Pacific Overtures Acquisitions of Financially Distressed Company Assets in Japan

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Oct 2004

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In free-market economies like Japan and the United States, asset acquisitions are a primary means of
business expansion. Strategic buyers will often acquire assets of
competitors or other companies to expand sales volumes, to enter into new
lines of business or to expand their geographical scope. Financial buyers
will purchase assets of companies primarily to secure a high return on
their investment, either by retaining the acquired business or by later
selling it at a profit.

With the ongoing recovery of the Japanese economy and
the increased value of the yen against the American dollar, Japanese
companies are in an advantageous position to enter the American market or
expand their existing presence there by acquiring the assets of American
companies. Similarly, the Japanese market continues to afford investment
opportunities for American companies eager to acquire Japanese businesses
for strategic or financial reasons. One example is the acquisition of Long
Term Credit Bank by Ripplewood Holdings.

For these strategic and financial buyers, acquiring
the assets of financially distressed businesses is a specialized form of
this growth strategy. There are many reasons businesses encounter financial
problems in market economies. The quality of management may be poor, which
has resulted in excessive expenditures and unrealistic business strategies
in a weak economy. The company may have suffered significant losses from an
extraordinary event, such as a large money judgment entered against it in
litigation. The company's main customer may have decided to switch
suppliers, disposed of its business line that provided a market for the
company's products or gone out of business altogether. Where the
financially distressed company's core business is sound and its
productive assets, such as its manufacturing facility and equipment, are
intact and in good working order, a strategic buyer may have an opportunity
to acquire this business as a going concern at a bargain price. How these
acquisitions may be made in Japan is the topic of this article.

<h4>Purchasing Assets of Financially Distressed Companies in Japan</h4>

In Japan, a new trend in insolvency cases has
developed, permitting the sale of the debtor's assets in the absence
of a reorganization plan. As discussed below, this trend has changed the
traditional nature of Japanese insolvency practice and has attracted
Japanese foreign investors interested in acquiring assets of financially
distressed companies in Japanese insolvency proceedings.

<h4>Traditional Japanese Insolvency Practices</h4>

1. Liquidation. Under prior liquidation practice in Japan, the procedures
were extremely simple and straightforward. The liquidator would sell the
assets and collect claims and receivables and then distribute the proceeds
among the creditors in accordance with the priority of the claims on a pro rata basis.

2. Reorganization. Under
prior reorganization procedures, the trustee would evaluate the assets of
the debtor and distribute that value to creditors. The amount paid could
not theoretically be less than the value of the assets of the debtor
determined as of the commencement of the insolvency proceedings. The funds
for this distribution and payment were obtained through (i) sales proceeds
of "surplus" assets, i.e., those assets not necessary for the continued operation
of the debtor, and (ii) the future income of the debtor.

During the reorganization proceedings, a plan would
be formulated under which the existing capital was ordinarily cancelled
without any compensation to the stockholders. On exceptional occasions,
the business of the debtor was sold to a third party. Those who acquired
the newly issued shares of the reorganized debtor or business from the
debtor were commonly called "sponsors." Sponsors acquired the
debtor's business or assets through the reorganization process and,
consequently, would attempt to enhance the enterprise value of the debtor
during the reorganization process. However, there were a number of problems
with this procedure:

(a) Under older reorganization practices, the
debtor's assets were often assessed a value significantly lower than
the true liquidation value of the particular assets, the ultimate effect of
which was to reduce distributions to creditors.

(b) Even where some goodwill value is recognized, the
artificially low valuation did not often reflect the future cash flow of
the debtor after the business improved.

(c) Under an installment payment plan, pre-bankruptcy
claims were paid in full (after forgiveness under the plan). The idea of
exiting the case through refinancing did not develop in Japan due to the
practice of paying no interest on payments made under the plan. The source
of payment of unsecured claims was the debtor's future income and
excess cash created from the sale of assets. Where most of the assets were
collateralized, asset-sale proceeds were applied only to pay the secured
claims, especially under the deflation economy. The bankruptcy proceedings
terminated only after the payments had been substantially completed under
the plan. The amount of future income was generally very small compared to
the pre-commencement claims after forgiveness, and as a result, the case
would remain open for an inordinately long period of time, sometimes for
10-15 years, before creditors were paid substantially in full and the case
could be closed. The longest installment in Japan under the plan was 19
years. In addition, no interest would be paid on pre-commencement debts
during this period, even if a claim was oversecured.

(d) From the viewpoint of the sponsors, installment
payment plans were not especially attractive because the debtor was subject
to the stigma of bankruptcy and could not exit from the proceedings for a
very long time. Consequently, debtor companies and their trustees often
experienced difficulties in obtaining sponsors. On the other hand, there
would be less competition for sponsors that often resulted in bargain
purchase opportunities.
</blockquote>

<h4>Recent Insolvency Practices</h4>

1. Change in Environment.
<blockquote>
(a) Debt trading by foreign investors is placing
enormous pressure on debtors to make early distributions to creditors.

(b) The desire of foreign investors to become sponsors
has caused significant amounts of capital to flow into the Japanese
distressed market. These investors' behavior, ways of thinking and
vast skills in reorganizing financially troubled businesses are now being
introduced to Japanese insolvency practice.

(c) The trend of early filing and quick exit has been
advanced as banks dispose of their non-performing loans on an expedited
basis under strong pressure from the Financial Services Authority.

(d) As deflation continues to plague the Japanese
economy, debtors do not expect that their debt burdens will ease while they
prolong their bankruptcy proceedings and extend the time of their payments.
</blockquote>

2. Recent Insolvency Practices.

Liquidation. In Japan, liquidation through sale is no longer limited to
real estate and tangible personal property. Claims, receivables, loans and
businesses are now often sold. The turning point was the Crown Leasing Corp. (CLC) case in
1997. In this chapter 7-type US$10 billion bankruptcy case, the trustee
sold the debtor's leasing assets through an auction to the Orix Group
for approximately US$3 billion. The transaction involved not only the
leasing claims but also all the elements of the leasing business, including
the existing leasing contracts, and contracts with vendors and employees.
Overseas financial assets booked at the headquarters were also sold in
bulk. Non-performing loans, real estate and financial assets held by
overseas subsidiaries were also sold in bulk to Bankers Trust, Goldman
Sachs and other investors at various auctions.

Reorganization. Trustees in corporate reorganization cases and
debtors-in-possession (DIPs) in civil rehabilitation cases now often sell
their businesses rather than reorganize them through the traditional type
of plan, under which the debtor retains the business and pays the
pre-commencement claims in installments. The purchasers (or
"sponsors") calculate the future cash flow of the debtor and,
on this basis, establish a purchase price for the debtor's business
assets. With limited competition, the prices will often be lower than the
fair market value. In addition, sponsors can acquire the debtor company
soon after the debtor exits from the reorganization proceedings.

Corporate reorganization law in Japan was reformed in
2004. Before the reform, it was unclear whether or not a sale of a business
was permissible outside of the plan. However, the Japan Leasings case in
1998 set the precedent for substantial businesses being sold other than
through a plan. In this US$25 billion bankruptcy case, the trustee obtained
the court's approval to sell the leasing business to GE Capital
before the plan had been formulated. The new Corporate Reorganization Law
enacted in 2004 now expressly permits such sales of businesses outside of
the plan where necessary for the reorganization—i.e., before the plan is formulated
and approved by creditors. These sales can be accomplished by obtaining the
bankruptcy court's approval for the sale. In deciding this issue, the
court will listen to the voices of the creditors and the union, and will
require compliance with other procedural requirements. See Part E(2)(c) herein.

Pre-packaged Proceedings. In order to maintain and prevent injury to the
enterprise value of the debtor, a "pre-packaged" proceeding has
been introduced to Japanese insolvency practices and is becoming
increasingly popular. Japanese pre-packaged proceedings are different from
pre-packaged chapter 11 plans often used in the United States. A Japanese
bankruptcy court cannot confirm a plan that has been voted for and approved
by the creditors pre-petition. In the context of Japanese insolvency
practices, a pre-packaged proceeding means determination of a sponsor
prior to the filing of the proceeding and, if necessary and feasible,
pre-arrangement of DIP financing. Such pre-packaged proceedings are
becoming increasingly popular and recognized in Japanese insolvency
practices. Pre-packaged arrangements facilitate the smooth flow of the
case, minimize the injuries caused to enterprise value and enable the
debtor to make a quick exit from the proceeding. The factors that are
increasing the popularity of this trend include the increase in potential
sponsors and also the increase in financial advisors who assist the debtor
in organizing such pre-arrangements. As investors realize that sponsorship
of distressed companies may often be quite profitable, the competition is
getting fierce, particularly for the more lucrative target companies and
those with valuable assets. Occasionally, disputes arise in relation to the
determination of the sponsor. In the case of Tohato, a well-known
confectioner with established brands, the debtor company conducted an
auction in order to find a sponsor. A Japanese fund was selected as the
sponsor pre-petition, but the unsuccessful bidders at the auction
complained about the pre-petition auction process. The supervisor
subsequently forced the debtor to conduct the auction again after the
petition had been filed. As a result, the same fund was the winning bidder
the second time around, but was required to pay a much higher price for the
same assets.

<h4>Impact of New Bankruptcy Legislation</h4>

New bankruptcy legislation has just been enacted by
the Japanese Diet and is expected to become effective in January 2005. This
new legislation makes the following changes to existing practice.

1. Treatment of Secured
Claims. Secured creditors will not be
stayed from enforcing their liens in the debtor's property once the
bankruptcy proceeding is commenced. In most current cases, however, secured
creditors have been cooperating with the trustee to sell the collateralized
assets free and clear of liens and interests to third parties. Upon the
closing of such a voluntary sale, the trustee will turn over the sales
proceeds to the secured creditors in accordance with their priorities after
carving out 5-10 percent of those proceeds for the benefit of the
bankruptcy estate. The trustee, however, sometimes faced difficulties when
a junior lienholder demanded unreasonable amounts of payments in exchange
for its consenting to the release of its lien. Under the new law, the
trustee can compel a voluntary sale by offering the sales amount less the
proposed carve-out. Such offered payment is deposited with the court and
then distributed by the court among the secured creditors in accordance
with their priorities. Secured creditors may challenge such an offer,
either by foreclosing the lien or by purchasing or having a third party
purchase the assets for a price that is 5 percent or more above the offered
sales price.

2. Characteristics of
Bankruptcy Sales.

<blockquote>
(a) The seller will be the trustee, who will normally
be a trustworthy attorney, but the transaction will ordinarily be on an
as-is basis, and no or little representations and warranties will be made
by the trustee.

(b) The sales price is often lower than the fair
market value, due to the above insufficiency of representations and
warranties, as well as less competition.

(c) The asset sale may not be avoided later in the
bankruptcy proceeding.

(d) The creditors' committee, if one is formed,
will not have a significant role to play in the sale proceedings.

(e) The bankruptcy court must approve the sale in
order for it to close.

</blockquote>

<h4>Reorganization Proceedings</h4>

1. Comparison of Corporate Reorganizations and Civil Rehabilitations. In Japanese corporate reorganization proceedings, secured
creditors are prohibited from foreclosing their lien interests in the
collateral, whereas under the civil rehabilitation proceedings, secured
creditors are not so stayed. In corporate reorganization cases, unsecured
preferred claims, such as claims for wages and retirement allowances, are
treated as one of the categories of claims that are subject to the
proceeding and are paid in accordance with the plan. In contrast, under
civil rehabilitation proceedings, these claims are outside the scope of the
plan and will not be affected by the proceedings. Accordingly, those rights
can be exercised as the creditors wish.

In corporate reorganization proceedings, the court
always appoints the trustees. In practice, upon official receipt of the
petition for the proceedings, the court issues an injunction order under
which an interim trustee is usually appointed from among experienced
bankruptcy attorneys. During this injunction period, the court determines
whether or not bankruptcy proceedings involving the target business will be
commenced. If the bankruptcy court orders the case to proceed, the court
will enter an order officially commencing the case and appointing the
interim trustee as permanent trustee. If a sponsor has already been located
and informally approved by the court by the time of commencement, the
sponsor will ordinarily be requested to provide another separate trustee.
The lawyer trustee is called the "legal trustee," and the
sponsor's trustee is normally called the "business
trustee." Usually, in civil rehabilitation proceedings, no such
trustees are appointed, and the former management acts as trustee,
continuing to operate the business of the debtor. In other words, civil
rehabilitation proceedings are similar to U.S. chapter 11 cases.

2. Corporate
Reorganization Proceedings.

Grounds for the
Proceedings. A debtor may file a petition
seeking reorganization in the following two instances:

<ol>
<li>The debtor's business operations would be
significantly impaired if the debtor were to pay its debts as they became
due; or

</li><li>An event of bankruptcy is likely to occur with
respect to the debtor corporation.</li></ol>

In the event of (2) above, a creditor who holds claims
equal to 10 percent or more of the paid-in-capital amount of the debtor, or
a shareholder who owns 10 percent or more of the voting shares of all the
issued and outstanding shares of the debtor, may also file the petition.

The court will issue an order commencing the
corporate reorganization proceedings unless one of the following factors is
present:

<ul>
<li>The required court fees have not been paid.

</li><li>Bankruptcy, corporate reorganization, civil
rehabilitation, company arrangement or special liquidation proceedings are
already pending and it is in the best interests of the creditors to allow
these to continue.

</li><li>The court concludes that a corporate
reorganization plan for continued operation of the debtor's business
cannot be formulated or approved by the interested parties or confirmed by
the court.

</li><li>The filing was made for unfair purposes or
otherwise lacked good faith.
</li></ul>

Appointment of Trustees. As part of the commencement order, the court will
appoint one or more trustees. The trustee will assume the authority of the
former management to operate the debtor's business, taking on full
responsibility for managing the company through formulation, confirmation
and full performance of the corporate reorganization plan.

Requirements for Asset
Sales. As previously stated, in order for
assets to be sold in the course of reorganization proceedings, the
bankruptcy court must specifically approve the sale. Under Japan's
new corporate law, §46 explicitly permits the debtor to sell its
business not in accordance with the plan, but with the court's
approval. Under the corporate law of Japan, a sale of a business requires a
special resolution (more than two-thirds of affirmative votes at the
shareholders' meeting, where the majority of shareholders are present
or represented). However, if the court finds that the debtor company is
insolvent (with liabilities of the company exceeding its assets), court
approval acts as a substitute for the shareholder approval normally
required under corporate law. However, the law requires a court to listen
to the voices of the creditors and the union. A trustee may sell the assets
free and clear by depositing the value of the collateral as determined by
the trustee with the court. In the event of a dispute with regard to the
valuation, the court will then determine the value.

Alternatively, the business may be sold through the
plan. There are two forms of sale, one being the cancellation of stock in
full without any compensation to the shareholders (which results in a
sponsor becoming the sole shareholder of the new company upon its infusion
of capital and for subscription of newly issued stock), and the other being
the sale of assets.

Formulation of
Reorganization Plans. Creditors are also
allowed to prepare and formulate competing plans of reorganization (though
they have seldom done so in the past), and the deadline for the period for
the trustee to file a plan usually continues for a period of one month or
so after the creditors' plan filing deadline.

Treatment of Secured
Claims. Secured creditors are stayed and
prohibited from foreclosing upon their collateral, and there is no
provision allowing secured creditors to obtain relief from the stay.
Although the trustee will assign a value to this collateral, this valuation
may be subject to dispute by the secured creditors. Once the
collateral's value is finally determined, that amount will be paid to
secured creditors in accordance with the plan. Payment is generally in
long-term installments without interest, even in cases where the creditors
are oversecured. Under the new legislation, a debtor may sell the business
and assets free and clear, even if the security interest-holder opposes the
sale or the conditions of the sale.

The Risk of Avoidance. Theoretically, if the case is converted from corporate
reorganization to a liquidation proceeding, there is some risk that a
previously approved asset sale can be avoided. However, in reality such a
risk is virtually non-existent because in Japanese practice, it is unlikely
that the bankruptcy court will later deny the approval decision once made
by the corporate reorganization court.

Examples of a Plan Sale
of Assets. In the corporate reorganization
case of Life Corp. involving indebtedness of US$9 billion, the trustee sold
the financial assets, including installment payment receivables, consumer
loans and credit card receivables, to Morgan Stanley, which subsequently
securitized those assets. The creditors of Life Corp. received a lump sum
payment under the plan, and the case was terminated immediately after this
distribution was made.

3. Civil Rehabilitation
Proceedings.

Grounds for the
Proceedings. The grounds for filing a
civil rehabilitation proceeding, and the negative requirements for
commencement, are similar to those for commencing a corporate
reorganization proceeding.

Retention of Management. Ordinarily, trustees are not appointed in civil
rehabilitation cases; the DIP continues to operate the business of the
company and supervises its reorganization. The court usually appoints a
supervisor from among bankruptcy lawyers to monitor the business operations
and the insolvency practices of the DIP. The DIP evaluates the assets,
examines the claims and formulates a plan. The supervisor may request
reports from the debtor or its directors about the debtor's
operations and financial conditions. The supervisor is also entitled to
inspect the debtor's books, accounts, documents and other matters.
The most significant aspect of the supervisor's power is that the law
allows him to exercise the right of avoidance.

Requirements for Asset
Sales. The basic procedures for sale of
assets and business are the same as for corporate reorganization. The
business can also be transferred through the plan in two ways. One way is
the cancellation of the existing stock and the issuance of new stock to the
sponsor. The other possibility is to sell the business to the sponsor under
the plan. Unlike corporate reorganization, the pre-petition management will
usually remain in office in the civil rehabilitation proceedings, and
therefore the sale of the assets requires cooperation of the directors. In
exceptional cases, where a trustee is appointed, the trustee takes over all
the power of the directors, and thus may issue new stock and allot the same
to any particular person.

Treatment of Secured
Claims. Secured creditors and unsecured
preferential creditors are not stayed. Security interests can be
extinguished by taking legally required proceedings, and the assets of the
debtor can be sold free and clear of any encumbrances. In actual practice,
however, such extinguishment proceedings are rarely used. Rather, the
debtor negotiates with secured creditors over the valuation of the
collateral, as well as the terms and conditions for extinguishment, in
order to facilitate sales of the assets.

4. An Example of Asset
Sales: Sale of a Golf Course Developer's Assets. Following the collapse of Japan's bubble economy, a
number of golf course developers encountered financial difficulties and
filed petitions for reorganization. These companies obtained financing for
the purchase or lease of land and for construction of the courses primarily
from two sources: members and banks. Members were required to deposit some
tens of thousands and, in some instances, hundreds of thousands, of dollars
with golf course developers before the courses were completed and opened.
Membership rights were composed of two elements: (1) a right in the deposit
and (2) a right to play on the course. These membership rights were traded
for ridiculously high prices far exceeding the deposit amount, and some
investors were purchasing these membership rights merely as investments.
Everyone, including the developers themselves, never imagined that these
deposits would be refunded to members at a later date. In essence, all the
people involved believed that the members would receive a higher return on
investment by selling the membership rights in the market and that a large
number of members would elect to do so.

Following the bubble economy's collapse,
however, the market for the resale of golf course membership rights
disappeared. Members then demanded the return of their deposits, which had
the ultimate effect of causing many course developers to commence corporate
reorganization and civil rehabilitation proceedings. In civil
rehabilitation proceedings, secured creditors (primarily banks) were not
prohibited from foreclosing their liens in the golf course assets but
generally did not take this action. These creditors knew that their real
estate collateral often consisted of mountains and steep hills having few
productive uses. In addition, interspersed among the parcels of real estate
subject to the bank's liens were other parcels leased from third
parties and not pledged to the banks. As a result, any real estate
foreclosure sales could be expected to result in deeply discounted sale
prices. In addition, it was anticipated that golf course members would
protest against the banks' attempts at foreclosure, which created
another disincentive to sell collateral through legal process after the
developer commenced a civil reorganization proceeding.

In these circumstances, debtors have often commenced
settlement discussions with their lenders in the context of civil
rehabilitation proceedings. Debtors will search for a suitable sponsor for
assistance in restructuring and have often selected either Goldman Sachs or
Lone Star for this role. Ordinarily, the golf course assets will be sold
(sometimes at auction) as a business unit to a sponsor. These assets
ordinarily consist of the land, clubhouse, equipment, employees and the
customer base. Before consummating the sale, the debtor and the sponsor
will negotiate with the lenders/mortgagees concerning the value of the
mortgaged assets and will attempt to reach a settlement agreement. In most
cases, members will recover only a portion of their initial deposit, but
their right to play golf on the course will be honored by the sponsor.
Those who elect to remain as members will be required to deposit their
distribution in the proceedings until their membership is terminated. Only
those persons electing to terminate their memberships will be entitled to a
distribution. The monies available for distribution to lenders and the
terminating members will be derived from the sales proceeds of the golf
course assets and new revenues generated by the sponsor's operations.
The asset sale transaction will normally be concluded before the
reorganization plan is formulated and confirmed by the court. As the number
of bankruptcies of golf course developers increase, the practice described
above is becoming the template for settlement and reorganization.
Consequently, it has become easier to persuade banks and members to accept
a restructuring scheme that involves substantial debt forgiveness.

<h4>Conclusion</h4>

In the United States, a purchaser may purchase the
assets of a financially distressed company by means of (1) a voluntary
transfer, (2) a foreclosure sale conducted under applicable state law and
(3) a sale conducted by the bankruptcy court administering the assets of
the distressed seller. The last type of sale, by means of a bankruptcy
court order, may be accomplished quickly. Although assets can be sold
pursuant to a reorganization plan approved by the seller's creditors
and confirmed by the bankruptcy court, this is not commonly done. These
sales are accomplished by a motion filed by the seller, which may be heard
upon 20 days' prior notice to the seller's creditors. In
addition, a sale under §363(f) of the Bankruptcy Code will discharge
most liens and interests in the assets, thereby facilitating their prompt
transfer. In short, bankruptcy sales of assets offer foreign buyers a quick
and effective means of entering or expanding their existing presence in the
American market.

Some 15 years have passed since the bubble burst in
Japan. Thousands of companies, from life insurance companies with more than
$30-40 billion of debt to small and medium-sized companies, have become
subjects of various types of bankruptcy proceedings. Because of this long
history, the Japanese are now accustomed to business failures and their
consequences. Through those experiences, a kind of common understanding is
gradually emerging: Restructuring is preferable to liquidation, after all.
Financial institutions often feel morally obligated to cooperate with, or
at least refrain from hindering, the restructuring efforts of the debtors.
On the other hand, bankruptcy laws as well as corporate laws have been
reformed during the past several years, providing debtors and sponsors with
a number of tools available for the reorganization of debtors in
complicated cases. Actually, successful reorganizations are reported in
Japan every week, often with the involvement of foreign financial
investors. Hopefully, the final stage of Japanese banks' financial
improvement has begun. In addition, more borrowers are expected to manage
their own financial difficulties rather than just waiting to be saved at
the last moment by outside intervention. Because of these recent structural
and additional changes in Japan, foreign investors should definitely
consider investing in the Japanese market, particularly by acquiring the
assets of financially troubled enterprises.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Patrick E.
Mears is an equity partner in the 400-lawyer American law firm of Barnes
& Thornburg LLP, resident in the firm's Grand Rapids office. Mr.
Mears is an elected fellow of the American College of Bankruptcy and the
American Law Institute. <a href="#1a">Return to article</a>

<a name="2">2</a> Hideyuki
Sakai is the founder and managing partner of Sakai & Mimura, located in
Tokyo, Japan. Mr. Sakai authors the Japan chapter of the Collier International Business Insolvency Guide, as well as many other articles (in both Japanese and
English) relating to insolvency and bankruptcy matters. Mr. Sakai is an
International Fellow of the American College of Bankruptcy. <a href="#2a">Return to article</a>

Journal Authors

Hideyuki Sakai

Patrick E. Mears

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004