By Hiroshi Kasuya, Yoshihiro Bartlett-Imadegawa and Masayoshi Kobayashi (Baker McKenzie)
Introduction
On 7 June 2024, the National Diet of Japan enacted the Act on the Promotion of Cash Flow-Based Lending (“Act”). The effective date of the Act will be separately determined within two and half years from its promulgation on 14 June 2024.
The Act will bring into effect a new type of security interest called the “Enterprise Value Charge” (“EVC”) by which the entire assets (including future assets) of a corporate debtor can be collateralised.
In this article we provide a brief overview of the EVC, which is anticipated to have a significant impact on both financing and debt restructuring in Japan.
Background
Bank financing and indirect financing have traditionally played a major role in Japanese financial markets, with mortgages over real estate and personal guarantees often being used to provide credit support for such debts. In practice, this has made it difficult for certain companies such as SMEs and start-ups to access financing in Japan due to (i) their limited ownership of tangible assets to offer as collateral for mortgages; and (ii) the potential liabilities of individuals (typically, business owners) personally guaranteeing a company’s debts often being excessively onerous.
Given such realities and in response to the growing demand for a breakthrough in conventional lending practices to facilitate financing to those companies without depending on real estate mortgages and personal guarantees, lawmakers toiled and hammered out the idea of the EVC. A concept like the EVC is unprecedented in the history of Japan’s transactional legal system, because it enables the entire value of a company’s business (including the value of intangible assets such as know-how, customer base and future cash flows) to serve as collateral, whilst traditional secured creditors have been heavily dependent on the aggregate value of the specific assets subject to their security interests.
EVCs are expected to energize the provision of financing to start-ups with limited tangible assets and to business owners hesitant to take on potentially devastating liability in their personal capacity. The use of EVCs may also incentivise financiers to monitor the borrowers’ day-to-day business and future projections in order to provide aid in a timely manner, which could have a positive impact on Japan’s business environment as a whole.
Creation, perfection and priority
EVCs can be created over the entire assets of a “company” incorporated under the Companies Act. Therefore, EVCs are not available to individuals or other non-company enterprises (including any entities incorporated or established outside Japan).
A company cannot create an EVC over its assets to secure the debts of somebody else.
As an important feature of EVCs, EVCs must be created through a security trust agreement executed between the debtor company as the settlor and a trustee who holds a special licence enabling it to act as an “Enterprise Value Charge Trust Company”, which is granted by the Prime Minister pursuant to the Act. Existing licensed trust companies and trust banks (i.e., banks licensed under the so-called “Concurrent Business Act” to operate trust businesses in addition to their ordinary banking businesses) are deemed to be licensed as Enterprise Value Charge Trust Companies, and a bank without a “concurrent business” licence may still act as an Enterprise Value Charge Trust Company on condition that it files a notification with the Japanese government.
The EVC trustee is the sole secured party (EVC holder) under the trust agreement. On the other hand, there are two types of creditors (i.e., beneficiaries of an EVC trust) secured by the EVC as follows.
- Creditors, whether they are a bank or a non-bank lender (e.g., private debt funds), who hold an underlying secured claim (which include future claims) specified under the trust agreement (“Specified Secured Claims”) benefit from the EVC as beneficiaries (“Specified Secured Creditors”).
- Other general creditors who are eligible to participate in a subsequent liquidation or bankruptcy proceeding of the debtor (“Unspecified Secured Creditors”) are also treated as beneficiaries of an EVC trust. The treatment of claims held by Unspecified Secured Creditors (“Unspecified Secured Claims”) in the enforcement process of an EVC is discussed below.
There is no requirement for an EVC trust to set out the maximum amount of the secured claims. However, the debtor may designate the maximum amount at any time by written request to the EVC trustee insofar as the designated amount is not less than the floor amount prescribed under the Act.
An EVC becomes effective when it is registered in the debtor’s commercial registry. If there are one or more perfected security interests other than the EVC (including other EVCs), the order of priority amongst these competing security interests are determined by the order of registration.
Restrictions on the parties
An EVC trustee is entitled to receive distributions in priority of other creditors during enforcement proceeding of the EVC. On the other hand, the EVC trustee is not entitled to receive payments in, amongst others, either: (i) an enforcement of non-EVC security interests; (ii) a compulsory execution filed by an unsecured creditor; or (iii) a recovery proceeding for unpaid taxes instituted by tax authorities. However, the EVC trustee has the right to file an objection to proceedings such as compulsory execution, provisional attachment and the enforcement of security interests if such proceedings interfere with the continuation of the business of the debtor.
If a Specified Secured Creditor concurrently holds other security interests over the debtor’s individual assets (e.g., mortgages over real property or pledges over movables or receivables) (“Overlapping Security Interests”), such Specified Secured Creditors are prohibited from enforcing any of its Overlapping Security Interests. Further, as a general rule, such Specified Secured Creditors are prohibited from exercising their rights under any guarantee or security agreement to which an individual is a guarantor or a security provider, which is aligned with the aim of the Act (i.e., to depart from the over dependence on personal guarantees).
The debtor retains its right to use, benefit from, and dispose of its individual assets even after the creation of an EVC, which is a feature similar to a “floating charge” under the laws of England and Wales and the laws of other Commonwealth jurisdictions and also similar to a floating lien over personal property under the laws of the United States. Nevertheless, any act considered to fall outside the ordinary course of business of the debtor (e.g., disposal of its material assets, transfer of all or material parts of its business, and supply of goods or provision of services at a price significantly less than the costs incurred without any good reason) shall be invalid unless it is conducted with consent from all EVC trustees. Provided, however, the ineffectiveness of such act cannot be asserted against bona fide third parties (i.e., those who are not aware of the fact that the act is outside the ordinary course of business, absent their gross negligence).
Enforcement of EVC
Enforcement proceedings for an EVC are commenced by court order. If an EVC trustee files a petition with a competent court and certain requirements are satisfied, the court is required to issue a commencement order.
Simultaneously with the issuance of the commencement order, the court appoints a “trustee” (to distinguish it from the EVC trustee, hereinafter referred to as “Enforcement Trustee”). An Enforcement Trustee has the exclusive right to manage the debtor’s business and assets and to dispose of such assets, whilst he/she owes a duty of care to the stakeholders. If the court finds it necessary, the court may require the Enforcement Trustee to obtain the court’s permission in order to conduct certain acts designated by the court.
Secured creditors (other than Specified Secured Creditors) with security interests over the debtor’s assets which have superior priority to the EVC (“Senior Security Interests”) are allowed to enforce their security interests outside the enforcement proceeding of the EVC.
Creditors with “Administrative Expense Claims” (e.g., procedural costs, pre-petition withholding tax and certain labour expenses) will be paid without being subject to restrictions under the enforcement proceedings.
Other claims including the following (i) through (iii) (“Distributee Claims”) and (iv) (“Non-Distributee Claims”) are not allowed to be paid outside the enforcement proceedings. However, claims which are considered to be indispensable for the purposes of the fair implementation of enforcement proceedings (e.g., from the perspective of the continuity of the debtor’s business or protection of the debtor’s customers/vendors) can be paid by the Enforcement Trustee outside the enforcement proceedings with the permission of the court.
- Tax claims
- Specified Secured Claims of the relevant EVC other than Administrative Expense Claims (“Petitioned Claims”)
- Secured claims (other than Administrative Expense Claims) secured by “Subordinated Security Interests” (i.e., security interests over the debtor’s assets (other than Overlapping Security Interests) which do not have superior priority to the EVC) (“Subordinated Claims”)
- Other general unsecured claims other than Administrative Expense Claims
A creditor holding (i) or (iii) above must file a proof of claim with the court (in the case of (i)) without delay or (in the case of (iii)) within the period designated by the court at the time of the commencement. On the other hand, a creditor holding (ii) above is not required to file proofs of claim because the Petitioned Claims are already specified in the petition for commencement of proceedings.
The commencement of enforcement proceedings are publicly announced immediately following the commencement order and individual stakeholders are notified of ancillary information such as the appointment of the Enforcement Trustee and the deadline for submission of proof of Subordinated Claims.
The Enforcement Trustee is responsible for determining to allow or disallow the Petitioned Claims and the Distributee Claims, and each of the petitioner and the creditors of the Distributee Claims can file an objection to such Enforcement Trustee’s decision within a certain period as designated by the court at the time of the commencement of proceedings.
To avoid impairing the value of the entirety of the debtor’s business, the Enforcement Trustee is generally required to liquidate the collateral (that is, the debtor’s entire assets) by way of a business transfer after obtaining the court’s permission. The court’s permission is granted only after hearing the opinions of known creditors who hold Distributee Claims and labour unions and/or other representatives of the debtor’s employees. In the event that the debtor is a joint stock company (KK), the shareholders’ resolution and other steps usually required under the Companies Act for the purpose of protecting dissenting shareholders are not required in connection with said court-permitted business transfers. There are some exceptions to the aforementioned general rule - the enforcement trustee may dispose of individual assets constituting the collateral if: (i) the court’s permission is obtained or the court admits that such permission is not necessary; or (ii) such voluntary sale is made in the ordinary course of the debtor’s business.
Upon liquidation of the collateral, the Subordinated Security Interests (other than any EVCs) and Overlapping Security Interests over the debtor’s assets shall be extinguished, whilst the Senior Security Interests and usufructs prior to the EVC remain effective even after the collateral is sold.
Sale proceeds of the collateral shall be distributed to the Distributee Claims. The Non-Distributee Claims do not have the right to receive distributions in the EVC enforcement proceedings. However, a certain proportion (to be prescribed by subordinate legislation) of the amount distributable to the EVC trustee (“Unspecified Secured Claims Reserve Amount”) shall be carved out and reserved for future distribution to Unspecified Secured Creditors in subsequent liquidation or bankruptcy proceedings (and therefore, creditors of the Non-Distributee Claims will receive distributions in such liquidation or bankruptcy proceedings). The EVC trustee shall distribute the remainder to the Specified Secured Claims. If any cash remains left over after distributions to the creditors, the Enforcement Trustee will return the remaining amount to the debtor. Once all distributions are complete, the enforcement proceedings are closed by an order of the court.
Treatment of EVC under insolvency proceedings
EVCs are deemed to be mortgages over real property for the purposes of insolvency laws. Therefore, the EVC trustee can enforce its EVC against the debtor outside of bankruptcy proceedings and civil rehabilitation proceedings - whilst in corporate reorganization proceedings for the debtor, EVCs cannot be enforced outside such proceedings and the claims secured by EVCs may only be satisfied to the extent of the value of collateral pursuant to the reorganization plan.
Enforcement of EVCs can be pursued concurrently with bankruptcy proceedings against the debtor. An Enforcement Trustee is granted a right to petition for the debtor’s bankruptcy, and further, is obliged to file such petition if the debtor turns out to be in a state of balance sheet insolvency. In bankruptcy proceedings, generally, enforcement proceedings can be pursued in priority to the bankruptcy proceedings.
Civil rehabilitation proceedings are suspended while enforcement proceedings of an EVC is pending in respect of the debtor, except that some remedies under the civil rehabilitation proceedings (such as suspension of enforcement of EVCs, avoidance of creation of EVCs, and court permission to release EVCs) may be available.
As mentioned above, EVCs are subject to corporate reorganization proceedings. Therefore, enforcement of EVCs is suspended when corporate reorganization proceedings commence. In corporate reorganization proceedings, the power of the Enforcement Trustee is subordinated to that of the reorganization trustee.
Prospects and Future Challenges
The Act will not only expand the financing options available to companies but will also promote changes to conventional financing practices, and is expected to have considerable impact on financial transactions.
In particular, lawmakers envisage EVCs to be utilized to (i) provide financial options to developing companies with limited tangible assets (such as start-ups); and (ii) provide cashflow financing (including leveraged acquisition finance and project finance) that relies on “all-asset security” schemes.
On 19 July 2024, the Financial Services Agency (FSA) announced that they established a project team for the promotion of the cash-flow based lending under the Act. Also, it is reported that the FSA is preparing a new guideline for financiers who intend to provide financing secured by EVCs (particularly, local banks which are less-experienced in cash flow-based lending) and a standard form of EVC trust agreement, which will be released in the spring of 2025. Through these activities, the FSA will likely identify, examine and address practical issues of EVCs and work more actively to propagate and promote the new regime.
As explained above, the Act is expected to have a significant impact on Japanese financial transactions and corporate restructurings. It would be advisable for all market participants to carefully follow any future legislative developments and discussions.
* This article was originally published by Baker McKenzie.