The traditional interplay between corporate law and business custom and practices in Japan is gradually changing, including with respect to bankruptcy law. Custom plays an important role in corporate relationships in Japan, where recourse to the judicial system is generally less prevalent than in some Western countries, notably the United States. The effectiveness of some of these customs has been eroded, however, and the growing inability of firms to count on traditional business methods has increasingly exposed the weakness of existing legal procedures. To a large extent, this is the case with insolvency laws. The Japanese authorities had for some time recognized that these laws needed to be reformed and had studied alternative approaches. The task became more urgent, however, because of the increasing ineffectiveness of customary approaches to deal with corporate financial distress.

The traditional interplay between corporate law and business custom and practices in Japan is gradually changing, including with respect to bankruptcy law. Custom plays an important role in corporate relationships in Japan, where recourse to the judicial system is generally less prevalent than in some Western countries, notably the United States. The effectiveness of some of these customs has been eroded, however, and the growing inability of firms to count on traditional business methods has increasingly exposed the weakness of existing legal procedures. To a large extent, this is the case with insolvency laws. The Japanese authorities had for some time recognized that these laws needed to be reformed and had studied alternative approaches. The task became more urgent, however, because of the increasing ineffectiveness of customary approaches to deal with corporate financial distress.

The basis of the traditional informal approach to corporate financial reorganization has eroded since the 1980s. Until that time, firms’ access to credit was dictated in large part by affiliation to economic groups built around major banks. Under these conditions, banks had privileged knowledge of a borrower’s prospects and strengths, and could, when they felt appropriate, lead an informal debt workout. Insolvency procedures were used mainly in connection with the liquidation of small and medium-sized firms, which depended largely on specialized banks and intercorporate credit and had little access to commercial bank credit. Partial financial liberalization in the 1980s, however, permitted large firms to reduce their reliance on bank loans and prompted commercial banks to look aggressively for new customers, mainly among small firms and nonmanufacturing companies (notably in the real estate sector), changing the functioning of the system.

When the financial bubble burst in 1990, major banks were often neither in a condition nor willing to intervene in ailing companies. Banks’ own balance sheets were too weak to face the losses from real estate loans, and banks did not have the advantage of a long-term relationship with many of their borrowers. As banks were not pressured by regulators to deal decisively with their bad loans, the problem of deteriorating corporate balance sheets was left festering, and the orientation of insolvency laws toward liquidation remained a secondary issue.

Bankruptcy law reform has become a priority because obstacles to the renegotiation of debts have increasingly become a potential source of inefficiency to the economy. Following the financial turbulence of 1997, the rate of corporate liquidations increased dramatically as banks faced tighter regulatory standards and the economy slowed down. The liquidity crisis that occurred made apparent the fragility of corporate balance sheets and motivated firms to accelerate their restructuring efforts. Corporate financial reorganization, however, continued to face many obstacles. Banks generally continued to grant or deny support to debtors based less on their assessment of the viability of the debtor than on considerations related to their own capitalization, notwithstanding the boost provided by the injection of public funds into their capital base. Formal insolvency procedures, on the other hand, were not providing effective means to restructure over-indebted but still viable firms for a variety of reasons, including the insufficient protection against secured creditors they typically afford and the difficulties in securing unanimous creditors’ approval of reorganization plans.

Faced with this situation, the Japanese authorities decided to accelerate bankruptcy law reforms, focusing on creating a new legal instrument for corporate rehabilitation, drawing on mechanisms that have proved to be effective in fostering corporate financial rehabilitation in other countries. Although some of these mechanisms already existed in Japanese legislation, they were scattered over several laws, and hence were not fully operational. The new Financial Rehabilitation Law is expected to gather these mechanisms under one single procedure, which could permit debtors to strengthen their position vis-à-vis creditors. By offering a realistic option for debtors to successfully emerge from a formal reorganization procedure, the law could also increase the odds for financially distressed companies to persuade creditors to participate in informal debt workouts.

The rest of this chapter discusses in more detail the existing laws, the reasons why a reform became necessary, and the prospective features of the Financial Rehabilitation Law.1

Existing Legal Procedures

There are five insolvency procedures in Japan, of which three aim at the financial reorganization of the firm and two at liquidation (Table 9.1). The laws governing these procedures draw on legislation from several countries and date from different periods. The Bankruptcy (hasan) and Composition (wagi) Laws of 1922 draw on old German Codes. The sections of the Commercial Code dealing with Corporate Rearrangement (kaisha seiri) reflect prewar British legislation on receiverships. The Corporate Reorganization (kaisha kousei) Law of 1952 mirrors the old U.S. Bankruptcy Code, albeit amended in the 1970s. The Bankruptcy Law (as well as sections of the Commercial Code not discussed here) deals with liquidation procedures, while the three other texts deal with reorganization procedures.

Table 9.1.

Legal Procedures for Insolvent Companies

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Source: Sakai (1998), Shea and Miyake (1996), Eisenberg and Tagashira (1994).

Procedures under the Composition Law typically aim at providing a reduction or rescheduling of unsecured debt, not at promoting the reorganization of the firm. Compositions, which can be filed only by the debtor, are aimed at serving small and medium-sized firms. They are often used just to provide the debtor with breathing space to seek an out-of-court resolution with short-term creditors.2 Indeed, about half of the petitions filed are withdrawn before the actual commencement of the case. For those few cases that go through, a 50 percent debt reduction is typically achieved. Although that reduction covers only unsecured debts, outcomes appear to be efficient, in the sense that the promised repayment is on average 2.5 times larger than the estimated liquidation value of the firm (Eisenberg and Tagashira, 1994).

Corporate rearrangements have a broader scope, but the approval of reorganization plans requires unanimous consent from creditors, and failure to satisfy that restriction often leads to liquidation. Corporate rearrangements are also a relatively flexible procedure in which incumbent management retains most of the control of the firm (court involvement in the firm’s daily management is minimal, being limited to steps to prevent managers from dissipating the firm’s assets). The procedure can provide for some temporary protection against secured creditors (at court discretion), but it requires unanimous consent for the adoption of the reorganization plan (which is usually drafted by the debtor). This requirement is aimed at protecting creditors in view of the limited role of the courts, in particular in the implementation of the reorganization plan. It tends, however, to heighten the resistance of secured creditors, who often stall negotiations. Because liquidation is mandatory when, after a statutory period, there is no prospect for reorganizing the company, courts tend to respond to such delays by forcing the firm into liquidation.

The Corporate Reorganization Law, which applies only to large firms, provides comprehensive protection against creditors, but the rigidity of its provisions limits its effectiveness in promoting corporate restructuring. The law provides for automatic protection (stay) against secured creditors. Such a provision reduces the chances of essential assets being stripped from the firm. Also, a qualified majority of creditors, rather than unanimity, is required for the approval of the reorganization plan.3 The procedure, however, includes a number of provisions that reduce the scope of its use, as well as its attractiveness to the debtor:

  • The procedure can be initiated only if the firm is about to default because payment would seriously impair its operation, or it is otherwise facing the risk of bankruptcy, limiting its usefulness in promoting early reorganizations.4

  • The law calls for the dismissal of incumbent management. This is a strong disincentive for its early use, especially in the case of large firms in which entrenched management is likely to be able to protect its tenure against shareholders’ interests.

  • The debtor may borrow new money only with the court’s approval, limiting the ability of financially distressed firms to continue operations (when the court approves the issuance of new debt, the new money is granted first priority).

  • Firms under reorganization cannot be sold. Although a piecemeal sale of assets may be done under court approval, the firm cannot be sold as a whole. This limitation reduces the scope for using the market to reallocate resources and can contribute to dissipation of the value of the firm.

  • The reorganization plan is drafted by the court-appointed trustee.

Because the simpler procedures provide little protection against creditors, and Corporate Reorganization is too rigid and penalizes management, formal reorganization procedures are used only sparingly in Japan. In a typical year, only about 2,000 corporate insolvency procedures are initiated in Japan, of which about 85 percent aim at the liquidation of the firm. The number of initial petitions for entering into any of the three reorganization procedures hovers around 300, of which a few dozen correspond to corporate reorganizations or rearrangements, with compositions accounting for about 80-85 percent of the total (Tables 9.2 and 9.3). By contrast, in the 1980s and early 1990s some 20,000 applications for reorganization were filed in the United States every year (under Chapter 11 of the Bankruptcy Code), in addition to hundreds of thousands of petitions for liquidation (under Chapter 7).5

Table 9.2.

Number of Insolvency Procedures

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Source: Matsushita (1999).

Includes plans that have already been approved and are under execution.

Table 9.3.

Number of Corporate Bankruptcies and Filings for Court Protection in Selected Industrial Countries

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Sources: Teikoko Data Bank; Matsushita 1999; Franks et al. 1994; and Kaiser, 1994.

Figures from the Central District of California Bankruptcy Court illustrate that the number of filings for liquidation (Chapter 7) is typically much larger than that of filings for reorganization (Chapter 11); also only about 30 percent of the cases filed under Chapter 11 are confirmed (the rate of confirmations for small firms, i.e., those firms with assets valued at less than US$ 0.5 million, is around 10 percent).

There is no official figure for total bankruptcies in Japan. Information is collected by Teikoko Data Bank and the Federation of Banker’s Association. According to Teikoko Data Bank, the number of bankruptcies actually initiated (rather than just filed) in 1997 was less than two thousand (2,617 in 1998). Among the total insolvencies, about 12-15 percent result in informal debt workouts.

In France, although the initial presumption of any filing is to achieve a reorganization, courts can order an immediate liquidation upon accepting the case. Of the cases closed in 1993, there were 782 liquidations in addition to the 4,913 immediate liquidations, 177 sales, and 146 successful reorganizations.

Transformation of the Main Bank System and its Impact on Corporate Reorganization

In the past, under the “main bank” system, major banks were in a good position to monitor firms’ behavior. Under this framework, firms usually borrowed from many banks, but the main bank was the syndicate leader and the bank responsible for monitoring that particular loan. The main bank was expected to prove its commitment to this task by shouldering the bulk of the cost of any reorganization. As a consequence, the bank would also use its leverage (based in part on the limited sources of external finance available to firms) to influence firms’ investment decisions, and charge relatively high interest. This arrangement was possible because, until the 1980s, access to credit was dictated in large part by affiliation to economic groups built around major banks. This relationship allowed the firm’s main bank to have a privileged knowledge of the firm’s prospects and strengths. As a result, firms belonging to a keiretsu were generally able to raise more money from banks than other “independent” firms.

Several incentives supported this delegated monitoring scheme (Sheard, 1994). First, the main bank’s participation in the group firms’ equity would tend to align its objectives with those of shareholders, while providing additional monitoring mechanisms such as the appointment of senior management and of members to the firms’ board of directors. Second, each bank could free ride on loans monitored by other main banks. Therefore, the arrangement allowed banks to minimize duplication of efforts. Finally, a close-knit banking system and the expectation of suasion on the part of the authorities could act as effective enforcement mechanisms.

When distress did occur, support from main banks helped to minimize the disruption to the affected firms. On these occasions, the firm’s main bank typically put pressure on suppliers (often group-related firms) to continue dealing with the distressed firm, while shouldering most of the financial cost of the rescue by easing its own credit terms to the distressed firm and paying off other bank creditors. The bank would also often intervene by appointing new directors and managers to the firm. In some cases, such arrangements allowed group-related firms to continue to invest even in periods of negative cashflow, and otherwise reduce their susceptibility to financial distress or a debt overhang (Hoshi, Kashyap, and Scharfstein, 1990). The evidence is not, however, unanimous (Hayashi, 1997).

During the 1980s, financial liberalization dramatically changed the environment in which Japanese corporations and banks operated. Although loans continued to be syndicated in the traditional way, the basic tenets of the main bank system were undercut by growing competition. In particular, the foundation of what could be seen as an implicit “insurance” system eroded when banks became unable to collect the economic rents they had grown accustomed to. With new sources of capital market financing becoming available, large corporations grew increasingly unwilling to pay a premium for an “insurance” that often limited their profitability and expansion prospects, preferring to tap the capital markets (Nakatani, 1984; Weinstein and Yafeh, 1998).6 Over a period of few years, those corporations were able to cut the share of bank borrowing in their balance sheet by half.

This loss of business prompted banks to look for new customers and venture into the relatively uncharted territory of loans to small firms and to nonmanufacturing companies. In the case of loans to the real estate and construction sectors, credit was extended mainly through banks’ nonbank subsidiaries. Major banks often relied more on the pledging of collateral than on careful screening when extending credit to these new borrowers. While banks were equipped to monitor a relatively limited set of large firms with which they had close links, they were probably not prepared to extend that effort to cover a much larger and less known universe. Thus, when the asset price bubble burst in 1990, banks had little incentive to provide significant support to customers that were difficult to monitor or control, and from which the scope for extracting long-term rents was limited.

The rate of bankruptcies among large firms was contained during most of the 1990s by the weak balance sheets of the major banks. Although banks were not in a condition or willing to rescue ailing companies, they feared to force them into bankruptcy. Loan syndication had made every bank vulnerable to each other’s actions. Foreclosing on a marginal loan could help shore up the balance sheet of Bank A, but was likely to affect other banks, which might have large exposure to that particular borrower. This could lead to retaliation, i.e., another bank could threaten a major borrower from Bank A. Any unilateral action against a given firm was thus viewed as potentially triggering a chain reaction of forced loss recognitions that could quickly wipe out the sector’s capital. Banks considered themselves in a “prisoner’s dilemma” and, absent major pressures from supervisors, chose mainly to roll over their loans, without forcing debtors into restructuring. The decline in interest rates reinforced this choice by reducing the carrying cost of nonperforming loans.

In the aftermath of the financial turbulence of 1997, the need to restructure the banking sector changed the debtor-creditor dynamics again, this time underscoring the vulnerability of creditors. After the failure of three large financial institutions in late 1997 and a tightening of regulatory standards, banks reassessed their strategies and started to curtail credit, not necessarily only on the basis of the riskiness of the borrower. The number of bankruptcies soared in the following months and started to decline only after the authorities took several measures to support credit, including the expansion of a program of loan guarantees to small and medium-sized enterprises and special loans to large firms facing the redemption of bonds. In most cases, bankruptcies led to liquidations, with only a few companies entering into formal reorganization procedures.

The injection of public money into major banks in 1998-99 and changes in tax rules have increased the scope for out-of-court debt workouts, but the restructuring completed to date has mostly aimed at restoring the debtor’s near-term solvency rather than providing for fundamental financial reorganization. Following a ¥7.5 trillion injection of public money into the major banks in the spring of 1999, several construction companies, as well as one of the top trading companies, succeeded in renegotiating their bank debts (see Chapter 8). The amount of debt forgiveness entailed by these agreements approached ¥1 trillion, being borne mainly by the respective main banks (the contribution of main banks typically accounted for 40-85 percent of the total written off). Generally, the debt reduction—equivalent to 20–30 percent of the liabilities of the firm—was estimated by market analysts to be insufficient to fully solve the problems of the beneficiary company. Indeed, some of the agreements appeared to have been prompted mainly by the desire of main banks to avoid the need to fully provision those loans in the event the company was inadvertently pushed into bankruptcy. In the case of legal bankruptcy procedures, write-offs might have reached 60–70 percent of the face value of the loans, reflecting the decline in real estate prices since the early 1990s.

Informal debt renegotiation is likely to remain rare as long as debtors possess too few options to compel creditors into collective negotiation. Independent of the still low capitalization of major banks, debt workouts face several hurdles. The tax treatment of debt forgiveness is still somewhat uncertain, and bank managers have expressed the concern that by forgiving debts they could incur the risk of being sued by shareholders.7 Also, securitization is still at an early stage, reducing the chances of banks to sell bad loans to specialized agents that could have more means to negotiate with debtors.8 More generally, many debtors in Japan do not face just a liquidity problem, being instead close to insolvency or insolvent. This weakness tends to render debt workouts difficult by heightening the chances that some creditors will hold out against renegotiation.9 In this situation, debtors have little leverage against creditors. A threat to file for court protection is not credible, because under the current laws the ensuing procedures are likely to result in the liquidation of the firm or, at the least, the dismissal of management. An attempt was made in 1998 to address some of these problems by establishing ad-hoc panels to mediate the resolution of real estate loans. Concerns about the perception by the public that those panels could result in the bailing out of politically connected construction companies, following the recapitalization of banks with public money, led the authorities to abandon this approach.

Directions for Reform: the International Experience and Academic Views

Since the late 1970s, several industrial countries have overhauled their bankruptcy laws to increase the use of formal procedures and promote efficiency. Starting with the overhaul of the United States code in 1978, new bankruptcy laws were introduced in the United Kingdom, France, and Germany. In Germany, reform was prompted in part by a transformation of the financial landscape similar to that which occurred in Japan, which reduced the effectiveness of the traditional methods for dealing with corporate financial distress (notably the weakening of the Hausbank system, which shared some similarities with the Japanese main bank system).10 Most of the new laws attempted to be more “debtor friendly,” with some making a larger effort to give priority to the (ex post) efficiency principle that states that insolvency procedures should preserve those distressed firms with an on-going value greater than the liquidation value.11 (Box 9.1 provides a summary of the aspects that help to characterize bankruptcy laws.)

Chapter 11 has achieved a remarkable success in fostering formal reorganizations in the United States. Chapter 11 replaced Chapters X and XI of the old U.S. Bankruptcy Code, introducing many features that are credited with having contributed substantially to the success of corporate restructuring in the United States (Table 9.4). The number of formal reorganizations increased by 85 percent in the first full year after the introduction of the new code and did not decline until the mid-1990s. Among the features of Chapter 11 that have contributed to its popularity are:

  • Automatic protection against secured debtors, and the granting of seniority to new debt.

  • Approval of reorganization plans that depends on the consent from a majority of creditors.

  • The ability of courts to “cram down” creditors, that is, force a class of creditors to accept a plan in which it will not be worse off than in liquidation.

  • Firms can be sold while undergoing financial reorganization.

Table 9.4.

Features of Reorganization Procedures in the United States and Germany and the Prospective Financial Rehabilitation Law in Japan

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Source: Franks and others (1996), Paulus (1998), Matsushito (1998).

However, some practitioners and academics believe that Chapter 11 has an excessive bias in favor of incumbent management. This perceived bias is reflected in the rather lengthy “exclusivity period” in which the debtor is the only party that can file a plan of reorganization, and to some extent in the “debtor-in-possession” provisions that allow the debtor (and, in about half of the cases, incumbent managers) to retain the control of the firm. Both tend to strengthen the hand of managers and can, when unchecked, slow down the pace of corporate restructuring and lead to inefficient outcomes.12 Indeed, many firms that emerge from Chapter 11 continue to experience poor operating performance and more than one-third of them must undergo a second restructuring (Hotchkiss, 1995), in part because managers insist on not allocating corporate resources to their highest-valued uses (Bradley and Rosenzweig, 1992).

Specific Features of Bankruptcy Laws

Five general aspects of bankruptcy law determine the balance between the protection granted to creditors and to debtors. They also indicate the extent to which the law favors the liquidation of the firm, its sale (as an ongoing concern or after a breakup), or its financial reorganization under the incumbent or a new management team. These aspects can be summarized as follows:

Screening mechanisms: Stringent screening requirements tend to reduce the number of bankruptcy petitions accepted, while increasing the proportion of those being completed (e.g., it is easy to enter into Chapter 11 in the United States, but less than 15 percent of the filings result in a confirmed reorganization plan). Liquidations can usually be initiated by creditors after default on payment or other covenant (e.g., a financial ratio). They can also be initiated by the court based on the insolvency of the firm (in some countries, the debtor who fails to report an insolvency may be prosecuted), or by the debtor. Reorganization procedures can usually be initiated by creditors or the debtor. In some countries, their acceptance by courts would depend on the court estimating the value of the firm to be sufficient to cover the cost of the judicial process, and the court may decide to convert the procedure into liquidation if over time it comes to believe that the reorganization will not be successful.

Stays of proceedings: Staying proceedings means to stop the repayment of claims, an action that increases the firm’s chances of survival. The absence of an automatic stay against senior secured debt may lead to the hasty sale of some assets of the firm. That may hamper the ability of the firm to continue operating, reduce the firm’s sale value, or impinge on the value of remaining assets. More generally, the stay allows information about the firm to be shared among claim holders and the court, i.e., it gives a breathing space before the decision on whether the firm should be reorganized or liquidated is taken.

Preservation mechanisms: These can operate in many ways. For instance, they include court supervision of managers to deter the dissipation of assets, as well as the granting of seniority to debt issued after the firm files for court protection, as a means to provide liquidity to the firm and help it continue operating. In some countries, the administrator is required to approve the granting of seniority to reduce the risk of an unviable firm being kept operating at the expense of the original creditors.

Control rights and power to design and implement the reorganization plan: In the United States the debtor-in-possession principle leaves these rights in the hand of incumbent management, and the flexible stance taken by the courts with respect to the observation of absolute priority, has contributed to raise the chances of the firm to apply for court protection and to continue operating afterwards (absolute priority means that junior claimholders are paid only after senior creditors are paid in full). Those privileges are not, however, an unmitigated good, because they can lead to overinvestment, especially when combined with the super seniority granted to debt acquired after the beginning of the procedure. Assigning these rights to a subset of creditors can also be distortionary; e.g., the receiver under U.K. law may favor a quick settlement that covers the claims he represents, over another plan that would maximize the value of the firm as a whole. The consequences of assigning those rights to a court-appointed administrator depend on the incentives and constraints faced by such administrator. It may bias procedures toward liquidation and, depending on the complexity of the procedures, entail large administrative costs. More specifically, complex rules may help avoid fraud and the undue treatment of individual creditors, but they may erode the value of intangible assets. For instance, suppliers may stop extending credit, customers may shun the products of the company fearing that it will eventually fold, and employees with particular expertise may leave the company when faced with the prospect of a long period of judicial intervention.

Voting powers: A requirement of unanimity among creditors usually makes the approval of reorganization plans difficult, biasing procedures toward liquidation. A common method to address this problem is to parse creditors who hold similar claims in specific groups. Approval may then require just the support of a majority of claimholders within each group. In the United States, only claimholders who are not being repaid in full can vote. Moreover, although support from all eligible groups is in principle required, when at least a class of creditors accepts a reorganization plan, courts may force claimholders to accept it as long as those claimholders receive at least what they would have received in liquidation. Together with the voting power granted to shareholders, that practice tends to bias procedures in the U.S. toward the reorganization of the firm.

The potential “pro-management” bias of Chapter 11 has in part been balanced by the existence of a strong market for corporate control in the United States. The existence of active capital markets in the United States provides mechanisms to help investors (including outside investors) to eject managers and can deter excessive management entrenchment (management turnover, although not exceptionally high after entrance in Chapter 11, is higher than among healthier firms). The sale of the firm as a going concern during the procedure is another method to change the way the company is operated, while often increasing the chances of its survival. Evidence of the sale of U.S. publicly traded firms in bankruptcy, for instance, suggests that such a market-based mechanism fostered an efficient reallocation of resources, often also contributing to the success of sectoral corporate restructuring (Box 9.2).

Several academics have also proposed the conversion of debt into tradable contingent claims as a means to foster efficient outcomes, but except for debt-for-equity swaps these alternatives have not been adopted in recent codes. A number of proposals have been made in recent years that seek to avoid the costs, uncertainties, and delays that usually result from the effort creditors must undertake to arrive at a consensual plan. Typically, they include the transformation of all claims into equity and options on equity (Aghion, Hart, and Moore, 1992; Roe, 1983; Branch, 1998) under an order from the court (a formal procedure is usually necessary to address the holdout and free rider problems that would affect voluntary exchanges). In most of these schemes, senior debtholders would receive all the equity of the firm, and junior claimants would receive calls on those shares. The strike price on those calls would be set in a way that junior claimholders would be paid only after senior creditors were repaid in full.13 The issue of control is not, however, always solved by these schemes—and some voting structure may still be needed—because if control is vested in senior creditors (who received all the equity) and their repayment is bounded by the options on that equity, a situation similar to that arising in receiverships may occur (that is, the senior creditors may focus on recouping their own investment, not necessarily in maximizing the value of the firm). In standard debt-for-equity swaps in which returns are not bounded, senior creditors are more likely to focus on the overall maximization of firm value. Debt-for- equity swaps have been relatively common under Chapter 11.

Acquisitions of Bankrupt Firms Under Chapter 11

Recent research finds that takeovers of distressed firms have the following characteristics (Hotchkiss and Mooradian, 1998).

  • The majority of buyers of bankrupt firms come from the same or related industries. This result supports the argument that potential buyers with the highest valuation of a bankrupt firm usually come from the same sector, even if industry conditions may constrain these potential bidders, who may themselves be distressed (Shleifer and Vishny, 1992). Firms from the same sectors will tend to know how best to operate the firm. They may also have had prior relations with the firm, reducing the problem of asymmetric information (i.e., they do know the strengths and weaknesses of the firm). Nevertheless, “vulture” investors, i.e., deep-pocket investors who specialize in the acquisition and the temporary management of distressed companies, tend also to be active in this market. More generally, vulture investors appear to have on balance facilitated corporate restructuring in the United States. For instance, Betker (1997) finds that the direct costs of Chapter 11 are lower when vulture investors are involved in the restructuring.

  • Most firms showed marked operating gains. These gains generally stemmed from reductions in operating expenses and employment. Ratios such as that of expenses to sales improved, while revenue increases lower than those observed industrywide suggested reductions in capacity.

  • Stock markets reacted positively to those acquisitions. Acquisitions usually led to abnormal stock returns for the bidder and the bankrupt target at the announcement of the acquisition.

The new German Code, which incorporates many features of Chapter 11, attempts to promote efficiency also by providing several mechanisms to foster coordination among parties. The code was introduced in 1999, although an early version had been applied in eastern Germany for some years. In the code, debtor-friendly provisions are balanced by the prominent role given to the creditors’ committee.14 Such a committee is appointed at the beginning of the procedure and can help the trustee draw up the reorganization plan (if the debtor has not proposed one, or the one proposed is deemed inadequate). Subsequently, the general assembly of creditors votes on this plan. If the assembly rejects the plan, it can ask either the trustee or the debtor to draw up a new one. Such coordination mechanisms, and the ample and timely production and dissemination of information among parties, can have an instrumental role in promoting efficient outcomes. They help expedite the procedure, while avoiding letting the debtor, creditors, or a court-appointed trustee monopolize decisions. Building on German tradition, the code also provides mechanisms to facilitate the takeover of distressed firms.15

Bankruptcy law reform has not been uniformly successful, reflecting the difficulty of striking the right balance between being “debtor-friendly” and being able to deal with firms that should close. For instance, the 1985 French law appears to have tried to reconcile too many conflicting goals in an effort to keep firms alive and preserve jobs. As a consequence, an excessive number of firms typically undergo repeated reorganizations.16 By contrast, the 1986 British Corporate Voluntary Arrangement (CVA) forces the transfer of the control of the firm away from the firm’s directors and is seldom used. Its inadequacy, as well as the drawbacks of other U.K. bankruptcy laws (such as receiverships), contributed to the prominence taken by the London Approach to debt workouts in the 1990s. That approach evolved as a response to the financial difficulties faced by many U.K. companies at the onset of the 1989 recession, and the transformation of the role of banks following financial liberalization in the United Kingdom—which made even strongly capitalized banks less able or willing to support distressed firms on a bilateral basis.17 Under this approach, the Bank of England took the role of an “honest broker” between parties, exerting some moral suasion, but leaving to the private parties the onus for designing and implementing the required restructuring strategies.

The Proposed Financial Rehabilitation Law

The project to reform Japanese insolvency law gained momentum in 1999. An Advisory Committee for the Reform of Insolvency laws was established at the Ministry of Justice in October 1996. The committee published a first document for discussion in December 1997. This document suggested that efforts should focus on drafting a law to facilitate the financial rehabilitation of small and medium-sized companies in order to carry out a comprehensive reform of all insolvency laws.18 Responding to the deterioration of the economic situation and the recognition of the importance of facilitating corporate restructuring, the pace of preparation accelerated in 1999, and legislation was proposed to the Diet in the fall of 1999.

The prospective features of the new Financial Rehabilitation Law tend to increase debtors’ bargaining power and extend some market mechanisms. The proposed law includes key provisions paralleling those in Chapter 11. In particular:

  • Courts will have discretionary power to provide stays against secured creditors, reducing the risk of the firm ending up in liquidation after being stripped of essential assets; the stays will not be automatic, although courts are expected to be liberal in issuing them. The law also envisages the issuance of comprehensive injunctions, saving the debtor from the current burden of requiring an individual injunction against each creditor.

  • The debtor-in-possession (DIP) principle will apply. Incumbent management will be entitled to remain in control of the firm during the procedure and propose the reorganization plan.

  • Debts acquired after the commencement of the procedure will be granted seniority over previous claims.

  • Approval of reorganization plans will require the support of a qualified majority of creditors, rather than their unanimous consent. Creditors will not, however, be divided by classes for the purpose of voting on the plan, and it is thus not clear if a mechanism similar to the ability of the court to “cram down” creditors will be available.

  • Debtors will be able to satisfy claims of secured creditors by paying off the current (estimated) value of the collateral and lumping the residual part of the loan with other unsecured debts. This provision extends the protection granted by the Corporate Reorganization Law, which states that any deficiency of collateral shall be treated as an unsecured claim.

  • Firms will be allowed to be sold as a going concern during the rehabilitation procedure, an option usually blocked under the Corporate Reorganization Law (there are mechanisms to sidestep this restriction, however, as illustrated by the quick sale of Japan Leasing Co., an affiliate of Long-Term Credit Bank (LTCB), even before a formal reorganization plan was approved).

  • Rules would be changed to permit debt to be converted into equity through the issuance of additional equity, rather than by replacing existing equity, which will tend to facilitate debt-for-equity swaps.

The new legislation will thus feature the stronger protection against creditors found in the Corporate Restructuring Law and the autonomy provided to the debtor found in the Composition Law and the Commercial Code. By combining features of all three laws, the new text may become more operational, leading to an increase in the number of petitions. The authorities expect the number of cases to double or triple. An effort has also been made to simplify procedures. For instance, although the authorities have been favorable to the creation of creditors’ committees, their structure and exact role are likely not to be codified.

The authorities are also considering changes in connected legislation. The implementation of measures such as the promotion of debt-for- equity swaps will require changes in other laws that are being carried out. Exemptions to the Commercial Code, for instance, are being considered to permit the reduction of the capital of the firm without the need of shareholders’ approval. Also, the Antimonopoly Law is being changed to permit a bank to hold more than 5 percent of the equity of a firm. Indeed, small changes in ancillary legislation and rules are likely to be instrumental to any increase in corporate financial reorganizations.

The ultimate objective of overhauling the texts of the insolvency laws in the medium term was not altered. Plans still call for a comprehensive reform of the insolvency laws in a 3–5 year horizon, as well as the connected changes in other laws, notably those referring to provisions in the Commercial Code.

Issues and Challenges

The accelerated introduction of new rehabilitation procedures can prove useful. The early passage of legislation supplementing current laws and addressing a relatively narrow set of problems can be helpful on two counts. First, it can provide an effective vehicle for corporate rehabilitation, thus helping to relieve strains on the economy from corporate distress, including liquidation. Second, it can work as a “pilot” for at least some sections of the final law. This was the strategy followed in Germany after reunification. Reform had been discussed in western Germany for many years, permitting the law of the former East Germany to be quickly modernized. The resulting temporary statute was used as a “test drive” for some of those concepts before the enactment of the new code for the unified country in 1994 (Paulus, 1998).

Promoting corporate restructuring, while reducing the risk of management entrenchment, is likely to require a delicate balance. The objective of facilitating the financial reorganization of the largest possible number of firms could lead to the preservation of inefficient firms. In this respect, international experience indicates the importance of avoiding an excessive relaxation of the criteria for evaluation of reorganization plans. The rights of minority shareholders as well as those of small creditors should also be safeguarded.

With respect to larger firms, the experience in the United States suggests that a strong market for takeovers can act as a balance against management entrenchment. Permitting this mechanism to develop can be crucial to ensure efficiency, especially if the desire not to overburden the law results in the exclusion of the formal checks and balances that, for instance, characterize the new German Code. There are indications that the ongoing financial reform and upcoming changes in accounting and disclosure rules could help the development of such a market.

Successful legal reform is also likely to promote a growing number of informal debt workouts. By providing new options to debtors, the reform could induce creditors to engage in out-of-court negotiations. It is often mentioned, for instance, that banks are reluctant to resolve or renegotiate real estate loans because a title on those loans is akin to holding an option on the value of the land collateral, and low interest rates make that strategy cheap. The provision under the proposed law permitting debtors to satisfy the secured part of those claims by paying cash for the current value of collateral essentially curtails this option under a legal reorganization proceeding, and creates an incentive for banks to renegotiate. If the ability to revert to formal procedures remains remote, however, the threat embodied in these provisions will not be effective.

International experience points to the importance of the judicial infrastructure in the success of bankruptcy reform. In the United States, a factor behind the success of Chapter 11 was the creation of a body of qualified private trustees to serve in bankruptcy cases and relieve the judge of much of the administrative responsibility (Morse and Shaw, 1988). In Japan, a review of court procedures and manpower available could also prove necessary. Revisiting the issue of restrictions on the role of foreign lawyers may be helpful in enlarging the pool of experience available to support the financial reorganization of Japanese firms.

Summing up, bankruptcy law reform can make a valuable contribution to the restructuring process by providing a fair and transparent legal framework for sharing losses between creditors and debtors, while protecting firms’ value as going concerns. While tradeoffs will need to be made between the interests of different parties, experience in other countries provides some useful pointers as to how best to marry efficiency and equity considerations. Thus, with skillful handling, new bankruptcy laws could help unleash forces that would find fruition in a renewed dynamism in the Japanese economy.


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The discussion does not address the issue of the compatibility of Japanese international insolvency law with international practice. For a review of this particular issue, see Matsushita (1998).


Compositions provide little protection against secured creditors, but they help to avert the presentation of promissory notes. The latter feature is valuable in Japan, because the failure to honor two promissory notes within six months leads to the suspension of business transaction with banks and the virtual death of any business (Matsumura and Ryser, 1994).


Approval of the plan requires two-thirds or more of the unsecured creditors’ aggregate voting rights, three-fourths or more of the aggregate voting rights of the secured creditors if the maturity of their claims is changed, and four-fifths or more if other modifications are involved, and generally the simple majority of shareholders.


Article 30 of the law states that the procedure can commence only when “a company is unable to pay its obligations that are due without exceedingly impeding continuation of its business” or “where the facts comprising causes of bankruptcy are likely to take place with respect to the company” (Shea and Miyake, 1996). The court, creditors, and debtors may all file for Corporate Reorganization (Sakai and Jacobson, 1998).


Owing to the current strength of the U.S. economy, the number of Chapter 11 filings has declined to around 8,000-10,000 per year.


A spectacular relaxation of the requirements imposed on firms wishing to issue domestic unsecured debt occurred after the Foreign Exchange Control Law was revised in 1980 to allow firms to issue unsecured bonds abroad. Only two firms met those criteria in 1979. By 1989, about 300 were entitled to issue unsecured debt, and 500 to issue unsecured convertible bonds (Japan Securities Research Institute, 1998).


It is difficult to gauge this specific risk, because court actions are not as common in Japan as in the United States, and corporate governance in general is exercised somewhat differently in the two countries. The expression of this concern, nevertheless, probably also reflects banks’ perception of some uneasiness on the part of stakeholders and possibly society at large with the use of public money to bail out companies that have or had close ties to political parties.


Although a new securitization law was adopted in 1998, investors have still balked at investing in bad assets, in part because deficiencies in loan documentation continue to exacerbate the problems raised by the complex web of liens usually attached to loan collateral in Japan.


The holdout problem is a coordination failure that emerges when marginal creditors realize that their own claims tend to become more valuable after claims of the main creditors are relinquished. The problem is less severe when the debtor is facing mainly a liquidity crisis, because in this case the on-going value of the firm is typically much higher than its liquidation value, making it easier to pay off creditors holding out. When larger sacrifices are required, reliance on legal procedures is more likely. For instance, Franks and Torous (1994) find that write-offs are relatively small and junior and senior debts are reduced by broadly the same proportion in the case of debt workouts, while legal bankruptcy is associated with larger write-offs, ones in which junior creditors absorb much larger losses than senior creditors. Although high-leveraged firms in the United States tend to prefer workouts to legal bankruptcy (Chatterjee, Dhillon, and Ramirez, 1996), this is typically explained by the fact that, in the United States, high leverage is associated with high interest payments. Highly-leveraged firms thus tend to default after relatively small shocks to their revenue flows, i.e., they often face more of a liquidity crisis than insolvency. In Japan, interest rates have been low and the disciplining effect of leverage has largely not been in operation (Jensen, 1986). Firms facing default are thus likely to have already depleted much of their assets and be close to insolvency, and their problems may be less easily addressed by informal bilateral workouts.


German law was heavily tilted toward liquidation. Similar to Japan, most liquidations and reorganizations proceeded out of court, in part because stringent screening mechanisms would bar most firms from applying to enter a legal procedure. In a typical year, only 60 petitions for compositions were accepted.


See also IMF, 1999 for a comprehensive economic analysis of key issues surrounding insolvency procedures. Ex ante efficiency, i.e., the extent to which the law affects contracts and credit, has until recently received less scrutiny.


The most cited case in which lenience toward incumbent managers afforded by the code has proved very costly is that of Eastern Airlines. When the company filed for bankruptcy it had $3.7 billion in assets, which was enough to repay its $3.4 billion in debts. After a year in Chapter 11, the company offered its creditors $1.6 billion, and in its final proposed plan it offered only $0.8 billion. The company was eventually liquidated, with creditors receiving less than a tenth of the firm’s stated value on entering bankruptcy (Neish, 1995). The Code was amended in 1994 to allow creditors to appeal against the extension of privileges to the debtor, but these changes were, on the whole, marginal.


A cascade of call options on call options could replicate the absolute priority structure, with the original shareholders exercising their call if a residual was left after all debtholders were paid. Proposals usually allow these securities to be traded before maturity, with the maturity time being set with a view to permit claim holders to exchange enough information to facilitate the rational exercise of their rights (e.g., after a full year of operation, or a detailed audit of the company).


Provisions akin to those in Chapter 11 include automatic stays against secured creditors, the division of creditors in classes for voting purposes, the sufficiency of majorities for the approval of plans, and the ability of the debtor to submit a reorganization plan when petitioning for protection. The code also allows incumbent management to remain in charge of day-to-day operations, although at the creditors’ discretion and under court supervision.


An aspect of the code that could also be of some interest in Japan is the attempt made to address the problem of dealing with labor redundancies following acquisitions through negotiations with employee representatives. This problem can be serious in Germany, where workers enjoy far-reaching employment protection.


The code was amended in the 1990s, but the problem to an extent still persists.


Under the London Approach, the Bank of England has attempted to be a catalyst to create a generally agreed framework and to help corral banks into unanimity, where this was a precondition for restructuring packages (Kent, 1997). The financial and legal expertise and its deployment in particular situations was left entirely to the financial institutions involved, as well as the company in difficulty. Ingredients of the London Approach include the commitment of banks not to initiate legal action against the troubled firm, rather keeping their credit lines open; efforts to keep the decision-making process collegial; and attempts to balance the respect for absolute priority with the desire to share the cost of rescuing the firm in a fair way. The Bank of England has been involved with over 160 workouts, a small proportion of the workouts that occurred under that framework but without the Bank’s involvement.


The document also gave priority to the development of laws covering individual bankruptcies and to reform international bankruptcy procedures. Although the new law is expected to supplement the composition law, all existing laws will remain in place until the original reform project is completed.