Insight: Japan to introduce a new type of security interest the ‘Enterprise Value Charge’
Introduction
On June 7, 2024, a new Act on the Promotion of Cash Flow-Based Lending (the Act) was promulgated in Japan.
The Act will introduce a new type of security interest, the “Enterprise Value Charge” (the EVC). In simple terms, the EVC is a new type of floating charge over all of a corporate debtor’s assets.
The Act outlines basic government policy on promoting business cash flow lending, certification of operators who support and promote business cash flow lending and the establishment of a new government office for business cash flow lending in the Financial Services Agency (the FSA).
In Japan, taking security over “all assets” generally requires lenders to take and register multiple security interests on an asset-by-asset basis, which can be cumbersome.
Inspired by the US and UK regimes, which allow for granting security over all present and future assets through either UCC filings or a fixed and floating charge registration, it will now be possible to create a security interest over all of a company’s assets through a single trust agreement, and to register it with the commercial registry of the debtor company in Japan.
The Act will come into effect by the end of 2026. The exact date is to be separately determined within two and a half years from its promulgation date after the relevant Cabinet Order and Cabinet Office Ordinance have been issued.
The EVC is expected to be used in cash flow-based lending, venture debt, leveraged financing, acquisition financing and project financing. It’s expected to have a significant impact on both financing and debt restructuring in Japan. This Insight provides an overview of the EVC.
Background
In Japan, bank financing tends to be difficult to obtain without a supporting real estate mortgage or a proprietor’s personal guarantee.
The purpose of the Act is to encourage business operators to obtain financing based on their business and future cash flow, ie the enterprise value of the business, as opposed to financing secured by real estate or a personal guarantee. This new type of security will cover intangible assets such as knowhow, relationships with customers and anticipated future cash flows as well as traditional tangible assets.
The Act aims to facilitate financing for business startups with limited tangible assets but with sufficient enterprise value, and for business operators who are hesitant to raise funds necessary to expand their business due to concerns about having to provide personal guarantees in respect of the company’s liabilities.
Article 1 of the Act provides that “the purpose of the Act is to support the continuation and growth of companies’ businesses by correcting financing practices that rely on real estate collateral or personal guarantees from individuals, and by facilitating the procurement of funds necessary for companies’ businesses, thereby contributing to the sound development of the national economy”.1
Basic features of the Enterprise Value Charge
Assets subject to the EVC
The EVC will cover “all assets” of the debtor company. “All assets” includes:
- real estate, shares held by the debtor company in other companies, intellectual property, the debtor company’s rights or status, and insurance policies; and
- all future assets that the debtor company acquires after the creation of the EVC.
It should be noted, however, that:
- if the debtor company operates multiple businesses, it cannot have assets pertaining to only parts of those businesses subject to the EVC; and
- third-party security is not permitted, ie no third party can create an EVC over its assets to secure the obligations of the debtor company.
The EVC is similar in nature to a UK floating charge. The EVC allows the debtor company to use or dispose of the EVC assets in the ordinary course of its business, without the consent of the EVC holder (ie the trustee) until the debtor company defaults and the enforcement of the EVC commences. The debtor company must obtain the consent of all of the relevant EVC holders to any asset disposals outside of the ordinary course of business.
Eligibility and structure
An EVC can only be created over the assets of a “company” as defined in the Companies Act of Japan. Individuals or other types of entities (including entities incorporated outside of Japan) and partnerships cannot grant an EVC over their assets.
The EVC is created through a security trust structure. The debtor company must enter into an EVC trust agreement with a licensed trustee (which includes a Japanese bank and trust company). One key advantage of this trust structure is that it can accommodate trading of the secured loans since the assignee of a secured loan will become a beneficiary of the EVC as a “Specified Secured Creditor”.
A Specified Secured Creditor is a person that holds specific claims or unspecified claims that fall within the relevant scope of the EVC trust agreement.
There is also a second class of beneficiary: the “Unspecified Secured Creditors”. These are general creditors of the debtor company who will be allocated a certain percentage of the enforcement proceeds if an EVC is enforced. The method of allocating value to Unspecified Secured Creditors hasn’t yet been determined but is expected to be outlined in the Cabinet Order that will implement the EVC regime.
Importantly, the EVC only becomes valid and effective when it’s registered in the commercial registry of the debtor company. Unlike in the UK, where the security interest has to be registered within 21 days, the Act doesn’t prescribe any period of registration.
Ranking/priority
The priority between competing EVCs and other security interests over any assets of the debtor company will be determined by the timing of the EVC registration and the perfection of the other security interests. Registration is not centralized, and it will be necessary to check both the debtor company’s commercial registry and the relevant asset register, if any.
Specified Secured Creditors receive distributions from an EVC’s enforcement proceeds in priority to other creditors (subject to the requirement for a portion of the distribution proceeds to be allocated to Unspecified Secured Creditors).
If a compulsory seizure exercise in respect of other security interests (even those subordinated to the EVC), foreclosure sale, or disposition for national tax delinquency is carried out against any asset of the debtor company before the EVC is enforced, the EVC holder might not receive payments from the realizations of the individual assets subject to those proceedings.
The EVC holder cannot file an action against these procedures unless it can demonstrate that the procedures would hinder the continuation of the debtor’s business.
Role of the trustee
Only those who have a license granted by the Prime Minister can act as an EVC holder (ie the trustee) by entering into an EVC trustee agreement with the debtor company. Such persons will be a trustee known as the “Enterprise Value Charge Company” under the Act and are subject to the supervision of the FSA. The trustee is the sole secured party under the trust agreement.
Enforcement
The key procedural steps involved in the enforcement of an EVC will include:
- The trustee filing a petition with the court against the debtor company.
- A court decision to commence enforcement proceedings and the appointment of an administrator to the debtor company.
- Business continuation by the administrator.
- A sale of the business of the debtor company (or of individual assets if approved by the court).
- Filing, investigation and determination of claims by the administrator.
- Distributions to creditors.
In respect of (a) above, the Act specifies that the EVC becomes enforceable if the secured claim isn’t paid when due or the debtor company is dissolved without paying the secured claim in full or at the time specified in the trust agreement.
Enforcement of the EVC is initiated by the first ranking EVC holder by filing a petition with the court to commence enforcement proceedings.
If the court decides to grant the petition and commence enforcement proceedings, the court will appoint an enforcement administrator, who will take over the management of the debtor’s business and has the power to dispose of its assets. At the same time, the court has to issue a commencement order. This is announced publicly, immediately after the order is published and individual stakeholders are notified of ancillary information regarding the enforcement proceedings. When the enforcement proceedings start, the debtor company’s payments (except for statutory priority claims)2 are generally stayed.
In principle, the assets that are subject to the EVC will be realized through a sale or transfer of the debtor company’s entire business (if, after the enforcement proceedings start, the enforcement administrator deems it necessary, individual assets of the debtor company may be disposed of with permission of the court).
Enforcement of overlapping security interests by the EVC holder is prohibited as long as the EVC exists, so it won’t be possible for the EVC holder to pursue enforcement action in respect of individual asset security in parallel. This is a key disadvantage of the EVC that lenders will need to consider when structuring their security package.
General creditors such as trade creditors or employees are beneficiaries of the EVC and when the EVC is enforced, a certain percentage of the proceeds must be retained for the benefit of the debtor company’s general creditors. As noted above, the method of calculating this amount and any cap on the quantum will be stipulated by the relevant implementing Cabinet Order.3 Further, under the Act, with the permission of the court, the enforcement administrator is allowed to pay general creditors’ claims if it is necessary for the continuation of the debtor company’s business, the protection of the debtor company’s trade creditors, or the fair enforcement of the EVC.
Secured creditors, other than the Specified Secured Creditors, with a security interest over the debtor company’s assets with a superior priority to the EVC can enforce their security interests outside of the EVC proceedings.
Treatment of the Enterprise Value Charge in insolvency proceedings
The EVC will be treated as a mortgage in formal insolvency proceedings in Japan, including bankruptcy, civil rehabilitation, corporate reorganization and special liquidation.
Consequently the EVC holder won’t be bound by a creditor moratorium in bankruptcy or civil rehabilitation proceedings and therefore can exercise its enforcement rights notwithstanding the proceedings. However, the EVC claim will be treated as a secured reorganization claim in a corporate reorganization proceeding and the EVC holder will be stayed from enforcing their security during the proceedings.
Key takeaways
We’re eagerly awaiting the Cabinet Order and Cabinet Office Ordinance for important further details on this new security interest and will need to see how it will operate in practice once implemented. The EVC, however, is a welcome addition to the secured lending tool kit in Japan. It will provide a simpler and more streamlined process for lenders to take security interests over all assets of the debtor company. This will be beneficial for various types of transactions, including leveraged or acquisition finance.
On July 19, 2024, the FSA announced that it has organized a project team in the FSA to promote cash-flow based lending and the issues relevant to the EVC are expected to be considered in the FSA with market participants.
We’ll keep you updated on further developments regarding the Act and the EVC.
1Under the Act, enforcing a personal guarantee provided by an individual for an obligation secured by an EVC is in principle, restricted, except for meeting certain requirements to be prescribed by the Cabinet Office Ordinance.
2Under the Act, claims of employees for the six-month period before enforcement proceedings start (among others) are categorised as priority claims which will not be subject to enforcement proceedings.
3This has some similarities to the position in the UK liquidation or administration where a portion of the proceeds of realizing assets covered by a floating charge must be set aside and made available to satisfy unsecured debts. In the UK this amount is calculated as a percentage of the company’s property which is subject to a floating charge and is currently capped at GBP800,000 for floating charges created on or after April 6, 2020.
