By Midori Yamaguchi (Mori Hamada & Matsumoto, Tokyo, Japan)
Debtor-in-possession (DIP) financing is known as the supply of additional financing to financially distressed debtors undergoing insolvency procedures. This kind of loan has become an essential component of restructuring as rescue financing for debtors on the verge of cash shortages.
Historically, the U.S. developed legislation in favor of DIP lenders by giving special protection to DIP loans under chapter 11, U.S. Code (the Bankruptcy Code). It has promoted DIP loans, resulting in a large DIP financing market.
Japanese law has also protected, to some extent, rescue financing during in-court and out-of-court restructuring procedures. The following is an overview of the legislative provisions and practical methods adopted to protect rescue financing in Japan, with some comparisons to the U.S. legislation.
DIP Financing in Court Procedures and "Pre-DIP" Financing in Out-of-Court Workouts
In Japan, whereas DIP financing entails additional funding during in-court procedures as other countries also define it, new loans provided during out-of-court workouts are called “pre-DIP” financing. Besides in-court proceedings, preliminary insolvency workouts outside the courts are becoming more common in Japanese corporate restructurings. They require the unanimous consent of the creditors involved but are more beneficial than court procedures since the workout is processed confidentially, faster and in a less costly manner, resulting in more going-concern value.
In particular, Japan has distinctive pre-insolvency regimes of rule-based out-of-court workouts in which participants must follow particular rules, guidelines or laws under the supervision of independent specialists. As preliminary insolvency proceedings, all of them aim to standardize the workout process and help facilitate the negotiations between distressed debtors and their creditors, which are mainly limited to financial institutions. For example, one of the major rule-based workouts, turnaround ADR (alternative dispute resolution), is employed primarily for the debt restructuring of large to medium-sized companies.
Each case is supervised by experts, usually attorneys and an accountant, who are selected as “operators” by the Japanese Association of Turnaround Professionals (JATP), a private organization but certified under the Act on Promotion of Use of Alternative Dispute Resolution. These operators preside over the process and review the proposed restructuring plan, according to the current Act on Strengthening Industrial Competitiveness, its regulations and the JATP procedural rules.
In these workouts, a debtor facing a shortage of liquidity often obtains new funding, pre-DIP financing, from lenders such as financial institutions or a potential sponsor.
Legislative Provisions on DIP Financing
In Japan, civil rehabilitation is the most common regime of judicial restructuring-type insolvency proceedings. According to the Civil Rehabilitation Act, which stipulates the civil rehabilitation process, DIP-financing claims made after filing for civil rehabilitation proceedings are considered “common benefit claims” if a court permits or a supervisor approves/consents to the DIP financing.
Since “common benefit claim” is a similar concept to administrative expense in the U.S. and must be repaid ahead of other unsecured claims during the civil rehabilitation process, it is comparable to giving priority over unsecured claims like in conversions from unsecured claims into administrative expenses under § 364(b) of the U.S. Bankruptcy Code. However, there are no systems such as super priority or priming liens in the U.S. that allow such claims to be prioritized over all other administrative expenses or existing liens.
Legislative Provisions on Pre-DIP Financing
In out-of-court workouts, pre-DIP financing is basically repaid outside the restructuring plan with priority over other claims of the creditors involved due to its indispensability.
Conversely, if an out-of-court workout fails and is transferred to judicial proceedings such as civil rehabilitation, the pre-DIP financing claim is not automatically treated as a common benefit claim with priority over other unsecured claims, unlike DIP financing described above, because the pre-DIP financing was not executed during the in-court procedure and must comply with the general bankruptcy equitable concept that the same class of pre-petition claims be treated equally.
This makes the lenders hesitant to provide pre-DIP loans due to concerns that they may not be protected if the debtor’s workout fails, resulting in court insolvency proceedings. In such cases, Japanese law may prioritize pre-DIP-financing claims to encourage rescue financing as follows.
If the workout is a turnaround ADR procedure and is transferred to civil rehabilitation proceedings, the court may approve a proposed rehabilitation plan that differentiates between the pre-DIP financing claims and the claims of other financial creditors participating in the workout, considering that equality will not be compromised, when the JATP confirms that (1) the new loan is indispensable for the continuation of the debtor’s business and (2) the debtor has obtained the consent of all participant creditors under Articles 56, 57 and 58 of the Act. With such confirmation, the pre-DIP-financing claims may be repaid preferentially in the subsequent court restructuring proceedings.
Though the ultimate decision is left to the court on the priority of the pre-DIP-financing claim, and that priority cannot be guaranteed, the court should properly respect the confirmation made by the JATP and the financial creditors’ consent in practice. It should be noted, however, that this preferential repayment is for when switching to a rehabilitation-type court procedure, not when transferred to a bankruptcy procedure. This preferential treatment has been extended to pre-DIP financing during another rule-based workout regime, the Councils Scheme, upon the 2021 amendment of the Act, indicating the trend toward promoting rescue financing.
Practical Means of Protection: Collateral and Conversion to Common Benefit Claims
Again, Japan has no legislation like super priority under § 364(c) of the U.S. Bankruptcy Code or priming liens under § 364(d) of the same. However, this does not hinder DIP or pre-DIP lenders from negotiating to obtain secured interests in any unencumbered assets or priority over existing liens. Rather, it is common practice for lenders to demand collateral to secure DIP and pre-DIP loans to already-distressed debtors.
Since viable-but-distressed debtors in many cases have already pledged substantial assets such as real properties to cover their existing debts, lenders frequently need to consider liquid assets such as receivables and inventory for collateral, which are not commonly pledged for normal working-capital loans. With full collateral security, there are also multiple legal approaches to convert pre-DIP financing into common benefit claims after the transition to the court procedure beyond the method of repaying preferentially in the restructuring plan mentioned above.
Conclusion
Since the Japanese legislative protection of DIP financing is not as strong as the U.S. version, rescue financing tends to be regarded as a high-risk investment, and its market in Japan is not as large as in the U.S. However, some major Japanese banks have recently established special departments to offer DIP and pre-DIP financing, which implies the possible growth of the rescue financing market.
Moreover, it is worth noting that the adoption of priming liens in Japan is being discussed, particularly in the context of a law concerning creating security interests in the entire corporate business. Part of the argument is that even if all assets of a distressed debtor are already pledged, it should be possible for DIP financing to be secured preferentially by any assets, as priming liens do. Otherwise, no lenders would be willing to extend DIP financing without any collateral. Further consideration is expected in systemizing and developing DIP financing and effective reorganization in Japan.
(*)The full article was published as a Committee Newsletter Post in the American Bankruptcy Institute.
