LBO Loan Security and Guarantees: The Timing of Providing the Target Company's Assets and Directors' Liability

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When a company is bought with part of the acquisition funds borrowed from a financial institution, the term sheet that arrives from the financial institution often includes, as loan conditions, the creation of security over all of the target company's assets and a joint and several guarantee by the target company. The borrower is the company on the buyer's side. The security and the guarantee, on the other hand, are provided by the target company, the company being acquired. This structure is the same whether in a deal where a company established by a successor buys the shares as part of a business succession or in an acquisition by an investment fund.

The buyer's staff in charge tend to accept these conditions as a prerequisite for obtaining the loan. From the perspective of the target company's directors, however, this is a transaction in which the company provides security and a guarantee, with no direct return to itself, for its shareholder's borrowing. If the timing of the provision or the resolution procedures are handled incorrectly, there is room for the directors to be held personally liable.

How the Target Company Supports the Buyer's Borrowing

In an acquisition using an LBO loan, the typical form is for the buyer to establish an acquisition vehicle (SPC) and for the SPC to acquire the shares of the target company with funds it has borrowed from a financial institution combined with its own funds. The SPC is a company that only holds the shares of the target company and has no business of its own that generates earnings. The source of funds for repaying the loan is the cash flow that the target company generates after the acquisition.

This means that the financial institution lends the funds without relying on the creditworthiness of the buyer or the sponsor. For that reason, as a rule, the financial institution requires security to be created over all of the assets held by the target company and its group companies, and guarantees to be given by each group company. Practical books on M&A refer to the former as the all-asset security principle and the latter as the target group guarantee principle.

Japanese law has no easy-to-use security interest that covers all of a company's assets as a single package. Financial institutions build up security interests one type of asset at a time. It is common to create pledges over shares and deposits, security assignments (security by way of transfer) over accounts receivable and movables, and mortgages over real estate.

In a deal where the shares of an unlisted company are bought from the seller all at once, the usual flow is for the SPC to borrow immediately before the share acquisition and use those funds to pay the purchase price to the seller, and for the target company to give the guarantee and create the security immediately after the share acquisition. There are also many examples in which the SPC and the target company are then merged, bringing the borrowing and the business together in the same company.

An Overview of the Issues

What decides the outcome in this transaction is whether the target company's directors may offer the company's assets and credit for the buyer's borrowing. Under the Companies Act, this arises as a question of the directors' duty of care of a prudent manager and duty of loyalty. How this point is resolved determines when the security and guarantees can be provided.

Surrounding it are three issues that govern the procedures for, and the scope of, the provision: the approval of conflict-of-interest transactions where officers on the buyer's side also serve as directors of the target company, the board resolutions needed for the guarantee and the creation of security, and the carving out of assets that are difficult to give as security because of contractual restrictions.

The Duty of Care and Duty of Loyalty of the Target Company's Directors

Article 330 of the Companies Act provides that "the relationship between a stock company and its officers and accounting auditors is governed by the provisions on mandate," and Article 644 of the Civil Code provides that a mandatary "has the duty to administer the mandated affairs in accordance with the main purport of the mandate, with the care of a prudent manager." Further, Article 355 of the Companies Act provides that directors "must comply with laws and regulations, the articles of incorporation and resolutions of the shareholders' meeting, and must perform their duties faithfully for the stock company." If directors neglect these duties and cause damage to the company, they are liable for damages under Article 423(1) of the Companies Act.

What the provision requires is the performance of duties "for the stock company." Even if the target company guarantees the SPC's borrowing, the target company receives no guarantee fee, nor do the borrowed funds come into the target company. If the SPC becomes unable to repay, the target company loses its own assets. The party that benefits is the buyer, which can acquire the shares through the borrowing.

For this reason, it has been pointed out that, at a stage where shareholders other than the buyer remain in the target company, the target company's provision of security and guarantees solely for the buyer's borrowing may breach the directors' duty of care and duty of loyalty. This is because the remaining shareholders are put in a position where the company's property is exposed to risk through a transaction that brings them no benefit at all.

The situation changes once the buyer has acquired all of the shares of the target company. For an acquisition of an unlisted company in which all of the shares are acquired from the outset, it is explained that there is no legal impediment to providing the security and guarantees at the same time as the loan drawdown, that is, immediately after the share acquisition.

By contrast, in a two-step acquisition in which the buyer first acquires a majority of the shares and later squeezes out the remaining shareholders, the general practice is to provide the security and guarantees after the squeeze-out has been completed, unless the consent of the shareholders other than the buyer can be obtained. In the meantime, the security that the financial institution can obtain is limited to assets on the buyer's side, such as the SPC shares held by the sponsor, the target company shares acquired by the SPC and the SPC's deposits. The buyer will discuss the loan conditions with the financial institution on the premise that security over the target company's assets will be created after the squeeze-out has been completed.

As a device for cases where minority shareholders remain, it has also been pointed out that there is room to interpret that the duty of care is not breached if the SPC lends part of its borrowed funds to the target company and the guarantees or security provided by the target company are capped at the amount of that loan. The idea is to have the target company take on the burden only to the extent of the benefit it receives. However, the discussion goes no further than saying "there is room," and I believe that adopting this approach requires examination on a case-by-case basis.

Approval and Board Resolutions Where There Are Concurrently Serving Officers

Article 356(1)(iii) of the Companies Act requires a director to disclose the material facts and obtain approval "when the stock company intends to guarantee a debt of a director, or otherwise to carry out a transaction with a person other than the director in which the interests of the stock company and that director conflict." The approving body is the shareholders' meeting, but in a company with a board of directors, it is read as the board of directors under Article 365(1) of that Act.

Immediately after an acquisition, it is usual for the SPC's representative director or officers dispatched by the buyer to also serve as directors of the target company. A transaction in which a company guarantees the debt of another company of which one of its directors is the representative is interpreted as a conflict-of-interest transaction under item (iii). As long as there are concurrently serving officers, the target company's guarantee of the SPC's debt and its provision of security are transactions that should go through approval as conflict-of-interest transactions.

Even if approval has been obtained, where the transaction causes damage to the company, Article 423(3) of that Act presumes that the director whose interests conflict, the director who decided on the transaction and the directors who voted in favor of the board's approval resolution neglected their duties. The question "for whose benefit is the security being provided?" remains even after the approval procedures have been completed.

As for the resolution, Article 362(4) of that Act provides that decisions on "the disposal and acquisition of important assets" (item (i)) and "significant borrowing" (item (ii)) may not be delegated to directors. Because a guarantee of an LBO loan can constitute significant borrowing, and the creation of security over key assets can constitute a disposal of important assets, a resolution of the board of directors is required in a company with a board of directors. A director with a special interest in the resolution may not participate in the vote (Article 369(2) of that Act). A director who also serves as the SPC's representative director is considered to be such a director with a special interest. At the stage of deciding the new composition of officers, the buyer needs to count whether the quorum and the majority can be met with the number of directors excluding the concurrently serving officers. When preparing the minutes, also check the statutory items covered in How to Prepare Minutes of Shareholders' Meetings and Board Meetings: Statutory Items and What Is Examined in Registration and Due Diligence.

Carving Out Assets Subject to Contractual Restrictions

Even though all-asset security is the principle, some assets are difficult to give as security because of contracts that the target company has entered into with third parties.

A typical example is accounts receivable whose assignment is prohibited under a master transaction agreement. Article 466(2) of the Civil Code provides that even where an anti-assignment agreement has been made, "the effect of the assignment of the claim is not impaired," so the creation of a security assignment is itself valid. Under Article 466(3), however, the business partner, as the obligor, may refuse to pay an assignee that knew of the restriction on assignment or that did not know of it due to gross negligence. A financial institution with which the results of the legal due diligence have been shared will take the receivables as security with knowledge of the restriction on assignment. Because a risk of claims that the contract with the business partner has been breached also remains, the choice will be between obtaining the business partner's consent and removing those receivables from the scope of the security.

Where a subsidiary of the target company has outside shareholders, a shareholders' agreement may require the consent of the minority shareholders for the creation of security over that subsidiary's shares or for a guarantee by the subsidiary. The directors of a subsidiary in which outside shareholders remain also face the same duty of care issue as the directors of the target company. You will negotiate to exclude such subsidiaries from the scope of the guarantors, but note that, under the loan agreement, transfers of funds to subsidiaries excluded from that scope are often restricted in the same way as payments to third parties.

There are also assets, such as those of less significant overseas subsidiaries, for which the cost of creating security is out of proportion to their value as security. The list of which company provides which assets is, by its nature, something that the buyer's side proposes based on the results of the legal due diligence and then settles through negotiation with the financial institution. Negotiation of the loan conditions as a whole is covered in LBO Loan Term Sheets.

How to Proceed with Creating Security in a Business-Succession Share Acquisition

Let us assume a deal in which a company established by a successor or the management team buys all of the shares from the owner at once. In this type of deal, the share acquisition makes the target company a 100% subsidiary of the SPC, so a structure can be adopted in which the target company provides its security and guarantees immediately after all of the shares have been acquired.

The first thing to prepare is a list of which company will offer which assets as security. Identify, without omission, the real estate, deposits, accounts receivable, shares of subsidiaries and other assets held by the target company and its group companies. Then, from the results of the legal due diligence, identify the assets whose exclusion should be negotiated, such as receivables subject to an anti-assignment clause and subsidiaries with outside shareholders.

Next, decide on the timing of the provision. For a deal in which all of the shares are acquired at once, it is explained that the security and guarantees can be provided immediately after the share acquisition. In a structure where some members of the founding family or an employee shareholding association remain as shareholders, that premise cannot be assumed. At the term sheet stage, discuss with the financial institution whether to obtain the consent of all of the remaining shareholders or to postpone the timing of the provision until after all of the shares have been acquired. If you agree to the loan conditions without settling this point, you will end up with, as a condition to drawdown, a provision of security that the directors cannot approve by resolution.

At the same time, check the post-acquisition composition of officers with an eye to the approval of conflict-of-interest transactions and the board resolutions. You need to have enough directors, excluding the concurrently serving officers, to meet the quorum and the majority.

If an existing lender holds security over real estate or deposits, the first-ranking security required by the new financial institution cannot be created unless the repayment of that loan and the cancellation of that security are completed first. For each lender, settle in advance the sequence of fixing the repayment amount of the existing borrowing, receiving the cancellation documents and creating the new security.

The release of the personal guarantee given by the owner, who is the seller, should also be included in the same plan. The SME M&A Guidelines (3rd edition) of the Small and Medium Enterprise Agency, revised in August 2024, cite, as a means of reliably releasing or transferring the personal guarantee by the business owner on the selling side, a method in which the covered debt is repaid at closing using the resources of the acquiring side and the acquiring side separately refinances. A structure in which the existing borrowing is repaid with an LBO loan and replaced with new borrowing overlaps with this means. The Guidelines also state that whether the release or transfer is carried out ultimately depends on the judgment of financial institutions and other creditors, and that the formal release or transfer must take place after closing, once the representative has been changed in the commercial register. On that basis, the Guidelines state that, in light of the fact that the consideration of the M&A will become known to the financial institution, it is also conceivable to ensure thorough confidentiality and hold a prior consultation together with the acquiring side.

For cases where the release is sought after closing without refinancing, the Guidelines cite positioning the release or transfer in the definitive agreement as an obligation of the acquiring side and making it a closing condition, as well as including termination and indemnification clauses for cases where it is not carried out.

The materials you will want to have on hand when you receive the term sheet are as follows.

• The target company's shareholder register, and whether any shareholders will remain after the share acquisition
• The composition of officers after the share acquisition, and any concurrent positions with the SPC or the buyer
• Clauses in the key master transaction agreements that restrict the assignment of claims or the provision of security
• The shareholder composition of subsidiaries and their shareholders' agreements
• A list of existing borrowings, and the security and guarantees attached to each borrowing

With these five items in place, you can present the financial institution with concrete counterproposals on the companies that can provide security and guarantees, the timing and the scope of the assets.