Initially, it was believed that the Japanese economy was not directly affected by the recent economic turmoil resulting from the US sub-prime shock. However, the drop in the Japanese stock market to date has, in fact, been much larger than that in the US or European countries. This is due to several factors, including the recent sharp appreciation of the yen against the dollar, which significantly hurt the Japanese export industry (including automotive and electronics companies); and also the withdrawal of foreign investment from Japan, which severely damaged the Japanese real-estate market. As a result, since last year there has been a dramatic increase in insolvency among major real-estate developers, construction companies, and electronic-parts manufacturers. The number of collapsed listed companies amounted to 34 in 2008, which is the highest since World War II.
To rehabilitate or to reorganise?
Japan has two types of legal proceedings for reconstructing business entities. One is civil rehabilitation proceedings, and the other is corporate reorganisation proceedings. Both aim to revive businesses that are in financial difficulty, rather than liquidating or dissolving them.
Civil rehabilitation proceedings are debtor-in-possession (DIP) type proceedings. That is, the existing directors and managers continue to control the business under relatively moderate supervision by the Japanese court. In almost all cases, such supervision is performed by a supervisor, who is appointed by the court from a list of experienced bankruptcy lawyers. The debtor company will establish its rehabilitation plan within the timeframe determined by the court. If such a rehabilitation plan is approved by a company's creditors and the court, the creditors will receive repayment according to the plan. Generally, secured creditors' rights will not be altered or affected by the proceedings or plan: their rights can be exercised separate from the proceedings, unless the court issues a special order to prevent such rights being exercised.
On the other hand, once a company files for corporate reorganisation proceedings, in principle, the control rights over the business would be handed over to a provisional trustee, who is an independent lawyer appointed by the court and becomes trustee once the court issues a commencement order. Under these proceedings, the existing directors lose their right of management, and the company continues to carry on its business and form its reorganisation plan under the trustee's direct control. Even secured creditors' rights are not allowed to be exercised during corporate reorganisation proceedings, and may be modified by the reorganisation plan.
Since the civil rehabilitation proceedings allows the existing directors to continue to handle the business, and since this proceeding has been much more flexible and quicker than corporate reorganisation, an overwhelming majority of distressed companies use civil rehabilitation rather than corporate reorganisation proceedings: the number of civil rehabilitation proceedings filed in 2008 was 884, while there were only 29 corporate reorganisation proceedings in the same year.
Japanese pre-packaged plan
According to established practice in the Tokyo District Court, an insolvent company that files for civil rehabilitation obtains a temporal suspension order which enjoins the debtor from repayment of its unsecured debts and from any transactions that are not within the scope of its ordinary course of business, unless having the supervisor's approval.
After approximately one week, a commencement order will be issued, which enjoins the debtor to submit its rehabilitation plan within three months. During this period, the debtor looks for a sponsor (sometimes with the help of financial advisers), initiates a bid process (where there are more than two potential sponsors), designs its plan with the selected sponsor, and submits the plan to the court, after which the creditors vote on the plan.
Until 2007, this standard process generally seemed to work well – many investment funds and strategic buyers were active in the Japanese market and it was relatively possible to hold a competitive bidding process.
However, the situation has now drastically changed. Many companies that filed for civil rehabilitation last year could not find sponsors despite extensive efforts. Making matters worse, the 20th Division of Tokyo District Court, the most common venue for civil rehabilitation filings, has been very reluctant in recent years to extend the submission period of rehabilitation plans.
In the current economic environment, where all players have suffered from the worldwide downturn, it can be very difficult to find a party willing to sponsor an insolvent company within the timeframe set by the court. As a result, commencing legal proceedings without identifying a sponsor could fatally harm the company's reputation, given that many know that it is not likely that a debtor company will find a strong sponsor and form an effective plan within the timeframe set by the court.
Directors of distressed companies therefore tend to believe that it would be imprudent to file for civil rehabilitation without first identifying, in advance, a favorable sponsor. In this regard, the trend is for distressed companies to file for the proceedings after entering into a legally binding sponsorship agreement with its white knight – a scheme referred to as Japanese pre-packaged rehabilitation. It must be noted that the meaning of pre-package here is quite different from the meaning which is used in US Chapter 11 proceedings. In Japan, pre-packaged means proceedings in which the sponsor is already selected before the court filing – it does not mean that a reconstruction plan is already established through a workout process transparent to the company's stakeholders. In addition, the Japanese pre-package does not imply that a sponsor is selected through an open, fair bid process. In Japan, it is not practical to disclose that a company is seeking a sponsor without having legal protection from the court, since this would cause immeasurable reputational risk and would trigger stoppage of material supply, foreclosures, or sudden off-settings by banks – all of which would make reconstruction impossible. Thus, save for an extremely limited number of cases, it is practically impossible to prearrange a sponsor through a totally transparent process.
Tohato case
A very simple (but significant) question can be posed against Japanese pre-packaged proceedings: would the pre-selected sponsor really maximise the creditors' interest? That is, whether an insolvent company's directors fulfil the directors' duty of care by choosing the sponsor prior to filing?
This question was extensively discussed after the notable civil rehabilitation of Tohato, filed in March 2003. In this case, Tohato initiated a two-stage bid process to select its sponsor before the court filing. Three bidders participated in the bid, and finally Unison Capital, a Tokyo-based buyout fund, won the bid at the price of ¥1.4 billion. Unison's successful bid was partly due to Tohato's immediate need for cash; the winner committed a certain amount of pre-filing DIP finance, while other bidders (seemingly) did not.
After the filing, a loser in the bid asserted that the bid was unfair and that the debtor company must start the sponsor selection process again on the basis that it proposed a price higher than that of Unison's during the initial bid process. Unison argued that the selection was fair since the opponent did not offer DIP finance even if it presented a slightly higher price, and also that it is extremely unfair to nullify the bid without giving any award to Unison who actually provided pre-filing finance and contributed to maintaining Tohato's value on a going-concern basis.
However, after discussion, Tohato's supervisor, who was appointed by the court, finally required that Tohato must start the bid process again.
Ultimately, Unison won the second bid, but at a price of ¥1.8 billion – which is approximately 30% higher than the original bid price.
In the Tohato case, the sponsor selection prior to the filing was executed through a bid process, although the solicitation of the bid was done in secrecy, and the winner was chosen not only based on its bid price but also by considering other merits for Tohato. Nevertheless, the supervisor forced the bid process to restart in order to make the process more transparent, and by doing so, to maximise the distribution to the creditors and thereby authenticate the performance of fiduciary duties by the directors.
Odaiba Approach
After the Tohato struggle, bankruptcy practitioners extensively argued how the legitimacy of pre-packaged sponsors could be assured. A well-known proposal in 2003 by a bankruptcy lawyer, the so-called Odaiba Approach, states that an original sponsor in pre-packaged proceedings will be considered legitimate, subject to the following conditions:
i) there is a risk that the value of the business will be quickly reduced unless a sponsor has been identified before the court filing;
ii) a proper solicitation process is performed so that there is substantial competition in the bid process;
iii) no unfair bidding conditions that can restrain a higher bid price;
iv) no unfair treatment when selecting a sponsor from the bidders;
v) terms and conditions of the sponsorship agreement are not unreasonably detrimental to the debtor;
vi) existence of a third-party opinion which confirms that the sponsor selection process is fair; and
vii) the selected sponsor performs its duty under the agreement in good faith and it fulfils its expected role.
Despite the existence of the Odaiba Approach, it is not frequently taken into consideration in pre-packaged proceedings in practice. This is partly because this approach inherently requires that a bid process is convened at the pre-filing stage, which is unrealistic in almost every case. Also, it is very difficult to find a suitable third-party to opine on the fairness of the sponsor selection process. Investment banks or financial advisers can declare the fairness of the valuation, but it is not within the scope of their business to determine the fairness of a process.
Many practitioners think it is obvious that the process cannot be challenged if the debtor materially follows the Odaiba Approach, but this does not mean that the Approach can become a standard practice of the pre-filing bid process. Thus, in Japan, there has been no common standard established for designing a rehabilitation scheme that takes into consideration a potential sponsor who is willing to buyout the business and support the process, at a pre-filing stage.
Compensating the bid winner
In addition to the problem described above, there is another issue in Japanese pre-package proceedings. Where a court-appointed supervisor believes that the pre-filing bid must be reversed for certain reasons, there is no practical way to measure how the prearranged sponsor should be compensated for its contribution to the company's rehabilitation up until the time a new sponsor takes over its position.
Paying a break-up fee is one possible approach, but under Japanese law, such a fee agreed between the debtor and the potential sponsor in the pre-filing period would be considered a general unsecured claim, which cannot be paid in full once a rehabilitation proceeding is filed. Once a civil rehabilitation proceeding starts, it is quite difficult to legitimise the payment of a break-up fee which was agreed before the filing.
Another approach is to give a reasonable advantage to the existing sponsor, for example, by inflating its bid price to some extent in the post-filing bid process. However, it is not certain how a fair and reasonable advantage should be determined, since there is no obvious precedent for this kind of practice in Japan.
Thus, if a party considers sponsoring a financially distressed company that is going to file for rehabilitation proceedings, that potential party cannot know whether the sponsor agreement executed in the pre-filing period will be considered legitimate by the court (or a supervisor), and how it will be treated when the agreement is nullified and a latecomer is selected as a new sponsor after the filing. Due to these uncertainties, many potential sponsors are reluctant to conduct extensive due diligence at great cost and to inject DIP finance into the moribund company. Therefore, they ultimately relinquish their opportunity to be the pre-packaged sponsor.
After Tohato
Despite the above, pre-packaged rehabilitations still exist. As there is no established practice to select a pre-filing sponsor, most insolvent companies simply pick a sponsor based on their directors' arbitrary preference. Occasionally, supervisors point out that the pre-filing sponsor selection may not be optimal or allege that terms of the sponsor agreement are not favorable for the debtor company and its general creditors. Supervisors can recommend that a transparent bid process be conducted, or that the terms should be re-negotiated by cancelling the agreement (such cancellation would be allowed under the Civil Rehabilitation Law).
Seemingly, however, a pre-filing sponsor agreement would not be cancelled in most cases, as the directors of the debtor company are unwilling to make efforts to find a new sponsor. Additionally, most investors and potential sponsors think that it would take a great deal of exertion to reverse the status quo and therefore, that it would not be wise to express interest in becoming a sponsor, especially where the target company's directors are not cooperative. As a result, in the absence of a specific competitor who is willing to be an alternative sponsor and as long as the distribution plan originally presented by the company is favorable for its creditors (rather than merely selling the business assets piecemeal), it is difficult for a supervisor to prove that the pre-filing sponsor selection is unfair and constitutes a breach of the directors' fiduciary duties, and that the rehabilitation plan created by the company is illegitimate. Consequently, the supervisor has no choice but to reluctantly admit the original rehabilitation plan even though it might not be optimal for the general creditors.
In some cases, however, the existing sponsors have been forced to increase the agreed amount to be injected into the insolvent companies, or to compete with new potential sponsors after the sponsor agreements were cancelled. In these cases, this was due to the supervisor's strong objection to the existing pre-package rehabilitation schemes that were secretly designed by the debtor companies and the original sponsors. Usually, supervisors can be aggressive in this way when a competitor of the existing sponsor appears and makes a firm offer with a specific amount to be injected into the company. If the latecomer's offer would result in a higher amount to be distributed to the creditors, it becomes difficult for the directors of the rehabilitating company to insist on the sponsor selected during the pre-filing stage. Usually, the latecomer can evaluate the rehabilitation company's business at a value higher than the original sponsor's pre-filing valuation, as long as it has the opportunity to perform reasonable due diligence, since many uncertainties associated with the court-filing process would have dissipated over time.
Practical strategy
As long as there is some possibility that the sponsor agreement signed before the filing may be reversed as a result of new competitors subsequently appearing or the aggressiveness of the court-appointed supervisor, the absence of a clear standard of good practice of pre-package sponsor selection will cause potential sponsors to hesitate to become a sponsor at the pre-filing stage. This will hinder the filing of rehabilitation proceedings at an appropriate time and could deter the timely provision of DIP finance, which may be fatal for the insolvent company.
Another problem regarding the lack of a clear standard for a pre-package scheme is that the directors of the insolvent company might enter into a definitive agreement with a sponsor who would guarantee the directors' personal interests, knowing that it would result in the distribution of unreasonably small amounts (but slightly better than expected liquidation value) to the creditors.
In any case, given the current situation, a company that is considering filing for rehabilitation along with its potential pre-package sponsor must try to do its best to minimise the risk that the supervisor may later try to reverse the pre-package arrangement, on the basis that it is unfair and not optimal. Here are some practical points to be considered when designing a "pre-package" rehabilitation scheme:
1) if possible, more than one party should be invited to consider becoming a sponsor in order to ascertain some measure of fairness;
2) the pre-package plan must distribute amounts to the general creditors well above the liquidation value;
3) the sponsor would help maintain the value of the business as a going concern by providing various support to the debtor company (providing DIP finance for instance);
4) obtain support for the pre-package arrangement from major creditors and maintain a good relationship with them;
5) make the terms and conditions of the sponsor agreement concrete and eliminate uncertainties for the insolvent company as far as possible;
6) in order to prevent a latecomer from entering the process, establish a security interest over the company's assets which are indispensable for its business.
The uncertainties involved in Japanese pre-package rehabilitation could intimidate potential sponsors from being actively involved in the rehabilitation of distressed companies. However, it is very important for a company in financial difficulty to find a good sponsor before entering into legal proceedings in order to maintain its business and maximise its creditor value, especially in the recent economic turmoil where a rehabilitation filing without first identifying a sponsor would have immeasurable reputational risk and could be fatal to its business.
Due to the absence of established rules for Japanese pre-package rehabilitation, directors of a distressed company are expected to succeed at a very challenging task: they must find a faithful sponsor by designing a scheme that would eliminate the risks that the pre-package plan would face after the court filing, while simultaneously fulfilling their fiduciary duties to the stakeholders.
| Author biography |
Junichi Tobimatsu
Mori Hamada & Matsumoto
Junichi Tobimatsu is a partner at Mori Hamada & Matsumoto. His practice focuses on corporate restructuring, including civil rehabilitation and corporate reorganisation, and various dispute resolution. He is admitted in Japan and New York. He worked at Skadden Arps Slate Meagher & Flom in Palo Alto from 2003 to 2004, and became a partner at Mori Hamada & Matsumoto in 2006. He received a LL. B. degree from the University of Tokyo in 1996 and a LL.M. degree from Stanford Law School in 2003. |