CORPORATE RESTRUCTURING IN JAPAN: A REVIEW
--- by Arthur J. Alexander

A key aspect of corporate restructuring in Japan involves the revaluation of assets according to market principles. As financial markets there have been deregulated and competitive market forces allowed greater sway, profitability and return on assets have begun to claim their proper roles in asset valuation. For these forces to be effective, however, actual market values for assets must be established and those values made known to market participants. Several methods have become increasingly important to accomplishing these vital economic tasks: asset securitization, mergers and acquisitions, and bankruptcy and corporate reorganization.

Asset Securitization - The packaging and subsequent sale of securities based on a portfolio of assets has taken off in Japan in the past five years (see JEI Report No. 32A, August 20, 1999). From almost zero in 1995, more than ¥12 trillion ($109.1 billion at ¥110=$1.00) worth of securitized assets were outstanding at the end of March 2000 (see Table 1). These securities are based on many types of assets, but receivables of all types predominate.
---

Table 1: Assets Held by Special-Purpose Companies and Trusts in Japan,
Fourth Quarter 1997-First Quarter 2000

The most important attribute in establishing the value of an asset is the predictability of its revenue stream. For example, credit-card debt and equipment leases are favorite targets for securitization because most users of these credit instruments reliably pay their monthly charges. However, if prompt payments are questionable, the assets are sold at a heavy discount.

Such assets as nonperforming property loans often are priced substantially below book value when securitized. According to one source, in 1997 and 1998, Japanese banks working with foreign financial institutions converted the equivalent of $120 billion of bad loans into $16 billion in cash. Last year, $180 billion in similar debt became $23 billion in cash. These transactions established a market price of about 13 percent of the book value of the underlying assets.

The Financial Services unit of General Motors Acceptance Corp., is moving strongly into the securitization of nonperforming loans, packaging them into portfolios of different sizes. To indicate the scale of these transactions, a portfolio defined as "large" has at least ¥100 billion ($909.1 million) in unpaid principal balance, 150 borrowers, 200 loans and 300 parcels of underlying property. GMAC has found that as securitization becomes more familiar to Japanese investors and as a wider variety of participants bid for such assets, yields have fallen. In 1998, a typical yield was 13 percent to 15 percent; by early 2000, it had dropped to about 10 percent.

Bank loans to businesses are the most frequently securitized asset. At first, banks were reluctant to sell their loans lest they appear to be devaluing long-term relationships with clients. In fact, banks often refused to divulge to borrowers that their loans were being sold. However, notification, or what is known as perfecting the transaction, is one of the requirements for a clean bill of sale. Moreover, buyers of securities based on bank loans require additional guarantees of solidity, thereby raising their cost. They are, nevertheless, now the most popular of all securitized assets, partly because large corporate borrowings earn high marks for reliable payment. Consumer loans and accounts receivable are the next two most popular securitized assets.

Mortgages have not taken off yet. Legislation permitting real estate investment trusts similar to those common in the United States was approved by the Diet earlier this year and will take effect in November. Several financial firms, foreign and domestic, already have assembled large amounts of money for investment in securitized real estate assets in anticipation of the new rules.

Nonfinancial companies seeking higher returns on their financial assets are the largest holders of asset-backed securities (see Table 2). Financial institutions supervised by the Ministry of Agriculture, Forestry and Fisheries are number two. Shinkin (credit associations) and shinkumi (credit cooperatives) had invested heavily in property markets during the asset-price "bubble" of the late 1980s and lost a substantial share of their money in the subsequent collapse. Asset-backed securities offer these troubled institutions a relatively safe investment with higher returns than could be earned from more traditional investments. Such attributes also have attracted pension funds, the third-largest owners of these securities.
---

Table 2: Main Holders of Asset-Backed Securities
Issued by Special-Purpose Companies in Japan,
Fourth Quarter 1997-First Quarter 2000

The government has been encouraging the use of asset-backed securities by reducing the cost of issuing them and by removing other impediments. For example, the fees for establishing a special-purpose corporation — the preferred type of organization for taking ownership of the underlying assets and then repackaging them into securities for resale — have been reduced, and participants have greater planning and marketing flexibility. Also, the expensive and tedious practice of notifying borrowers of the reassignment of their loans has been simplified. As Japanese financial markets become better acquainted with asset-backed securities and as the legal restrictions on their issuance are reduced, this investment vehicle should grow in importance. Buyers will be able to cut through the murkiness of domestic accounting procedures, and the valuation process will become more transparent.

Mergers and Acquisitions - M&As establish the value of a merged or an acquired firm by disclosing the amount that a buyer is willing to pay. A major defect of the Japanese economy involves the area of corporate governance — particularly the market for corporate control. Although the American popular press has given corporate raiders, takeover artists and leveraged-buyout kings a bad name, the existence of an active market for corporate buyouts and mergers has forced managers to focus on profits. If an outside party believes that a company can generate higher earnings through a new management approach, that business is a potential takeover target. Indeed, mergers and acquisitions in the United States have been a source of productivity and high rates of return.

In Japan, the practice of mutual shareholdings has been an explicit tactic for avoiding takeovers. Moreover, executives there customarily have viewed buyouts as humiliating experiences, something that signifies both corporate and personal failure. Even when a firm might have benefited from being acquired — for example, when an aging founder wished to leave the monetary value of the business to his or her heirs — the sale of a company was uncommon.

These attitudes are changing, especially because financial industry deregulation, consolidated financial reporting and the adoption of more transparent accounting standards are bringing greater attention to firm performance. Now, not only is a a merger or an acquisition an acceptable means for saving foundering companies, these options are actively sought.

Changes in corporate law have facilitated M&A activity. For example, holding companies now are legal. A holding company structure enables firms to spin off parts of their operations into separate companies for later sale. Such moves account for a large share of the country's increased M&A transactions, industry insiders say.

Legislation passed in 1999 allows stock-for-stock transactions. That permits an acquiring company to purchase all of the shares of a target in exchange for newly issued stock of the acquiring firm. Moreover, these deals require just majority approval by the shareholders of the acquired company without — as was necessary in the past — the agreement of each individual shareholder. In anticipation of passage of the stock-for-stock law, the tax code was changed to eliminate capital gains taxes and stock transfer taxes on such transactions.

By most accounts, M&As are booming in Japan. The problem is that there are many different accounts. Although they tell the same story, the details differ because of the absence of definitional standards and because the data compilers have incomplete views of the economy. For example, Nikko Securities Co., Ltd. and M&A specialist RECOF International, Inc. track the number of M&A cases between domestic companies and between foreign and domestic ones (see Table 3). KPMG LLP reports the dollar value of foreign investments in Japanese companies. For comparison, Table 3 also shows KPMG's estimates of foreign M&A activity in the United States.
---

Table 3: Mergers and Acquisitions in Japan,
Domestic/Domestic and Foreign/Domestic, 1986-2000

These problems notwithstanding, the big story is that domestic M&A activity is up by a factor of five over the last decade and that foreign incursions in the Japanese economy have increased tenfold. According to a late May report in leading business daily Nihon Keizai Shimbun, foreign investment funds earmarked for the acquisition of Japanese companies totaled some ¥1.4 trillion ($12.7 billion) at the time. This amount included ¥400 billion ($3.6 billion) held by Manhattan's Ripplewood Holdings LLC and Marriott International, Inc. for investments in hotel properties. Other foreign investors standing by with money gathered from overseas investors were the Carlyle Group of Washington, D.C. and New York City-based Cerberus Group.

Foreign equity investment in Japan long has been infinitesimal in comparison with similar activities in counterpart economies. Despite the expansion of foreign M&As in Japan, the KPMG estimates indicate that the value of transactions there remains equivalent to roughly 5 percent of the U.S. figure. Still, what is happening in Japan is a remarkable change from as recently as 10 years ago.

Bankruptcy and Corporate Reorganization - Bankruptcy proceedings wind up insolvent companies; reorganization rescues those firms with a viable future (see JEI Report No. 25A, July 2, 1999). Both procedures uncover the underlying value of a failed company. The worth of an insolvent business is zero. Reorganization usually wipes out the value of equity shareholders and reduces the amount that creditors can recover. Recapitalization then establishes a new value for the firm. The rationale for this type of rescue is that an ongoing company is worth more to society and its creditors than a discontinued business.

Formal court-managed bankruptcy proceedings as well as informal shutdowns and workouts are running at near-record rates in Japan. Seasonally adjusted bankruptcies reached new highs in early 1998 (see Figure). A panicked government then expanded in a major way a fund to guarantee loans to small firms with the express aim of reducing the number of business failures. As the money was used up, the number of bankruptcies resumed its climb this year toward the previous high (see JEI Report No. 22B, June 9, 2000).

Business failure used to be a small company affair. Before 1990, average liabilities of a collapsed firm totaled approximately ¥200 million ($1.8 million). Driven by the failure of some big-name companies, that figure crept up during the 1990s to ¥1.2 billion ($10.9 million) in 1999 and was close to ¥1.5 billion ($13.6 million) in the data available for this year. The July 2000 figure for the total liabilities of failed companies was just under ¥4.3 trillion ($39.1 billion) — the largest on record.

The share of liabilities represented by the five biggest bankruptcies is a good measure of the growing impact of large-scale failures. For the first seven months of 2000, this ratio was an astounding 43 percent. (To calculate the top five, all of the separately incorporated department stores affiliated with failed Sogo Co., Ltd. — see JEI Report No. 28B, July 21, 2000 — were consolidated into a single figure.) The share of liabilities attributable to the top five failures climbed from 18 percent in 1996 to nearly 25 percent in 1997 and 1998. It fell back to under 20 percent in 1999, only to shoot up again this year.

A new civil rehabilitation law went into effect in April 2000. Replacing at least two previous bankruptcy laws, it eases the requirements for keeping a distressed company alive. The revised legal framework encourages early recognition of serious financial difficulties and seeks resolution before the problems get worse — as they usually do. It also emphasizes convenience, speed and disclosure. The law's usefulness is indicated by the increased number of companies seeking protection under its provisions.

The first company to be revived under the law was Hotaka Recreation Co., Ltd., a ski resort, which had applied for protection in late April with debts of ¥11.8 billion ($107.3 million). By mid-July, the firm had made arrangements with its creditors to waive 90 percent of their claims, allowing it to resume what are hoped to be profitable operations. This three-month process could have taken two to three years under the old bankruptcy regime.

Conclusion - Certain common themes appear in the recent history of asset securitization, M&As, and bankruptcy and corporate reorganization in Japan. The number and the size of transactions have increased markedly, dictated in part by the scale of the problems facing domestic firms. These developments would not have occurred in the past for at least one primary reason: the legal and the regulatory environments would not have allowed them. Driven almost equally by the political leadership and the requirements of the situation, the government has implemented significant legal and regulatory changes in order to facilitate the restructuring of struggling Japanese businesses.

Motivated by earlier deregulatory moves, companies themselves have pushed for further changes, the need for which was demonstrated by the impediments they encountered in their attempts to adjust. For example, as securitization progressed, problems with cumbersome restrictions on special-purpose companies retarded their greater use. The bureaucracy responded by increasing the flexibility of these companies and reducing their costs. A similar responsiveness has been seen in the other areas.

At the same time, Tokyo has backtracked in certain areas when the political costs of change seemed to outweigh any immediate economic benefit. The credit-guarantee program for small firms is a prime example of a number of businesses being kept alive for a year or so that ultimately will have to face the consequences of their insolvent condition. It is not intuitively obvious that the preservation of "zombie" companies does anyone much good, either in the short term or over the long run.

What does seems clear, though, is that corporate Japan is restructuring — often with help from foreigners. The pace may be slower than many analysts think is warranted. However, progress that may seem slight to an outsider often looms large to a participant in the process. That said, enough change has been set in motion that the comfort derived from a reliance on familiar landmarks may not be all that long-lasting.