Private Workouts, Bankruptcies and Industrial Revitalization
Faculty Fellow, RIETI
While there are many Japanese companies like Toyota that are doing well, the number of firms which seek private workouts after repeatedly receiving debt waivers, or those which attempt to rehabilitate through the Corporate Reorganization Law or Civil Rehabilitation Law, is gradually increasing. In this column, I will attempt to find out how an industrial revitalization policy should be, by offering an economic analysis of industrial revitalization and an overview of the corporate restructuring experience of the United States in the 1980s, based on the results of study by RIETI's corporate revitalization analysis project.
The key decisive factor in private workouts is the fraction of bank loan secured
A private workout or a bankruptcy filing takes place after a default. Regardless of the process being "private" or "legal," the responsibility of the top executives is sought through their replacement. For this reason we can say that bankruptcy is the most important aspect of corporate governance. In particular, selecting the firms which must be closed down is a fundamental mechanism of industrial revitalization. That is why debt contract is the universal method for procuring outside funds. However, just because a firm goes bankrupt does not mean its entire business should be cleared away. The first step in industrial rehabilitation is to move the section which is to be rehabilitated away from excessive debt as soon as possible while closing, liquidating and transferring the unprofitable sections. Concrete procedures include: 1) private workouts through debt-for-equity swaps and abandonment of debt by the lenders, particularly the bank lenders; and 2) legal procedures through Corporate Rehabilitation Law and Civil Rehabilitation Law, which are accompanied by a larger debt release. Normally, the burden of direct bankruptcy costs - such as litigation fees - as well as indirect bankruptcy costs - caused by the depletion of asset value - involved in reorganizing a financially distressed firm is heavier in legal procedures compared to private workouts. What then is the reason for financially distressed firms choosing direct legal procedures rather than trying to restructure debt privately?
The U.S. corporate revitalization experience suggests that the tendency for deciding on a private workout is stronger if the percentage of loans from banks and insurance companies is higher. On the other hand, legal procedures are preferred when the proportion of public bonds outstanding is greater. This matches theoretical analysis of the free-rider problem of small creditors. Up until the 1990s, there were not many large firms whose data was relatively easy to obtain that filed for bankruptcy under the Corporate Reorganization Law. There was, therefore, virtually no study conducted on the choice between private workout and the legal bankruptcy procedure. But according to a recent positive analysis I have conducted, the most important factor for private workouts through debt waiver and interest waiver by financial institutions is the percentage of bank debt secured. The result of this positive analysis is supported by the results of another piece of research I have carried out showing that the recovery rate of secured claims which have been processed under the Corporate Rehabilitation Law and Civil Rehabilitation Law is virtually 100%. Furthermore, the larger the percentage of debt from small creditors, the stronger the tendency is to file for bankruptcy rather than private workouts. But one must also take note that in Japan, small claimholders through corporate credit transactions are definitely more dominant than public bondholders.
Whether rehabilitation is possible or not, a swift decision is the key
While it is impossible to ask small creditors to waive their claims, coordinating lending banks as to the amount of loans to be waived is also no easy task. Recently, the Industrial Revitalization Corporation of Japan (IRCJ) decided to offer rehabilitation support to four corporations including Mitsui Mining and Dia Kensetsu. The IRCJ's main strategy is to buy up the loans held by non-core banks and help rehabilitate the suffering corporation with the cooperation of the main bank. Basically, this kind of support is considered a private workout. Coordinating the interests of the lending banks is an important role expected of the IRCJ here. Furthermore, tax reforms such as tax-free write-off for banks which have waived their loans, as well as the inclusion of appraisal losses, due to the fall in asset prices, as expenses for the rehabilitating corporations, will no doubt support the revitalization activities of the IRCJ. For the IRCJ to fulfill its function, it must not only buy up the loans from the non-core banks but also buy up the diffuse claims resulting from corporate credit transactions. This is because the banks are reluctant to seek aid if the proportion of small claims is large; as the banks would have to shoulder the debt. How to deal with secured bank loans is another important issue; and reforms removing tax from the income arising as a result of exemption of debts would be indispensable.
The most important thing is, whether rehabilitation is possible or not, that the decision must be made as soon as possible. In the United States, one out of four corporations which have attempted to rehabilitate themselves has within a year sought again for a debt waiver or sought court protection under bankruptcy law. If judged possible for rehabilitation, then support must be offered swiftly to a corporation so as not to miss the opportunity. If signs of failure become apparent after a decision to support the rehabilitation has been made, then legal procedures should be taken to avoid losses from snowballing. The positive analysis result of the U.S. Debtor in Possession (DIP) finance shows that while DIP finance plays a role in increasing the chances for corporate rehabilitation by offering funds, it also points at the necessity of spotting corporations which cannot be rehabilitated as soon as possible. Furthermore, while the role of new rehabilitation funds is important, DIP finance from existing financial institutions is equally crucial in seeing the rehabilitation of corporations.
September 16, 2003
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