The Act was originally enacted on December 4 2009 in response to the financial crisis. The legislation obliges banks to use, at the request of SMEs, best efforts to accept amendments to the terms and conditions of loans and to implement an acceptance system to ensure compliance with such obligation, such as a proper disclosure and reporting system to the appropriate financial regulator. It also sets forth the government's obligations to expand and improve the credit guarantee system. The Act was initially set to expire as of March 2011; however, given that the economic conditions in Japan remained unchanged in 2011, it was decided to extend the Act to the end of March 2012. Based on publicly available information, approximately 90% of the loan term amendment applications submitted pursuant to the Act have been accepted by banks.
While the practice of amending loan terms pursuant to the Act has been generally well received, and has prevented the insolvency of certain SMEs, it has been pointed out that there has been an increase in the number of SMEs seeking to obtain the benefits of amending their borrowing arrangements without preparing a business improvement plan. In consideration of this and certain other factors, the government decided in late 2011 again to extend the term of the Act for an additional year until the end of March 2013, and that there would be no further extensions.
Need for a soft landing
Amending loan terms is merely temporary relief: the decrease in the number of SME bankruptcy filings does not necessarily mean that there has been an improvement of economic conditions of SMEs in Japan. Should the Act expire without any alternative ameliorative measures being taken, the number of SME bankruptcy filings may increase dramatically and, subsequently, financial institutions would need to address a number of non-performing loans that had been characterised as high-ranked claims in accordance with the practice under the Act. It is likely that local banks would be particularly hard hit by such a development.
As a countermeasure, the government has announced certain additional measures that will mitigate the impact of the Act's expiry, including facilitating banks providing certain consulting services to SMEs. With respect to the rehabilitation of SMEs, it is believed that the promotion of capital loans might be the most practical method available to local banks.
Capital loans can assist with the rehabilitation of debtors through so-called debt-debt swaps, where certain claims are converted into claims with different terms (typically, subordination to other claims). This method is set forth in the Inspection Manual for Deposit-Taking Institutions, which contain the guidelines by which inspections of financial institutions are conducted, with the practical function of regulating the operation of financial institutions. According to the Inspection Manual, loans that satisfy certain requirements can be regarded as capital for the purpose of assessing the financial condition of debtors, which can mitigate the risk of debtors having to file for bankruptcy; in addition, such an approach relieves certain statutory disclosure obligations with respect to non-performing loans and offers an opportunity to benefit from the release of credit loss reserves.
Capital loans, however, have not, in practice, functioned as originally anticipated. This is partly because the Inspection Manual provided certain examples of loans that satisfy the criteria to be considered a capital loan but did not prescribe what these requirements are. Thus, practitioners struggled to determine when loans could be converted into capital loans and, generally, had to refer to the examples in the Inspection Manual and precedents in order to decide how the loan terms should be amended.
On November 22 2011, the government published a policy (Active Utilisation of Capital Loans) in which the requirements for a loan to be a capital loan were clearly set forth, including conditions with respect to redemptions, the setting of interest rates and subordination (the necessity of collateral releases, and so on). It is believed that the objective of the government is, among other things, to minimise the impact of the termination of the Moratorium Law by promoting the use of capital loans. Discussions between practitioners have also begun regarding more concrete product designs and model contracts for capital loans.
Clarifying capital loan requirements assists with the usability of such instruments. However, the use of capital loans is predicated on the belief that the respective SME's business is a viable going concern; banks are unable to convert lending obligations into capital loans for those SMEs without a viable business plan in place. At this stage, it remains questionable whether the current approach effectively addresses the problem of mitigating SME insolvency applications.