Workouts Versus Bankruptcy: Corporate Reorganization in the U.S. and the Current Practice of Japan

XU Peng
Faculty Fellow, RIETI

From around the last half of the 1990s, a significant number of listed companies have gone bankrupt in Japan, while others are increasingly attempting out-of-court reorganizations. The situation resembles the wave of bankruptcies that hit the United States from the latter half of the 1970s through the 1980s. This column analyzes the current practice of corporate reorganizations in Japan in light of the U.S. experience with corporate reorganizations.

Due diligence of reorganization value and liquidation value is of paramount importance in reorganizing troubled companies

In economics, we often encounter problems caused by information asymmetries. One of the most straightforward manifestations of information asymmetry can be seen in corporate reorganizations. In the reorganization of a troubled company, not only conflicts of interests but also information asymmetry, which exist between outside investors and insiders such as managers, pose extremely serious problems. Both the managers and employees hope to keep the company alive. Should the reorganization attempt fail, however, investors will suffer secondary losses. Therefore, in considering a corporate reorganization plan, it is of utmost importance to examine and compare the reorganization value and liquidation value of the company. This is to emphasize the importance of due diligence in determining the reorganization value and liquidation value of the troubled company in question. In the case of a listed company, however, the cost of due diligence is enormous. This cost is part of the cost of bankruptcy, a subject that has long been discussed in corporate finance. And the cost of bankruptcy is a type of transaction cost that is well known in economics. Apart from the cost of due diligence, there are direct costs such as legal fees, as well as indirect costs in the form of the impairment of value caused by the prolonged reorganization process. Information asymmetry continues to pose serious problems even after reorganization proceedings begin. It is thus extremely important to ensure thorough and frequent disclosure of management information, not only to existing stakeholders but also to potential investors, so as to avoid or minimize secondary losses incurred by a reckless reorganization plan.

To prevent such problems, the U.S. Bankruptcy Code imposes strict reporting requirements on "Chapter 11" companies or those subject to reorganization. Specifically, troubled companies seeking relief under Chapter 11 are required to disclose detailed information, including the filing of monthly reports on the company's financial conditions. All such information is subject to inspection not only by creditors and other stakeholders but also by the general public ("Transaction Costs and Capital Structure Choice: Evidence from Financially Distressed Firms," Journal of Finance, Vol. 52, Gilson, 1997). Unfortunately, information disclosure requirements under bankruptcy-related laws in Japan are not as strict as those in the U.S. The greater the role turnaround funds come to play, the more important it is to provide information to potential investors rather than simply to the stakeholders of the company under reorganization. A series of revisions to bankruptcy-related laws implemented in recent years, including the introduction of debtor-in-possession financing, has been strongly influenced by the U.S. Bankruptcy Code. In order to maximize the benefits of the revised bankruptcy laws, Japan should consider requiring companies above a certain size to make monthly financial reports available to the general public, for instance, by disclosing such information on official gazettes. Meanwhile, in the case of out-of-court reorganizations, microfinance institutions would frown on a borrowing company's request for debt forgiveness, thereby hampering the sale of assets. This is because companies seeking an out-of-court reorganization are not as transparent as those subject to liquidation in terms of information disclosure. Furthermore, the transaction costs involved in a corporate reorganization - whether in the form of bankruptcy costs, the realization of loan losses on the part of banks forced to write off loans, or costs attributable to taxation, for instance, of gains from debt discharge on the part of the debtor company - are enormous. In the U.S., tax relief measures applicable to companies reorganizing under Chapter 11 of the Bankruptcy Code with respect to gains from debt discharge are, in many cases, not applicable to companies reorganizing under out-of-court proceedings (Gilson, 1997). Consequently, debt restructuring through out-of-court reorganization proceedings tends to be superficial rather than drastic, with the scale of debt waivers limited to the extent to which gains from debt discharge can be offset by loss carryovers. Thus, the progress of debt restructuring is far more modest for companies under out-of-court reorganization proceedings than for those under court-administered reorganization proceedings. Also, one out of every three listed companies attempting an out-of-court reorganization ends up filing for court-administered reorganization within one year.

Increase the number of successful out-of-court reorganization cases

Out-of-court reorganization through debt waivers by creditor banks has been cited as one of major functions of the main-bank financing system that has long supported the Japanese economy. However, amid the rapid increase of corporate bankruptcies, out-of-court reorganizations through creditor bank intervention have often failed to produce the intended results; worse, some creditor banks themselves have been forced into bankruptcy. MaxValu (formerly Yaohan Japan Corp.) and Kawaden Corp. (formerly Kawasaki Electric Corp.) filed for court-administered reorganization under the Corporate Reorganization Law and the fast-track Civil Rehabilitation Law respectively, instead of seeking out-of-court reorganization. Recently, both MaxValu and Kawaden have made successful comebacks after reorganizing their businesses with the help of a corporate sponsor in the case of MaxValu and a turnaround fund in the case of Kawaden. These two cases, in which both failed companies managed to list their stock after reorganization, illustrate that anyone can recognize. With Yahohan Japan, there was no bank to take a leading role because the company raised capital primarily through the issuance of bonds. In contrast, Kawasaki Electric was forced to file for protection under the Civil Rehabilitation Law because it was unable to raise funds for the redemption of convertible bonds after its main financing bank went bankrupt. In both of these cases, the absence of intervention by banks led to the initiation of court-administered reorganization proceedings at an early stage. Thanks to timely court-administered proceedings, the recovery rate on reorganization claims (i.e., claims that existed prior to the commencement of reorganization) against Kawasaki Electric reached 20%, a level rarely seen in the reorganization of listed companies.

As mentioned above, in the U.S., too, out-of-court reorganizations through debt relief tend to be more of a makeshift scheme to avoid insolvency, and often fail to provide a fundamental solution because of the problem of information asymmetry and transaction costs involved, such as taxes on gains from debt discharge. Judging from the experience of the U.S. as well as from the current situation in Japan, the early initiation of a court-administered reorganization is another key to successful reorganization, that is, apart from implementation of a drastic out-of-court reorganization. Should they hesitate to seek a court-administered reorganization out of fear of a sharp fall in corporate value, companies miss an opportunity to reconstruct their businesses. What is important is for a troubled debtor company to choose one of the two workable solutions, namely, promptly seeking either drastic debt relief from creditor banks or a court-administered reorganization. Recently, prefectural associations have begun to provide creditor banks with information about reorganizing debtor companies in order to support the revitalization of small and medium enterprises (SMEs) from the standpoint of a neutral and impartial mediator. It is hoped the move, which is part of the due diligence process, will provide a clue to solving the problem of information asymmetry. In order to further bolster corporate reorganizations through out-of-court proceedings, it is necessary to expand the scope of a special tax abatement scheme that allows a reorganizing company to offset gains from debt discharge with valuation losses on assets such as real estate. The scheme, which currently applies only to companies reorganizing under court-administered proceedings, should be expanded to cover companies reorganizing without court intervention, including those rehabilitating under or with the support of the Industrial Revitalization Law, the Resolution and Collection Corp., the Guideline on Private Reorganization, or a prefectural association for the rehabilitation of SMEs. Such a step is expected to boost the number of successful reorganizations through out-of-court proceedings. At the same time, major companies reorganizing under the Corporate Reorganization Law or the Civil Rehabilitation Law should be required to make monthly disclosures through official gazettes in order to enhance the transparency of court-administered reorganization proceedings.

February 15, 2005

February 15, 2005

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