimes require the shareholders or subcontractors of an SPC to guarantee all or some of the obligations of the SPC under the offtake agreement. In this regard, it should be noted that sometimes the offtake agreement will impose obligations on the SPC to pay large monetary amounts to the offtaker under certain circumstances (breach, for example).

No cure period

Under project financing schemes, an agreement between the project finance lenders and the counterparty, including the offtaker, over the project agreement executed by the SPC (or the so-called direct agreement in the case of the PFI) is important. One of the matters to be set forth in such an agreement is the cure period for the project finance lenders. The cure period enables the project finance lenders to cure the default by the SPC, find a third party who will take over the project and continue to carry out the project and have the project transferred to such third party. However, some offtakers (especially the offtakers of PFI projects) do not agree to a cure period. From a practical point of view, not only the project finance lenders but also the sponsors should confirm the availability of an acceptable cure period for project finance lenders before they enter into an agreement with the offtakers.

New security trustee system

One recent development that has greatly benefited project finance in Japan is the introduction of the security trustee system by the New Trust Act, which took effect on September 30 2007.

It is generally known that the security trustee structure reduces the costs and the amount of time it takes to transfer loans secured by a security interest. These benefits facilitate loan financing, especially project finance loan syndication. Since the enforcement of the New Trust Act, some loan syndications have adopted the security trustee structure. Yet, many bankers are still not confident in using the security trustee structure. One reason for this apprehension is that in syndicated loans: (i) the procedures for enforcement of such security interest; and (ii) the procedures that take place in the event of bankruptcy of the borrower, are unclear. Another practical issue is that each lender prefers to have a security interest in its name and to be able to enforce such security interest on its own.

Under Japan's security trustee system, the security trustee only acts as the holder of a security interest. In project finance loan syndication transactions, however, the security trustee's role is not limited to that of a holder of a security interest. For example, in project finance loan syndication transactions, the security trustee confirms the satisfaction of the conditions precedent to a loan advance, gives and receives various kinds of notice and other communications for the project finance lenders, and at times becomes a beneficiary of a letter of credit that is the credit enhancement of the loans. These issues should be highlighted and resolved through the future practice of project finance in Japan.

The most serious problem with project finance in Japan is the lack of practitioners who have a good knowledge of the legal issues. Unless these issues are recognised and resolved, the Japanese market will not be attractive to foreign investors or sophisticated Japanese investors who actually know project finance. The resolution of this problem is of practical importance to further economic growth in Japan.

Author biography

Takao Higuchi

Nagashima Ohno & Tsunematsu

Takao Higuchi received an LLB from the University of Tokyo in 1987, was admitted to the Japanese Bar in 1989 and received an LLM from Columbia in 1995. Takao's practice involves banking, project finance, structured finance and corporate law.