Daiei's Rehabilitation - IRCJ's Support Must Be Based on Strict Asset Assessment and Market Mechanisms
On October 13, 2004, Daiei Inc., an ailing supermarket chain operator, finally sought help from the state-backed Industrial Revitalization Corporation of Japan (IRCJ). The company initially insisted on a private-sector bailout and the Ministry of Economy, Trade and Industry, the supervising agency for the retail industry, supported the idea. Daiei was left with no choice but to turn to IRCJ, however, after its major creditor banks - UFJ Bank, Mizuho Corporate Bank, and Sumitomo Mitsui Banking Corp. - refused to provide further assistance except under an IRCJ-prescribed scheme. Daiei's creditors took a hard line, saying that if Daiei refused to seek help from IRCJ they were prepared to take steps toward a court-administered liquidation. (The banking regulator, the Financial Services Agency, agreed with this stance.) Those familiar with past cases handed by IRCJ may be perplexed by this turn of events. Previously it was creditor banks rather than borrowers who resisted any IRCJ involvement. Another peculiar aspect of the Daiei case is that one government agency (METI) attempted to prevent the involvement of another (IRCJ), calling for a "private-sector solution to a private-sector problem." In this article, I discuss the role of IRCJ in reconstructing Daiei and attempt to shed light on the complex situation in which each party finds itself.
What IRCJ's involvement in Daiei rehabilitation means
Let us first focus on the circumstances surrounding Daiei's major creditor banks. In the run-up to Daiei's decision, the creditor banks must have had opportunities to force Daiei to seek help from IRCJ. But their initial stance was to avoid bringing in IRCJ, just as with earlier cases involving a major borrower. Indeed, this reluctance on the part of creditor banks is one reason why only a few mostly midsize, local companies have been rehabilitated by IRCJ thus far. Generally speaking, creditor banks are reluctant to get involved with IRCJ because it may lead to revelations of lenient screening of borrowers by the banks in terms of corporate and asset values.
Under a typical rehabilitation scheme, IRCJ purchases loan assets from the creditor banks of a troubled company, but does so only after the creditors have taken a share of the losses, specifically by waiving loan claims in excess of the value of assets held as collateral. If the IRCJ's assessment of the value of the collateral is less than that of a creditor bank, the bank must relinquish a greater portion of its loan claims than it would in a scheme with no IRCJ's involvement. Naturally banks do not want to have their "hidden wounds" exposed, especially if the wounds are serious. Thus, large borrowers - with whom creditor banks might be forced to drop claims large enough to threaten their own management under an IRCJ-led scheme - tend to be subjected instead to a bank-prescribed rehabilitation scheme that seeks to put off the day of reckoning.
The banks' aversion to IRCJ involvement points to the strict asset assessment criteria IRCJ has been applying in deciding whether or not to assist particular borrowers with their corporate rehabilitation efforts.
When the government decided to set up IRCJ, I expressed concern about the possibility that the institution might become a "state-administered moral hazard generator" that would pass the burden of bad corporate decisions on to taxpayers - that is, if it purchased loan assets from banks at overvalued prices so as to minimize losses to the banks (see reference). Such concern, which was shared by many market participants, however, seems to have been adequately taken into consideration by IRCJ. Judging from IRCJ's track record to date, the institution is adhering to the principle of not providing support in a way that distorts market mechanisms, for instance, by purchasing assets at overvalued prices.
Why then have Daiei's major creditor banks decided to work with IRCJ? The change came after a series of stringent measures taken against UFJ Bank, Daiei's largest creditor, including a business improvement order by the FSA. To employ a boxing metaphor, regulators sent UFJ back to its corner, effectively giving the management an ultimatum to quit stalling and promptly resolve the problem of bad loans to its big borrowers. Subsequently the whole situation changed and UFJ has finally begun to face up to the reality that it can no longer put off dealing with the Daiei problem. Since UFJ must relinquish a considerable portion of its loan claims to Daiei anyway, the best available option for the bank is to do so through an IRCJ scheme. Loans to Daiei, currently classified as risk-managed loans on the bank's balance sheets, can be reclassified as normal loans - though at much lower, revalued prices - once they are transferred to IRCJ, thus helping UFJ cut in half its bad loan ratio by the end of March 2005 compared to that of the end of March 2002, a target imposed by regulators. Furthermore, the involvement of the state-backed institution provides a better defense for the management of the bank, which is fearful of shareholder lawsuits arising from its waiving of claims on loans to Daiei for the third time.
Although it saw its escape routes closing, Daiei continued to resist going to IRCJ, insisting until the last minute that it would seek its own reconstruction scheme financed by private-sector backers. Daiei's arrogant belief that it was "too big to fail" allowed management to take a defiant stance. This reminds me of how UFJ, which then held the rotating chair of the Japanese Bankers Association, led the chorus of criticism against the government in the autumn of 2002 when the FSA adopted the Program for Financial Revival, a key step that spurred banks' disposal of bad loans. But the situation has since changed. In 2002, UFJ and other creditor banks granted a partial waiver of loan claims to Daiei for the second time, probably because they thought the failure of the retailing giant would deal a critical blow to the economy. This time around, however, Daiei's "too big to fail" defense did not work because the Japanese economy and retailers' performance have begun to pick up. Another key factor that forced Daiei's management into seeking assistance from IRCJ was its independent auditors' refusal to certify the company's financial statements unless the assumption of going concern, a basis for auditors' certification, was reasonably assured through continued financial support from Daiei's creditor banks. This situation was quite similar to the one that led to the effective nationalization of Resona Bank.
IRCJ's refusal to go along with a rehabilitation scheme or the purchase of assets in a way that would distort market mechanisms is a comfort to those who were initially concerned about the possibility of its becoming a government-sponsored bad loan repository, which takes in bad loans from the private sector and simply keeps them there. However, it is true that IRCJ, because of its stringent criteria, has handled very few large-scale cases up to now. Indeed, its assistance has been almost exclusively targeted at relatively small local companies. IRCJ typically dispatches managers to help rebuild these companies, which often lack capable management. These efforts are interesting in their own right as they represent a new business model. That said, however, there remains the unavoidable question of why a public sector body like IRCJ should assist troubled private-sector companies. To answer to this question to the satisfaction of taxpayers, IRCJ needs to handle more cases involving large companies operating nationwide (i.e., those with significant external effects). This is because public-sector involvement in the rehabilitation of a private-sector company can be justified only when the failure of that company would cause substantial negative external effects, harming a number of other companies that do business with the troubled one. The most important role of IRCJ as a public organization is to reconcile conflicting interests among a number of creditors. Ever since the later half of the 1990s, when confidence in the so-called main bank system collapsed, the presence of a fair and impartial third-party mediator has become indispensable for corporate rehabilitation. Such an entity must reconcile the diverse interests of creditors, taking over the role traditionally played by the main bank (i.e. the leading creditor bank) of a failing corporate borrower. From this standpoint, IRCJ should carefully consider whether or not to assist with the rehabilitation of Daiei, which is a symbol of Japan's bad loan problem and involves a large number of creditors.
IRCJ must reject intervention by politicians
With the legally imposed deadline for purchasing loan assets set at the end of March 2005, IRCJ does not have much time to conduct an assessment of Daiei assets. Meanwhile, the sheer amount of work required for such an assessment will be far greater than any of the cases IRCJ has handled in the past. The critical question is how thoroughly IRCJ will be able to assess Daiei's mountain of assets in such a short time. It is no exaggeration to say that the fate of IRCJ - whether it is able to avoid becoming a "state-administered moral hazard generator" - hinges on the answer to this question. IRCJ must not rule out the possibility of withdrawal if, after a thorough examination, it finds Daiei unworthy of its assistance. Given the scale of Daiei's external effects and the number of parties concerned, IRCJ may be subjected to greater market-distorting political pressure than in any of the previous cases it has handled in terms of assessing assets, determining their purchase prices, and drawing up an overall rehabilitation scheme for Daiei. For this reason as well, IRCJ needs maintain a withdrawal option and take an unwavering stance against any political intervention in the case.
Obviously, the content of the rehabilitation scheme is the critical factor that will decide the success or failure of Daiei's rehabilitation. In this regard, we should remember that the creditor banks' decision to press Daiei to seek help from IRCJ was influenced by the desire of bank managers to defend themselves against possible litigation by shareholders, not necessarily because they believe IRCJ will be able to draw up a better rehabilitation scheme than private-sector sponsors. The root cause of Daiei's failure was its reckless diversification during the bubble period. Daiei must take bold steps to focus on its core business if its rehabilitation is to succeed. Daiei has closed a number of stores in an attempt to slim down. But this has led to a further deterioration in its performance, forcing the company to close even more stores. First and foremost, IRCJ's rehabilitation scheme must prescribe measures to end this downward spiral. Then it needs to map out ways to improve the profitability of Daiei's main business, thereby presenting an attractive business model that provides investors an exit route (an easy means of selling off their investment in the future). IRCJ must also select appropriate sponsors for Daiei. Although a number of difficult issues lie ahead, I hope IRCJ will overcome the criticisms that have been leveled against it so far and that it will clearly demonstrate its ability based on the principle of respecting market mechanisms.
"Kokkateki moraru hazado: Sangyo saisei kiko ga motarasu dameji to wa (State-administered moral hazard: The damage that may be caused by IRCJ)," Mainichi Economist, Jan. 14, 2003.
October 26, 2004
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