No. 22 — June 9, 2000


Weekly Review

--- by Arthur J. Alexander

Japanese companies once again are going bankrupt in record numbers. Several forces are driving the latest trend. The government's loan-guarantee program for small businesses (see JEI Report No. 12B, March 26, 1999), which was boosted in the fall of 1998 when failures were reaching disturbing levels, ran out of money last year. Since then, almost 3,000 firms that had received government-backed bank loans have foundered as the economy has continued on its indecisive course.

The run-up in the number of business failures in 1998 (see JEI Report No. 5B, February 5, 1999) was followed by an equally big decline when additional resources were made available for the loan-guarantee program (see Figure 1). The more recent jump in bankruptcies is as dramatic as the earlier contraction. As many analysts had predicted it would, the failure rate returned to its old highs once the extra money pumped into the loan-guarantee program dried up because the underlying problems of Japan's business community had not been resolved. Companies were operating with excessive costs, unsupportable debt burdens and profits too low to be sustainable. The beefed-up loan-guarantee facility merely postponed the day of reckoning — and left the government to pick up the tab. According to estimates compiled by Teikoku Databank, Ltd., in the last year, the liabilities of failed companies that had taken advantage of the program exceeded ¥1 trillion ($9.1 billion at ¥110=$1.00).

A second reason for the rise in failures is a pickup in corporate restructuring, especially after new accounting standards requiring consolidated reporting went into effect April 1, 2000. Firms with large numbers of money-losing subsidiaries are beginning to dissolve these affiliates. Top economic daily Nihon Keizai Shimbun recently noted, for example, that a major food wholesaler had liquidated eight affiliates in order to clean up its balance sheet to prepare for a merger with another company in the same industry.

With the current crop of failures, the average size, as measured by liabilities, has dropped from the figure for 1999, when the largest bankruptcies in Japan's history occurred. Although smaller firms were saved last year by the loan-guarantee program, larger ones that could not be sustained through emergency transfusions went under. The average debt per failed company reached ¥2.5 billion ($22.7 million) in March 1999. The 15 largest bankruptcies in 1999, though, each had debt greater than ¥110 billion ($1 billion). Indeed, of last year's 15,460 failures, the top five alone accounted for 17 percent of all liabilities. As the smaller fry escaped the net, the collapse of larger firms helped to drive the average debt to new heights (see Figure 2). Although the number of failures fell in 1998, the average value of debt rose; the opposite trend appeared in 1999.

Until the collapse of the "bubble economy" at the start of the 1990s, bankruptcy in Japan mostly was a small company affair. Average liabilities hovered around ¥200 million ($1.8 million), with the number of failures rising and falling over the business cycle. That situation, however, changed dramatically in the 1990s. Failures climbed along with the size of the firms going under. In fact, the average debt left by bankrupt companies nearly quadrupled between 1990 and 1992. The figure then shrank, only to grow again in 1996 as the second recession of the decade took hold. By the time the government expanded its loan-guarantee program, business failures had reached 1,800 a month and the average value of liabilities had hit ¥1 billion ($9.1 million).

The third reason for the recent gain in business failures is the April 2000 implementation of the Civil Rehabilitation Law, which the Diet approved last December. Until then, bankruptcies in Japan had been governed by five separate laws (see JEI Report No. 25A, July 2, 1999), three of which had provisions for corporate reorganization similar to those provided by Chapter 11 of Bankruptcy Reform Act of 1978. The other two laws presume the liquidation and the dissolution of a bankrupt company.

Nearly 90 percent of the failing firms going to court in 1998 were liquidated. However, most bankruptcies — some 85 percent in recent years — did not involve the court system at all. They were private undertakings that typically ended in the dissolution of the company. Such affairs often are messy, with creditors descending on the failed firm to seize whatever property that can be taken from the premises. A growing number of observers concluded that many companies could continue to operate profitably if a means were found to bring creditors together in a speedy and orderly process to divide the available assets in a way that preserved the existence of the debtor.

Bankruptcy experts believe that the key to successful rehabilitation is addressing financial problems quickly, before they grow so large as to overwhelm any rescue effort. They argue that a nation's legal framework should provide a predictable, transparent and fair way to restructure the balance sheet of a failing business so that both the debtor and its creditors see advantages in going that route rather than dissolving the company. Japan's bankruptcy laws did not meet that standard.

In 1996, the government started to review its bankruptcy statutes with the idea of wholesale reform, including consolidating the five separate procedures under a single, unified law. At that time, the plan was to submit a bill to the Diet in 2002. This exercise was speeded up in April 1998 as the recession took firmer hold and the number of failures shot up. In September of that year, the process was accelerated again. To accommodate the telescoped time frame, the government decided to focus exclusively on the revision of the wagi (composition) law, which was designed to handle the reorganization of failed small and midsize businesses. Legislation to reform the remaining bankruptcy statutes is expected to be acted on in another two or three years.

In drafting the Civil Rehabilitation Law, the government attempted to eliminate two major shortcomings of the then-existing legal regime. Under wagi, a court's supervision of a comeback agreement between a debtor firm and its creditors ended when the court approved the plan. If the company did not comply with the terms of the arrangement, creditors had to begin new proceedings within the notoriously congested court system — a process that could last more than a decade. Debtors, therefore, often failed to honor their deals. Creditors understandably preferred to force the dissolution of the bankrupt company to get what they could immediately rather than work through the uncertainties of the wagi law. The Civil Rehabilitation Law allows each creditor to enforce its rights under continuing court supervision of the turnaround plan.

Another of the government's objectives in framing the Civil Rehabilitation Law was to deal with a provision of a second rehabilitation law, kaisha seiri (reorganization under the Commercial Code), that required complete or nearly unanimous approval by creditors of a reorganization plan. This condition often caused a bottleneck. As a result, debtors tended to avoid the kaisha seiri process since failure to obtain full consent forces a court-ordered bankruptcy. In fact, less than 20 failed firms a year have used this procedure.

The new law loosens the consent requirement to a simple majority of the value of all claims, plus a majority of the creditors participating in the scheme. In practice, the Civil Rehabilitation Law probably will displace kaisha seiri, just as it replaced wagi.

While addressing two big shortcomings of Japan's bankruptcy regime, the new law preserves an important feature of the old system. Under the so-called debtor-in-possession concept, a bankrupt company's management remains in control of the business unless compelling facts suggest that a new team should be brought in. This provision encourages management to endure rehabilitation since executives know that they will not lose their jobs.

Although the Civil Rehabilitation Law does not provide for an automatic stay on creditors seizing assets, it does empower the courts to issue an immediate injunction to preserve the assets of a distressed company. A review of the first month's operation of the new bankruptcy regime indicated that the courts had acted speedily to minimize creditor disruption and to preserve management continuity under active court oversight.

The court system in Tokyo has indicated an interest in adopting prepackaged agreements like those used the United States. Under this process, financially troubled American companies can propose a reorganization plan to their creditors before a formal court case starts. Assuming that sufficient creditor support is obtained, the firm may begin a Chapter 11 proceeding and immediately file its prepackaged plan for approval. The courts usually expedite the matter, thus allowing the business to emerge quickly from bankruptcy.

It is too soon to evaluate the impact of the Civil Rehabilitation Law since it has been in effect for just two months. However, by late May, 100 companies around Japan already had made use of the new process. Bankruptcy lawyers predict that 500 cases will be filed under the law in FY 2000. On average over the past year and a half, only about 15 bankruptcies a month were pursued under the old system. Legal experts believe that the number of court-supervised bankruptcies will increase as companies take advantage of the speed, ease and protections of the revamped process.

Mergers and acquisitions specialists add that the disclosure provisions of the law make it easier to accurately evaluate the finances of a distressed company. Access to improved information will make a troubled firm a more likely acquisition target. The first such deal under the law already has been closed. In April, after an electric furnace steelmaker filed for bankruptcy, another company in the same business took over its management.

With the removal of the many institutional barriers to an effective corporate reorganization process, Japan's new bankruptcy regulatory regime may help to accelerate the restructuring of businesses. Whether the nation's clogged courts and its small number of experienced bankruptcy lawyers are up to the task is another issue.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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