Debt/Equity Swap (“DES”) using common stock or preferred stock (class stock) by listed companies



In light of the recent deterioration in the market, many companies are looking for ways to reduce their debt and increase their capital to improve their financial situation. Common methods include public offerings of common stock or allotment of stock to a third party. In addition to these methods, companies can use Debt/Equity Swaps (“DES”): transactions to convert existing debt into equity such as common stock or preferred stock.

This newsletter provides an overview of the use of DES by listed companies and major points to note in the steps required for DES in Japan.

Please note that the following content is not intended to be exhaustive; the situation of each company must be analyzed individually.

1. Presentation of DES

(1) Presentation of DES

A debt/equity swap is a method by which creditors with monetary claims on a debtor company exchange those claims for shares of the company (common stock or preferred stock).

By executing a DES, the debtor company is able to reduce its debts and increase its capital, thereby improving its financial situation through the restoration of solvency.

(2) Benefits of DES for Creditors

As described above, a DES is a method to improve the debtor company’s financial situation. Benefits to creditors of this method include (i) the ability to raise more funds in the future, through preferred dividends on shares to be issued and share sales, than would be available through waiver of debt, and (ii), the possibility for the creditor to exercise control of the debtor company by acquiring voting rights. (iii) Further, in light of points (i) and (ii) above, it is easy to explain that the choice of DES by the creditor administrators was a rational business judgment.1

(3) Two types of DES methods

There are two main approaches to DES under Japanese law.

Under the first approach, the creditor pays the debtor company in cash and receives an allotment of shares from the debtor company. The debtor company then immediately repays its obligation to the creditor with this cash, thus extinguishing its debts.

In the second approach, the creditor contributes monetary claims in kind and is allocated shares by the debtor company.

2. Class of shares issued by DES

In a DES, common stock and preferred stock (class stock) are often issued. Class shares tend to prevail over common shares in terms of surplus dividends and distribution of residual assets, and carry no voting rights at shareholders’ meetings. In addition, many Class Shares have a put option and are subject to a purchase clause (vesting clause), pursuant to which such shares will be exchanged for common stock or cash consideration. The shares issued depend on the characteristics of each case. Below is an overview of the terms and conditions of the shares issued by DES.

(1) Voting rights

Listing rules impose certain restrictions on voting rights. In addition, there are restrictions on acquiring voting rights of 5% or more under the Banking Law and the Antimonopoly Law where the creditors are banks, and restrictions under the Foreign Exchange Law and foreign trade when the creditors are foreign investors.2

(2) Dividends and distribution of residual assets

Dividends from shares issued in a DES generally prevail over dividends from ordinary shares. However, the terms and conditions of these actions are directly linked to economic conditions and therefore vary considerably; these are decided through negotiation between the parties involved and coordination with other stakeholders (such as other creditors). In some cases, measures such as setting the start date for preferential dividends after a certain period of time has elapsed since the start of the company’s restructuring plan can be adopted.

In addition, with a view to ensuring the possibility of paying preferred dividends to creditors, cumulative preferred shares, which provide that if the dividends for a given period do not reach the prescribed amount of preferred dividends, the amount of the deficit accumulates and the accumulated amount from the next period’s income will be paid in preference – may be issued in some cases.

(3) Shares with put option and shares subject to call

Preferred shares issued by a DES can be shares with a put option, which can be redeemed at the request of shareholders, and callable shares, which can be redeemed by the stock company upon the occurrence of a specified event. When these shares are redeemed, they are exchanged for common stock or cash as consideration.

The grant of the put option in return for common stock allows creditors to easily sell shares issued by a DES. On the other hand, by granting the vesting clause in return for common shares, a debtor company can avoid the long-term existence of preferred shares by acquiring them.

A put option for monetary consideration has the advantage for creditors of being able to recover their investment within the limit of the distributable amount, and debtor companies can prevent the dilution of ordinary shares and the interference with the independence of management rights. that occurs when common stock is used. as consideration. The acquisition for consideration clause allows the debtor company to avoid the dilution of the ordinary shares and the obstacle to the independence of the management rights.

3. Consideration concerning the procedures for carrying out the DES

When a listed company performs a DES, it is important to understand the outline of the procedures required by the laws and regulations as well as the reasons for these procedures. Although detailed explanations are beyond the scope of this bulletin, the main points to note will be explained below.

The Companies Act requires various legal procedures, including confirmation of the total number of authorized shares, resolution of the board of directors regarding the issue of new shares, resolution of the meeting of shareholders to amend the necessary articles of association to the issue of class shares, consideration regarding the applicability of the issue of new shares at a particularly favorable price, preparation of documents relating to the issue procedures such as the subscription agreement and the register of shareholders, and registration. These procedures affect the timeline of a DES.3

In addition, with regard to the law on financial instruments and exchanges, it is necessary to draw up the extraordinary report and to follow the procedures necessary for the massive capital increase by allocating shares to a third party. In some cases, it is necessary to file a title registration statement. Accordingly, prior consultation with the competent authorities, the preparation of related documents and a certain waiting period until the entry into force of the securities registration statement are required. It is also necessary to take into account the large volume holding report and other documents that may be required under the law on financial instruments and exchanges.

In addition, it is necessary to prepare various documents and comply with the procedures required by the stock exchange, including the preparation of a press release, the prior consultation of the stock exchange, compliance with the code of business conduct, for example investigation of any relationship with anti-social forces, preparation of a written opinion by an independent third party and an assessment report by an external assessment body.

Further procedures under the Antimonopoly Law, Foreign Exchange and Foreign Trade Law and other regulatory laws governing business activities, as well as the drafting of documents to be submitted to the relevant authorities, are required.

It is necessary to carry out legal analyzes with respect to the above, to plan a workable timetable and to prepare the necessary documents, including the information documents. Therefore, it is essential to proceed with legal counsel familiar with the capital market practices of listed companies in Japan.


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