Japan has quietly been improving its legal infrastructure to aid economic recovery and establish a new legal foundation for the 21st century. One major area of legal reform is the country's aging insolvency system, and the government has introduced the Civil Rehabilitation Law (CRL) to address this.
It focuses on facilitating and expediting the rehabilitation of viable businesses that have run into financial difficulties. In so doing, the CRL borrows from some of the concepts in the business rehabilitation statute in the US, known as "Chapter 11".
There is a tendency to underestimate the value of business rehabilitation systems such as the CRL and Chapter 11. Where such laws are in place, therefore, the real issue can often be whether the government, the courts, creditors and businesses are willing to utilize the laws and implement them quickly, effectively and fairly.
Systemic objectives of an effective Rehabilitation Law
1) The law should enable the quick and effective rehabilitation of troubled businesses, especially in times of economic crisis
The key to successfully rehabilitating a business is to address the financial problems quickly, before the problems can overwhelm it. This requires the rehabilitation law and the legal infrastructure (the courts, the government, etc) to encourage and expedite the implementation of business solutions to what are, essentially, business problems. The law should also provide a predictable, transparent and "fair" framework for restructuring the balance sheet, so that banks and other creditors will "buy in" to the rehabilitation and work to make it succeed.
The latter is especially vital in times of systemic economic difficulties. In order for banks to participate effectively in rehabilitations, it is often necessary to convert their debt to equity or to write off a portion of their debt. This means banking regulations must be flexible enough to permit banks to make true economic decisions, rather than decisions motivated by a desire to avoid harsh regulatory consequences, even if those decisions lead to a failure of the rehabilitation.
If the banking regulatory framework is not addressed, then the country's economic system will only worsen. Businesses will fail if their banks do not participate in the rehabilitation due to regulatory restraints, and as more businesses fail, more bank loans will go into default. Banks will then be less able to provide new loans, driving more businesses into financial trouble because they cannot obtain continuing financing, with the business failure cycle feeding on itself until there is a systemic business and banking crisis of major proportions.
On the other hand, if a regulatory framework is sufficiently flexible that it does not overly punish banks for writing down the value of their loans, then banks can participate in sensible rehabilitations. This saves more businesses and returns them to economic viability, which injects into the system a greater number of healthy companies to which banks can make new loans. This cycle improves the banks' financial health, until there is a systemic improvement in the economy.
Further, if the consequences of loan write-downs are made manageable within the regulatory framework, the option of an immediate write-down of their loans by selling the loans in the secondary market is also available.
2) The law should encourage entrepreneurial activity by not unduly punishing failed businesses
Countries around the world take widely differing views as to how they treat businesses in financial distress. At one extreme are countries that treat the first signs of distress as a signal that the business should quickly enter bankruptcy and be liquidated, often followed by strict scrutiny of the directors and managers to determine if they should be held personally liable for the failure. This leads to very conservative business practices, resulting in a mindset of risk avoidance, rather than business growth.
While this approach sounds reasonable on the surface - businesses should not take imprudent risks - it tends to retard overall economic growth. The US, for example, takes a more moderate approach towards business financial problems. Not that financial problems should be encouraged, rather the consequences of financial problems should not be so potentially draconian as to discourage risk-taking.
Starting with Mark Twain, through to P.T. Barnum and Donald Trump, the American business landscape is filled with entrepreneurs whose businesses were insolvent (often more than once) before they eventually succeeded. In part, this is because they were not unduly punished for initial failures and knew they would not be if they failed again. This encouraged them to continue to take entrepreneurial risks until they succeeded. It is certainly the case that, the greater the risk taken, the greater the chances of failure.
It is equally the case that, the greater the risk taken, the greater the success will be if the risk pays off. While the US has a high number of business failures, it has an enormous number of substantial business successes, overall leading to a strong systemic economy even in times of global financial crisis.
While the US system is not without its own faults, the concepts of encouraging rehabilitation and not overly discouraging risk-taking are taking greater hold throughout the world. For example, Australia and New Zealand introduced new rehabilitation laws in the early 1990s, Germany enacted a new law in 1999, and Britain and South Africa are currently considering new legislation to facilitate and expedite business rehabilitations for this very purpose.
Analysis of Japan's new Civil Rehabilitation Law
Japan, with the adoption of the CRL, now has a more efficient and effective process for rehabilitating troubled businesses, not just because of the specific provisions of the law but also because of the presence of a constructive attitude and infrastructure.
1) The CRL recognizes that financial problems are primarily business, not legal, problems
Businesses seldom encounter financial difficulties for purely legal reasons. More typically, they encounter problems through a combination of macro-economic factors (a weak economy), micro-economic factors (their competitors are better situated), balance sheet problems (too much debt), and management problems (inability to adapt to changing marketplace). Because of this, an effective rehabilitation system must include laws and a court system that provide a framework and a forum for business solutions to be negotiated and implemented.
Clearly Japan recognizes this. For example, the Ministry of International Trade and Industry (MITI) and the Tokyo District Court jointly conducted a symposium on the new CRL in Tokyo on April 17. The purpose was to educate the participants on the workings of the CRL and to make it clear MITI intends to assist in making the law work.
Judge Sonoo, the Judge of the Tokyo District Court in charge of the CRL docket, expressed the intention that the court would assist in the rehabilitation process, and MITI has also expressed its support.
2) The CRL includes the essential elements for an effective process
(a) Maintenance of business value during the rehabilitation process
When a rehabilitation starts, the CRL empowers the Court to issue an injunction effectively preventing creditors from taking individual actions to dismantle the business. While the CRL follows the US practice of leaving existing management in place, the Court can appoint a supervisor to review the management and conduct of the business and approve key decisions.
While the CRL came into effect on April 1, 21 rehabilitation cases had already been filed as of April 17. In each case the Court issued an injunction against creditor actions and appointed a Supervisor. The result is businesses with continuity of management, minimized creditor disruption and active oversight by the Court with the assistance of the Supervisor.
(b) Creation of balance to encourage a consensual plan
A balanced rehabilitation system is an incentive to each of the major constituencies to negotiate a consensual rehabilitation plan and the risk of disincentives if they seek to oppose a consensual plan.
For example, the CRL provides that secured creditors can be forced to give up their liens if a cash deposit is made equal to the value of the collateral; shareholder interests can be eliminated if creditors do not approve a plan; and unsecured creditors who oppose a plan can still be bound by it if more than 50% of all unsecured creditors vote in favor of the plan.
(c) Encouragement of "pre-packaged" plans
A practice that has developed in the US is for a financially troubled business to propose a plan to creditors and get their acceptance before opening the rehabilitation proceedings. If sufficient acceptances are obtained, the business then commences a Chapter 11 case and immediately files this "pre-packaged" plan for court approval.
It is often the case that, within 30 to 60 days, the court will consider the plan and approve it, thus allowing the rehabilitated business to emerge very quickly from the insolvency proceedings.
While pre-packaged plans are, as one might expect, more common when a simple balance sheet restructuring is needed rather than when fundamental business practices need to be changed, they are a very effective and efficient mechanism in the right situations. Often if a plan is "pre-packaged" the marketplace soon forgets a court process was necessary in the first place.
Under the CRL, if 60% of creditors vote to approve a plan, that can result in the invocation of a special summary process, by to which the plan can be approved quickly by the court. If these consents can be obtained before the business actually opens a CRL rehabilitation proceeding, it should be possible for the business to proceed on a "pre-packaged" basis with a prompt court approval process, thus shortening the time the business is engaged in the Court process.
(d) Ability to shed burdensome contracts
It will often be helpful for a troubled business to terminate unprofitable or burdensome leases and other contracts as part of the rehabilitation process. The CRL allows such terminations, except for labor contracts. The court is required to hear the views of the labor representative regarding a plan. This is one of the critical issues in the law's effectiveness. US law also provides special protection for labor contracts, such as a higher standard the troubled business must meet before it can terminate a labor contract. In practice, US courts have taken a balanced view of the needs of labor and the rehabilitation needs of the business, and it is hoped that Japanese courts will take a similar view.
(e) Encouragement of active creditor involvement
Rehabilitation systems work best when creditors play an active role, because having a say in the plan makes creditors more supportive of the rehabilitated business. According to Judge Sonoo, the practice before the CRL was for creditors to rely primarily on the courts and not play an active role.
The CRL provides the opportunity for a creditors' meeting and more active creditor participation via the selection of a committee to represent the interests of creditors generally. Judge Sonoo indicated his intention to call a creditors meeting in every case.
The CRL further encourages active creditor participation by permitting creditors under some circumstances to file a CRL petition and, under any circumstances, to file a creditors' rehabilitation plan. This power, combined with the need of only a 50% creditors vote to approve a plan, will encourage creditors to use this procedure for their strategic advantage.
(f) Encouragement of active judicial involvement
A rehabilitation system can work only as well as the judges enable it to. The judges must appreciate the vulnerability of a business in a court proceeding and the need to encourage parties to negotiate a consensual rehabilitation plan. The MITI conference was helpful since it presented an opportunity for both MITI and the Courts to articulate their practical and commercial philosophies.
While it can often take a year or more for a new rehabilitation law to begin functioning properly, this does not appear to be the case in Japan. Given governmental and judicial attitudes expressed at the MITI conference, it appears the CRL is already on the road to becoming effective.
Opportunities for investors
The question arises whether the CRL presents new opportunities for investors in Japan? The answer is yes, in two areas in particular:
Distressed debt purchases - Category 2
Bank category 2 non-performing loans often involve situations requiring business rehabilitation. By providing for a more predictable, efficient and expedited rehabilitation process, the CRL will increase the value of non-performing loans. This allows higher prices to be paid to the banks, other financial institutions and the RCC, while creating more opportunity for profit by debt purchasers with restructuring skills and capital to invest in restructured companies.
Private Equity - MBO investments
Many companies have numerous liens on their assets, making it much harder to attract private-equity investments or accomplish a management buy-out (MBO). By facilitating the negotiation of consensual rehabilitation plans, including, in the right circumstances, "pre-packaged" plans, the CRL will facilitate new equity investments and encourage MBOs by creating a better framework for investors to provide the supporting loans.
These days, private equity funds have a great deal of money available to invest, but their challenge is finding appropriate investment opportunities. The CRL should facilitate significantly more opportunities for private equity investors.
Richard Gitlin and Evan D Flaschen are from US law firm, Bingham Dana LLP. Gitlin is a partner in the firm's Financial Restructuring Group, and is currently representating the Government of Indonesia in its efforts to develop a restructuring culture and supporting legal structure. Flaschen is co-head of the same group, and head of the firm's business practice in the Hartford, US office.
