On 20 January 2023, the Interim Proposal on the Reform of Secured Transaction Law (“Interim Proposal“) was published by the Japanese government. The Interim Proposal is, among other things, intended to govern security interests created by secured transactions, such as security assignments and sales with retention of title, that have been recognized by court precedents. The Interim Proposal also considers the introduction of a new type of security interest over all the assets of a company’s business. In this article, we briefly discuss key topics with respect to such security interests and the potential impact of the Interim Proposal on secured transactions and corporate restructuring and insolvency.
- Indirect finance, primarily bank lending, has traditionally played a major role in the Japanese financial markets. Real estate collateral (mortgages) and personal guarantees have often been used to secure such bank debts.
- As such, in practice it is difficult for some small and medium-sized enterprises (SMEs) and start-ups that do not own many real estate assets to access such traditional financing. On the other hand, liabilities of any individuals who personally guarantee a company’s debt (typically, business owners) could be excessively heavy. To reduce banks’ over-dependence on real estate collateral and personal guarantees, there has been growing demand for more diversity in financing options.
- One possible solution has been for banks to accept a company’s movable property and receivables as collateral. In practice, security assignments (joto tampo) and sales with retention of title (shoyuken ryuho) have been widely used to secure movable property that needs to remain in the company’s possession for the continuation of its business (e.g., inventory and machinery), whereas security assignments have been commonly used to secure receivables and other claims.
- In the absence of statutory rules specifically governing such transactions, the rules have been exclusively formed through court precedents. However, the scope and applicability of court precedents are not always clear, and there are still legal questions to which court precedents do not provide answers.
- In light of the above, the government considers it necessary to review the current law on secured transactions, taking into account the increasing use of movable property and receivables as security in financing transactions. It has compiled the Interim Proposal to clarify the application of the law and enhance commercial certainty.
Clear rules on security assignment
- Due to the absence of statutory provisions, the legal effect of security assignments remains unclear. For instance, there is no clear court precedent on whether it is legally possible to assign a single property to multiple creditors by way of security (in other words, whether it is possible to create senior/subordinated security interests through the assignment of property).
- The Interim Proposal expressly allows for the creation of multiple security interests over a single asset through multiple security assignments. The Interim Proposal also clarifies that the subordinated secured party can enforce its security interest only when it obtains consent from all senior secured parties.
Aggregation of movables/claims
The Interim Proposal intends to introduce specific rules for security assignments of collective movables and future claims, both of which have already been recognized by the courts.
- The Interim Proposal defines “aggregation of movables” as a group of movables that fall within a scope specified by category, location, designation of quantitative threshold or any other characteristic of which new movables would become a part upon the creation of the security interest. It confirms that the security interests over an aggregation of movables can be created through security assignment.
- Furthermore, the Interim Proposal defines “aggregation of claims” as a group of claims that fall within a scope specified by (i) the period during which such claims arose and (ii) the cause of such claims, which may contain future claims.
Perfection of security assignment of movable
- According to the Interim Proposal, security assignments of movables can be perfected by delivery of the subject movable, including constructive delivery (i.e., an obligor has manifested an intention to possess the subject movable on behalf of an obligee but there has been no physical delivery of the subject movable). Security assignments of an aggregation of movables can be perfected by delivery of constituent movables. Delivery of the subject movables is deemed to be made upon registration of a security assignment of movables.
- The order of priority among competing security interests in movables is determined by the order of perfection.
- However, with regard to the rule on the order of priority between (A) security assignments of individual movables and (B) security assignment of aggregation of movables where (A) is made after (B) and the individual movables subject to (A) become part of the aggregation of movables subject to (B), two proposals have been made: the order of priority shall be determined by the order of (i) perfection of each security assignment, or (ii) perfection of (A) and the individual movables’ entry into the aggregation of movable.
- Notwithstanding the above, an exception called the “registration priority rule” has been proposed. According to this rule, if any security assignment of movables perfected by registration conflicts with a security assignment of movables perfected only by constructive delivery, priority shall belong to the registered security assignment.
Perfection of security assignment of claims
- Security assignments of subject claims against the obligor can be perfected by way of written notice from the assignor (i.e., the security provider) to the obligor, or by written consent of the obligor. If such notice is given to the obligor or such consent is obtained through an instrument bearing a certified date, perfection becomes effective against third parties as well as the obligor.
- Security assignment of claims can be perfected against third parties other than the obligor through registration. Further, if the obligor is informed of the registration by receipt of a certificate of registered matters or the obligor consents to such registration, the security will be perfected against the obligor.
- Unlike the security assignment of movables, the registration priority rule has not been proposed for the security assignment of claims.
Enforcement of security assignment
- Security assignments of movables can be enforced by way of voluntary sale of the subject movables or, if the security provider does not cooperate with such sale, public auction under the Civil Execution Act.
- Enforcement of security assignments of aggregation of movables requires notice to the assignor and, at the time of receipt of such notice, the aggregation of movables shall “crystallize.”
- New movables that enter into the aggregation after such crystallization has taken place will not be subject to the security assignment.
- The secured party (assignee) will be unable to re-enforce its security interests in respect of any movables that join the aggregation following the first enforcement action.
- While in general, an enforcement notice will crystallize all movables constituting an aggregation, if the secured party gives notice to the assignor in respect of a specified part of the aggregation, the subsequent enforcement action will still be permitted to cover the remainder of movables constituting the aggregation.
- To enforce the security assignment of claims, the secured party (assignee) can exercise its right to collect the subject claims against the obligors or conduct a voluntary sale of such claims.
Treatment of security assignments under insolvency proceedings
It is proposed that the existing rules on the treatment of security interests during insolvency proceedings be extended to security assignments. This would have the following effects:
- Secured creditors would be able to exercise and enforce their rights under the security assignment separately from the bankruptcy proceedings or civil rehabilitation proceedings for the assignor.
- However, in the case that the assignor is subject to corporate reorganization proceedings, security interests created by way of security assignment will not be separately enforceable. The claims secured by security assignment will only be repaid in accordance with the reorganization plan, under which
- holders of such claims (i.e., secured creditors) will enjoy first priority to the extent of the value of their collateral.
- Any contractual provision that causes the release of ownership by the assignor of any assets subject to security assignment upon the filing of civil rehabilitation proceedings or corporate reorganization proceedings will be void.
Introduction of an all-assets security interest
- Most secured transactions envisage that the proceeds realized through the sale of specified individual collateral will be used to repay the secured obligations. On the other hand, under certain cash flow-lending transactions, typical examples of which are project finance and LBO finance, security interests are created over all the borrowers’ individual assets within the current secured transaction law system and the lending is provided based on the cash flow of the borrower rather than on the value of the individual assets it posts as collateral.
- In addition, start-ups and other companies without tangible assets such as factories will often struggle to procure traditional bank loans, which depend upon a borrower’s ability to provide real estate collateral or personal guarantees. Such companies have a need for financing based on the going-concern value and potential value of the business.
- In light of this, the Interim Proposal examines whether to introduce a new type of security over all the assets of a company business (“Enterprise Charge“). It discusses various issues, such as the scope of parties who will be entitled to make use of Enterprise Charges, the scope of the subject property, the effects and enforcement of such security interests and their treatment under insolvency laws.
- The Enterprise Charge is being separately discussed by a working group, which published a report on 10 February 2023 summarizing the results of its deliberations.
Prospects and future challenges
- If successfully passed by the Diet as proposed in the Interim Proposal, the forthcoming legislation will be a revolutionary reform of Japanese law on secured transactions and may make financing transactions more diverse, secure and predictable.
- However, please note that, regardless of the publication of the Interim Proposal, there are a number of issues that remain to be discussed, including the following:
- Whether to amend the current registration system for the transfer of movables and claims
- The effect of a security assignment of an aggregation of movables/claims on movables/claims that join the aggregation following the commencement of insolvency proceedings
- Whether to permit clawbacks when the debtor increases the movables/claims subject to aggregation (i) by an extraordinary extent (e.g., beyond the ordinary course of business), or (ii) under certain subjective conditions of the debtor
- The details of the rules on Enterprise Charges
The new reform is expected to have a significant impact on Japanese financial transactions and corporate restructurings. All market participants should carefully follow any future legislative developments and discussions.
This post was co-authored by Kiki Kurosawa, a Trainee in the Tokyo office.