Practical Explanation of Debt-Equity Swaps (DES) in Japanese Corporate Law

A Debt-Equity Swap (DES) is a powerful method for companies to improve their financial health and pursue business reconstruction. This transaction involves converting a company’s debt into equity, specifically into shares of the company. In practice, creditors holding monetary claims against a company can contribute those claims as capital, receiving the company’s shares in return. This approach has the potential to dramatically improve the balance sheet of companies burdened with excessive debt. For instance, by reducing liabilities and bolstering equity, it can resolve insolvency issues and restore credibility with financial institutions and business partners. DES can also be utilized in the context of mergers and acquisitions (M&A) and business succession to reorganize the debts of the acquired company and lessen the burden on successors. However, behind its powerful effects lie complex regulations set forth by Japanese Corporate Law and Tax Law. Legally, DES is treated as a form of capital increase known as “in-kind contribution,” which requires strict procedures for its execution. This article provides a detailed explanation of the legal nature of DES, its managerial benefits and risks, specific legal procedures, and points of particular practical concern, all based on Japanese legislation.

Overview and Legal Nature of Debt-Equity Swaps (DES) Under Japanese Corporate Law

One of the most crucial aspects to understand about DES is that it is positioned as a form of “in-kind contribution” under the Japanese Companies Act. While those who subscribe to shares typically pay money to the company, Article 199, Paragraph 1, Item 3 of the Japanese Companies Act allows for contributions in the form of property other than money. Such contributions of property other than money are referred to as “in-kind contributions.” In a DES transaction, the creditor contributes their “monetary claim against the company” to the company, not in cash, but as the contribution itself.

As a result of this transaction, the company acquires the contributed monetary claim. In other words, the company becomes both the creditor and debtor of its own debt. When the rights and obligations of a debt are attributed to the same entity, they are extinguished. This legal effect is based on the principle of “confusion” as stipulated in Article 520 of the Japanese Civil Code. Consequently, the company can issue shares to increase its capital while simultaneously extinguishing the corresponding liabilities.

Thus, the fact that DES is legally structured as an in-kind contribution has implications beyond mere technical classification. The Japanese Companies Act imposes strict regulations on in-kind contributions to prevent the company’s capital from being effectively impaired by the contribution of worthless assets or overvalued assets, which could disadvantage other shareholders and creditors of the company. Therefore, when executing a DES, it is essential to strictly adhere to the series of legal procedures related to in-kind contributions. Understanding this legal nature is the starting point for grasping all the procedures and risks associated with DES.

The Strategic Advantages and Potential Risks of DES in Japanese Corporate Management

Debt-Equity Swaps (DES) represent a strategic option that involves significant management decisions for both debtor companies and creditors. It is essential to carefully weigh the advantages and risks involved.

From the perspective of the debtor company, the primary advantage is a fundamental improvement in financial health. By converting debt into equity, liabilities on the balance sheet decrease, and net assets increase. This leads to an enhanced equity ratio, allowing the company to escape from a state of excessive debt. If external creditworthiness is restored, it can lead to new financing from financial institutions and improved relationships with business partners. Furthermore, the elimination of the need to repay loans and interest payments significantly improves cash flow, freeing up funds for business restructuring and growth investments.

However, there are significant risks for the company that cannot be ignored. The most considerable risk is the dilution of management rights. Financial institutions that were previously mere creditors become shareholders with voting rights, exerting direct influence on management. This can lead to a decrease in the controlling power of existing shareholders and potentially restrict management’s freedom. Additionally, while interest payments are eliminated, there may be a burden of paying dividends to new shareholders if the company’s performance recovers. Moreover, if the capital increase results in a capital stock exceeding 100 million yen, the company must consider the tax disadvantage of no longer being eligible for preferential tax measures for small and medium-sized enterprises.

On the creditor side, DES can be a realistic option for recovering claims from companies on the brink of bankruptcy. While debt forgiveness results in a complete loss of the claim, acquiring shares through DES allows for the potential upside in the future. If the company’s restructuring is successful, the value of the shares held can increase, potentially yielding a return that exceeds the original claim amount through capital gains from the sale of shares or dividend income. Additionally, as shareholders, creditors can participate in management and actively work to oversee the restructuring process and maximize their investment value.

Yet, the risks for creditors are also significant. The greatest risk is the subordination of legal claim priority. A loan, which has a preferential repayment ranking against the company’s assets, is converted into shares, which have the most subordinate claim. If the company fails to restructure and is liquidated, the value of the shares becomes zero, making it extremely difficult to recover the investment. Furthermore, the contractual interest income is lost. Additionally, if the target company is a private entity, the acquired shares lack marketability, making it very challenging to sell and liquidate, presenting a liquidity issue. Essentially, DES is a transaction that fundamentally shifts the creditor’s investment stance from a defensive position of low risk and low return to an offensive position of high risk and high return.

Execution Procedures for Debt-Equity Swaps Under Japanese Corporate Law

Since a Debt-Equity Swap (DES) involves in-kind contribution, it is necessary to follow the strict procedures set by Japanese Corporate Law. At the heart of these procedures is the investigation system conducted by an inspector appointed by the court.

Article 207, Paragraph 1 of the Japanese Corporate Law stipulates that when an in-kind contribution is made, the company must apply to the court for the appointment of an inspector to investigate whether the value of the property contributed is appropriate. This procedure is an important system to prevent overvaluation of in-kind contributed assets and to ensure the enrichment of the company’s capital, but it can be a significant burden in practice due to the time and cost involved.

However, Japanese Corporate Law provides significant exceptions to this principle. Article 207, Paragraph 9 of Japanese Corporate Law lists several cases where the investigation by the inspector is not necessary under specific conditions, making the execution of DES feasible, thanks to these exceptions. The most relevant to DES is the provision in Item 5 of the same paragraph. According to this provision, the investigation by the inspector is not necessary if the property contributed is a “monetary claim against a joint-stock company” and the following two requirements are met:

1. The payment date for the monetary claim has arrived.
2. The contribution value set for the monetary claim does not exceed the book value of the liability related to the monetary claim.

This provision is designed to facilitate DES. When a company contributes its own debt as an in-kind contribution, the value can be objectively verified by the company’s books, reducing the risk of overvaluation and thus the necessity for an inspector’s investigation. In practice, if the payment date for the claim has not yet arrived, a widely used method is for the debtor company to make a declaration of “waiver of the benefit of the term,” artificially bringing the payment date forward to meet this requirement.

Considering these provisions, the general procedure for a DES is as follows: First, the company and the creditor agree on the execution of the DES. Next, the company’s board of directors resolves on the issuance of new shares for subscription, and a special resolution is obtained at the shareholders’ meeting (typically requiring the attendance of shareholders with a majority of voting rights and approval by a two-thirds majority of the voting rights of the attending shareholders). After approval, the creditor applies for subscription of the shares, and the company allocates the shares. Then, within two weeks from the effective date, an application for registration of changes is submitted to the Legal Affairs Bureau. At this time, in addition to the registration application, it is necessary to attach the minutes of the shareholders’ meeting, a shareholder list, a share subscription certificate, and copies of the company’s accounting books to prove the existence and value of the monetary claim that was the subject of the contribution.

Significant Legal and Tax Considerations in Implementing DES in Japan

While Debt-Equity Swaps (DES) are an effective financial restructuring tool, their implementation carries significant legal and tax risks. Overlooking these risks can lead to unexpected losses and liabilities.

One legal risk that requires particular attention is the “liability for shortfall in contribution value.” Under Japanese Corporate Law (Articles 212 and 213), if the value of the property contributed in kind is significantly less than the amount of capital stipulated by the company, the parties involved, such as the creditors in the case of DES or the directors who conducted the solicitation, are jointly responsible for compensating the shortfall to the company. Even if the inspection by the statutory auditor is waived, there remains a risk of being held accountable for this liability if the valuation of the contributed claims is deemed inappropriate after the fact. Therefore, it is crucial to ensure that the claims being contributed are legally valid and have a substantive value equivalent to their book value.

However, from a practical standpoint, the more serious issue often lies with the tax risks, namely the taxation on “gains from debt forgiveness.” From a tax law perspective, when a company receives a waiver of debt, the amount waived is considered profit (income) for the company and is subject to corporate tax. In the context of DES, if the book value of the debt being extinguished is higher than the market value of the shares being issued, the difference may be recognized as a gain from debt forgiveness and become taxable. For example, if shares worth 50 million yen are issued to extinguish a 100 million yen debt, the difference of 50 million yen could be taxed as a gain from debt forgiveness. It is imperative to avoid a situation where, despite implementing DES for financial improvement, a substantial amount of tax payment is required, which could paradoxically worsen the company’s cash flow.

Learning from Case Law: The Risk of DES and the Duty of Explanation by Experts

The significance of tax risks associated with Debt-Equity Swaps (DES) is evident from actual case law. Particularly noteworthy is the Tokyo District Court’s decision on May 30, 2016 (Heisei 28), which strictly questioned the breach of the duty to explain by a tax professional.

In this case, a certain accounting firm proposed the execution of a DES to a client company as an inheritance tax measure for the owner. However, they failed to adequately explain the significant risk that the execution of DES would result in a substantial debt forgiveness benefit for the company, leading to a corporate tax liability of approximately 300 million yen. As a result, the company that executed the DES was forced to pay an unexpected and substantial amount of taxes.

The court fully recognized the accounting firm’s responsibility and ordered compensation for the entire amount of damage suffered by the company. In its decision, the court pointed out that the tax risk associated with the debt forgiveness benefit of DES is a matter of common knowledge for tax experts. Furthermore, the court ruled that as professionals providing advice, they had a duty to explain such significant risks concretely and sufficiently so that the client could understand. The failure to do so was concluded to be a breach of the duty of care required of professionals.

This case clearly demonstrates that DES is not merely a matter of corporate procedural law. Even if DES is executed with legally perfect procedures, ignoring the tax implications can deal a devastating blow to management. In planning and executing DES, integrated knowledge spanning both corporate and tax law is essential, and professionals are subject to an extremely high duty of care.

Another Approach: Comparing with “Pseudo-DES”

To avoid the tax risks associated with debt extinguishment gains in kind contribution DES, a practice known as “Pseudo-DES” is sometimes employed in the field. This method aims to achieve different tax effects by changing the legal form while maintaining the same economic substance as the in kind contribution DES.

Pseudo-DES consists of two consecutive transactions:

1. First, the creditor makes a cash contribution to the company, similar to a normal third-party allotment increase, and receives shares in return.
2. Then, the company uses the paid-in cash to “settle” the debt owed to the creditor.

In this method, the debt is extinguished not by “confusion” through in kind contribution but by “settlement” with cash. Since the capital increase through cash payment and the debt settlement with cash are structured as separate transactions, the company does not typically realize a debt extinguishment gain, thereby avoiding the tax risk.

However, there are risks associated with Pseudo-DES as well. If the tax authorities view this series of transactions as essentially one and determine that the sole purpose is to reduce the tax burden, they may deny it as a “tax avoidance act” and tax it in the same way as in kind contribution DES.

Below is a table summarizing the main differences between in kind contribution DES and Pseudo-DES.

Choosing between these two methods requires a sophisticated strategic decision that takes into account tax risks, procedural clarity, and the potential for being classified as tax avoidance by the authorities.

Conclusion

Debt-equity swaps are an extremely effective means of revitalizing a company’s financial structure and enabling its recovery. However, executing them is akin to handling a sword with a sharp blade. Not only must one strictly adhere to the procedures for in-kind contributions as stipulated by the Japanese Companies Act, but managing the significant tax risk associated with debt forgiveness gains is also crucial to the success or failure of such endeavors. The decision to choose between an in-kind contribution-based DES and a synthetic DES, along with its application, requires deep insights and careful planning across both legal and tax aspects.

Monolith Law Office has a wealth of experience in advising on the execution of debt-equity swaps for a diverse range of clients, both domestic and international. Our team includes several English-speaking attorneys with foreign legal qualifications, enabling us to handle international cases. We provide comprehensive support, from the formation of transactions compliant with Japanese corporate law and the execution of procedures to the identification and mitigation of related tax and legal risks. To safely and effectively utilize such complex financial strategies, please take advantage of our specialized knowledge.