Securitization trends

Author: | Published: 5 Jan 2004
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The Japanese securitization market has seen an increasing use of sophisticated techniques and structures in relation to both existing and new asset classes and business operations. The general desire of the authorities to facilitate the use of securitization by clarifying legislation and removing legal uncertainties or inefficient regulation has no doubt helped. The recognition of the range of purposes for which securitization may be used - including more efficient use or financing of assets or business operations, corporate restructuring and, in the case of financial companies, the release of finance to smaller and start-up businesses - has been evident in the various proposals recently announced.

Recent regulatory initiatives

Proposed amendments to insolvency laws
After receiving public comments on its proposals last year, the Ministry of Justice published a Summary of Proposed Amendments to the Bankruptcy Law on September 10 2003. The proposed amendments referred to in the Summary include a number of substantive reforms as well as a general review of the procedures to be followed in insolvency proceedings. The proposed reforms of particular relevance for securitization transactions are summarized below.

The actual drafts of the amended Bankruptcy Law (Law 71 of 1922, as amended), Corporate Reorganization Law (Law 154 of 2002, as amended) and Civil Rehabilitation Law (Law 225 of 1999, as amended) are expected to be made available and submitted to the Diet next year. Amendments to the existing proposals set out in the Summary, or new proposals, could be introduced during the drafting and legislative process.

Sale of an asset at the fair price - judicial interpretation of Article 72 of the Bankruptcy Law
The Great Court of Judicature (the Supreme Court's predecessor) determined in a case in 1933 (12 Minshu 637 (Great Court of Judicature, April 15 1933)) that a trustee in bankruptcy of a seller may nullify the sale of real estate, pursuant to Article 72 of the Bankruptcy Law, on the grounds that the transaction is prejudicial to creditors of the transferor even if the purchase price represents the fair value of the relevant asset.

The Supreme Court's reasoning was that if the nature of the asset changed from real estate (non-moveable and not easily realizable) to cash, the seller would be able to dissipate or misuse the cash more easily and, depending on the specific circumstances of each bankruptcy, creditors in bankruptcy may be prejudiced as a consequence.

Although the courts have subsequently recognized some limited cases where a sale would be upheld and not nullified, the burden of proof is on the purchaser to establish whether any of these limited cases applies. In a separate case, the Supreme Court confirmed that a trustee in bankruptcy could not nullify the sale of a movable asset if it could be established that the purchase price received by the seller represented the fair value of the asset.

These court decisions relating to real estate pose a nullification risk in relation to the securitization of real estate. This has hampered the development of the securitization market for real estate as an asset class.

In the Summary it is proposed that the Bankruptcy Law be amended so that a trustee in bankruptcy will not be able to nullify the sale of any type of asset if the purchase price represents the fair value of the asset unless the following conditions are met:

  • the nature of the change of asset resulted in a probability that the seller would conceal or dissipate the sale proceeds or otherwise prejudice the interests of creditors of the seller (prejudicial action);
  • at the time of the sale, the seller intended to take prejudicial action; and
  • at the time of the sale, the purchaser knew that the seller intended to take prejudicial action.

If the proposed amendments are enacted, a trustee in bankruptcy would have to prove that these three conditions are met to nullify the sale of an asset at the fair price. In relation to the second and third conditions, the assessment would be made as at the time of the sale, and subsequent circumstances would not be taken into account in determining whether or not the sale may be nullified.

Similar amendments would be made to the equivalent provisions in the Corporate Reorganization Law and the Civil Rehabilitation Law.

If enacted, the amendments would remove the specific nullification concern in relation to the securitization of real estate.

Bankruptcy of a lessor - Article 63 of the Bankruptcy Law
Under Article 63 of the Bankruptcy Law, if a lessor has been declared bankrupt, an assignment of lease receivables by the lessor to a third party purchaser may not be asserted against creditors (and thus will not be recognized) in the bankruptcy of the lessor unless the relevant receivables are payable in respect of the current and immediately following rental period as at the time of the declaration of bankruptcy. Accordingly, except for the rental payments payable in respect of the current and immediately following rental period, (which if the rental period were monthly would mean the rental payments for two months only), the assigned lease receivables are treated as assets of the lessor in any bankruptcy proceedings relating to it.

There was concern that this provision jeopardized the successful securitization of lease receivables in Japan. But after a Supreme Court decision in 1995 (49 Minshu 4, 1063 (Sup Ct, April 14 1995)), it has been generally accepted that Article 63 applies only to an ordinary lease and not to a finance lease. However, this interpretation has not been free from doubt because the case the Supreme Court addressed regarded the interpretation of a related, but not equivalent, provision to Article 63 in the Corporate Reorganization Law. Also, the Supreme Court was considering the position of a bankrupt lessee as opposed to a lessor.

Following the facts of that case it is assumed that a finance lease has the following characteristics:

  • the lessor will recover all of the funds invested by it in the purchase of the leased asset by way of lease payments;
  • the lessee has no option to terminate the lease;
  • the lessor is not obliged to repair or maintain the leased asset; and
  • the lessee assumes all risks relating to the performance and quality of the leased asset.

It is unclear from this case whether all of such characteristics are necessary to qualify as a finance lease but it is generally accepted that this is the prudent approach to take. In any event, it is clear that Article 63 does apply to an ordinary lease and the issue has added additional complexity to the securitization of leased assets and lease receivables where a finance lease is clearly not involved.

Under the proposed amendments, Article 63 of the Bankruptcy Law will be deleted. Accordingly, lease receivables sold by a lessor to a third party purchaser will not be treated as assets of the lessor in insolvency proceedings unless the sale is otherwise nullified for fraudulent conveyance or preference.

Similar provisions in the Corporate Reorganization Law and the Civil Rehabilitation Law will be also deleted.

Bankruptcy of a lessor - Article 59 of the Bankruptcy Law
Under Article 59 of the Bankruptcy Law, if neither the debtor nor the third party has completed its performance of a bilateral contract, the trustee in bankruptcy of the debtor may choose either to terminate the contract or to perform the contractual obligation of the debtor and demand that the third party perform its obligations.

It is arguable whether or not Article 59 of the Bankruptcy Law applies to a lease. The Supreme Court (49 Minshu 4, 1063 (Sup Ct, April 14 1995)) has held that, before its amendment in 2002, the then Article 103 (now Article 61) of the Corporate Reorganization Law (which is the equivalent provision to Article 59 of the Bankruptcy Law) does not apply to a finance lease, but has not otherwise addressed this issue.

The decisions of the lower courts are divided on the point. A material reason for this uncertainty is that it is argued that Article 59 should not be permitted to operate in any way that prejudices the general protection afforded to a lessee under Japanese law. The better view is that Article 59 should not apply to a lease of land or building if a leasehold right in respect of the land or building is perfected as against third parties.

In the Summary it is proposed that the Bankruptcy Law be amended to make it clear that Article 59 does not apply to a lease if the right to use the asset is duly perfected as against third parties. It is proposed that similar amendments will be made to the equivalent provisions in the Corporate Reorganization Law and the Civil Rehabilitation Law.

Before the Summary was issued it had been suggested that a new provision should be inserted into the Bankruptcy Law confirming that Article 59 does not apply to a finance lease. No such proposal is contained in the Summary. It is believed that this omission reflects a reluctance to delay the publication of the Summary in order to determine a suitable definition of finance lease to include in the legislation as opposed to any opposition to the general interpretation of the Article following the Supreme Court decision referred to above.

Bankruptcy of a lessee - Article 621 of the Civil Code
Under Article 621 of the Civil Code, when a lessee has been declared bankrupt, a lessor may terminate a lease. But the courts have consistently restricted the termination of a lease by a lessor in the case of a lease of land to protect the lessee (including the Supreme Court (27 Minshu 9, 1287 (Sup Ct, October 30 1973)).

In the Summary it is proposed that Article 621 of the Civil Code be deleted. Thus, if a lessee goes bankrupt, a lessor may not terminate a lease, but the trustee in bankruptcy of a lessee may choose to either terminate or continue the lease in accordance with Article 59 of the Bankruptcy Law.

Limited recourse provisions
In public discussions before the publication of the Summary it had been suggested that the treatment of limited recourse provisions and the validity of non-petition clauses should be specifically addressed and clarified in the new legislation. These issues are of great importance in the context of a securitization transaction.

The prevailing view is that a limited recourse provision is valid and enforceable as against a specific creditor but the treatment of such clauses by the trustee in bankruptcy in insolvency proceedings has been open to interpretation and is thus uncertain. In relation to non-petition clauses, the prevailing view is that a non-petition clause restricting a creditor as opposed to a director from taking action to institute bankruptcy proceedings is valid and enforceable as against the creditor but there is no statutory confirmation or judicial precedent for such view.

The publication of the Summary was considered an ideal opportunity to clarify the position in the Bankruptcy Law and other relevant legislation but unfortunately the Summary does not refer to or propose any amendment to the Bankruptcy Law to address these issues. The reasons for this omission are unclear but it can only be surmised that it was decided not to delay the publication of the Summary in order to address this issue.

Proposed amendments to the Trust Business Law
The Trust Business Law (Law 65 of 1922, as amended) restricts the range of assets that may be transferred to a trust and requires any entity wishing to conduct trust business to obtain a trust licence. Rigorous requirements are required to be met to obtain a trust licence and in practice principally the Japanese trust banks conduct trust business in Japan.

Trusts have been widely used in securitization structures in Japan because of certain tax advantages, bankruptcy remoteness and the general flexibility of a trust. But the involvement of a Japanese trust bank has added to transaction costs and this involvement has not necessarily been warranted where the relevant assets continue to be managed and serviced by the originator or a third party.

Pursuant to its general desire to facilitate the further use of securitization techniques, a division of the Deliberation Council (Kinyu Shingikai, Kinyu Bunkakai, Dai-ni Bukai) set up by the Financial Services Agency issued a report in June 2003. It proposed that the Trust Business Law be amended to expand the range of assets that may be the subject of a trust and to encourage more participants, including corporate and other non-financial institutions, to engage in certain categories of trust business.

While draft legislation remains to be published, the report indicates that the limitation on the assets that may be the subject of a trust will be abolished, thereby permitting assets such as intellectual property rights to be the subject of a trust. The report also proposes that new categories of trust business, including holding assets on trust solely for purpose of the issue and sale of beneficial interests and holding trust assets without any discretion as to the management of such assets, be introduced that may be conducted by a broader range of participants. The criteria to be met by any such participant has not been determined but it is expected to be much less onerous than that required to be met to obtain a full trust business licence. Equally the form or manner of authorization remains to be determined.

One proposal is to require an entity conducting a new category of trust business to be registered with a competent authority (probably a local finance bureau). Any such registration procedure would be expected to be relatively straightforward.

If pursued and enacted, such proposals would be expected to facilitate the setting up of trust vehicles by originators for the conduct of securitization transactions as opposed to having to appoint a Japanese trust bank. This would be likely to increase the flexibility of securitization structures, permitting for instance the setting up of trust vehicles by corporate groups for securitizations by members of the group, and help in reducing costs.

In a related development, in an interim report issued by a division of the Deliberation Council (Sangyo Kozo Shingikai Sangyo Kinyubukai) set up by the Ministry of Economy, Trade and Industry (METI), it is reported that consideration is being given to the amendment or repeal of the Specified Claims Law (Law 77 of 1992, as amended).

The Ministry initially introduced the Specified Claims Law in 1993 to facilitate the securitization of receivables by leasing and credit card companies to enable them to diversify their funding sources and raise further funds to finance new lending. The Law imposed a number of restrictions on the structure and implementation of securitizations by leasing and credit card companies that were initially considered necessary to protect investors in the new forms of transaction.

If the Trust Business Law is amended to facilitate the setting up and operation of specific categories of trust business by new market participants, the Specified Claims Law would almost invariably continue to impose more onerous restrictions on the use of such new trusts by leasing and credit card companies unless it is amended or repealed. It appears that METI does not see any reason to retain or impose any more onerous restrictions in relation only to leasing and credit card companies. In terms of timing it is likely that any legislation would be introduced to coincide with the amendment of the Trust Business Law.

The Specified Claims Law also introduced a simple perfection method in relation to the transfer of receivables securitized under it. Anecdotal evidence suggests that in recent years, after the enactment of the Perfection Law (Law 104 of 1998, as amended) that introduced a new registration system for perfection purposes, the perfection procedure under the Specified Claims Law has not been so frequently used. While the authorities have not announced a decision as to the retention or otherwise of this means of perfection, it may well be abolished in view of its declining use in practice.

Continual clarification

Securitization practitioners will welcome the proposals to amend the insolvency laws and the Trust Business Law. The amendments will clarify various legal and structuring concerns and should present opportunities for the securitization of new and more problematic asset classes and business operations.

However, these proposals should only be regarded as a further step in the right direction. The clarification and review of the legal and regulatory environment in the specific context of securitization must be a continual process.

Author biographies

Masayuki Okamoto

Freshfields

Masayuki Okamoto is a partner of Freshfields Law Office. His specialties include finance and banking, and corporate and commercial matters. His clients include both Japanese and international banks and securities companies and large international corporations.

Okamoto was educated at the University of Tokyo, the Legal Research and Training Institute of the Supreme Court of Japan and Cornell Law School. He is a Japanese bengoshi and a member of the Dai-ichi Tokyo Bar Association and the New York Bar. He speaks Japanese and English.


Mark Keeler

Freshfields

Mark Keeler is a partner of Freshfields Foreign Law Office. He has worked in Asia for more than 20 years, including in Tokyo, Hong Kong and Singapore. He specializes in all aspects of international debt and equity capital markets offerings, structured financings and securitization. His clients include large Japanese and international financial institutions.

Keeler was educated at King's College London and the College of Law, London. He qualified as a solicitor in England and Wales in 1980 and is a licensed foreign lawyer in Japan. He is a member of the Dai-ichi Tokyo Bar Association and the Law Society of England and Wales.


Shigeru Kaneko

Freshfields

Shigeru Kaneko is a senior Japanese associate in Freshfields Law Office. His practice area covers corporate and finance transactions, including securities issues and derivative transactions.

Kaneko was admitted as a Japanese bengoshi in 1996 and was admitted in New York in 2002. He was educated at the University of Tokyo, the Legal Research Institute of the Supreme Court of Japan and New York University, School of Law. He is a member of the Dai-ni Tokyo Bar Association and the New York Bar. He speaks Japanese and English.



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