Debt finance

Some key areas affecting giving and taking of guarantees and security are as follows.

Capacity

It is important to check the constitutional documents of a company giving a guarantee or security to ensure it has an express or ancillary power to do so and there are no restrictions on the powers of directors that would otherwise restrict the provision of security. For instance, a decision to borrow and/or to give a guarantee in respect of a significant amount must be made by the board of directors and may not be entrusted to any individual director. Furthermore, a transaction giving rise to a conflict of interest (such as a guarantee by a company for the obligations of its directors) must be approved by the board of directors, with the director in conflict abstaining from the vote on the relevant resolution. Each director of a company owes the duty of care of a good manager and a duty of loyalty to the company. As such, a director must be able to demonstrate that adequate corporate benefit is derived from the giving of a guarantee or security.

Insolvency

Guarantees and security may be at risk of being set aside under Japanese insolvency laws if they are:

• provided with little or no consideration within six months of or after the company's suspension of payment;
• provided after the company becomes unable to pay its debts generally and the creditor is aware of the suspension of payment or the company's inability to pay its debts generally; or
• provided after the application for commencement of bankruptcy proceedings and the creditor is aware of such application.

Guarantees and security may also be challenged on other grounds relating to insolvency.

Provision of profit

A company may not provide any benefit to its shareholders in relation to or in connection with the exercise of shareholder rights by a shareholder.

Obligation of a lender taking a guarantee from an individual

A lender taking a guarantee from an individual is required to use credit information held by a designated credit bureau to verify the individual's credit worthiness. However, the Total Volume Control lending requirement (that the amount of total lending against the individual's annual salary must be one third or less) does not apply to guarantees given by an individual.

Upstream guarantees

Upstream guarantees are possible. However, if there is no adequate consideration for or corporate benefit derived from such guarantee, a breach of the directors' duties would be an issue.

Common forms of guarantees

Two types of guarantees may be given.

(Normal) guarantee (hosho)

A guarantor has the right of defense of demand which permits a guarantor to require that the beneficiary first demand performance by the principal obligor. The further right of defense of reference permits a guarantor to require that the beneficiary first enforce against the principal obligor's property by demonstrating that the principal obligor has sufficient financial resources to satisfy the debt and that the satisfaction of the obligation could be easily performed by enforcing against the principal obligor.

Joint and several guarantee (rentai-hosho)

A joint and several guarantor does not have the right of defense of demand or the right of defense of reference. Under this type of guarantee, the guarantor owes the same obligation as the primary obligor.

Under the amended Civil Code that is effective as of 1 April 2020, regardless of the type of the principal obligation, if the guarantor of such obligation is an individual, the amount guaranteed by such individual much be subject to a clear cap. As a result, in the case of a guarantee of any type of principal obligation, including tenant’s obligation under a lease agreement or purchaser’s obligation under a continuous sales and purchase agreement, as long as an individual is the guarantor, the guarantee must specify the maximum amount of the guarantor’s obligation. Otherwise, such individual guarantee would be invalid.

Common forms of security

Three basic types of security interest can be created under Japanese law.

Mortgage (teitouken)

A mortgage may be created on rights to real property and certain other types of property such as automobiles, aircraft and factories.

Pledge (shichiken)

A pledge may be created on an asset that can be assigned to others such as chattels, real property and rights. For a pledge (other than a pledge on right without a deed) to be effective, the asset must be ‘delivered’ (hikiwatashi) to the pledgee. In the case of a pledge on movable property, the pledgee must continuously possess the pledged asset for the pledge to remain valid.

Security by way of transfer (joto-tampo)

A security by way of transfer is not a statutory security. It is commonly used to avoid the potentially stringent requirements for a pledge on a movable property, in particular, that the pledgee must continuously possess the pledged asset. A security by way of transfer enables the pledgor to possess and use the pledged asset even during the security period.

Giving or taking guarantees

To be valid, a guarantee must be in writing.

There is a further risk that a guarantee may be set aside if improperly obtained, for instance, by undue influence. It is best practice for a party taking the benefit of a guarantee to take steps to avoid claims of undue influence by, for example, requiring the guarantor to obtain independent legal advice.

Giving or taking security

Once granted, security must be properly perfected. Perfection formalities may include:

• 'delivery' of the pledged assets to the security holder (e.g. a pledge on a movable property);
• registration of the security (e.g. a mortgage on a real property); and
• notification to the obligor of the right pledged.