Annual Report on the Japanese

Economy and Public Finance

2002-2003

- No Gains Without Reforms III -

October 2003

Cabinet Office

Government of Japan


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Section 3 Rebuilding Enterprises


1. Challenges Facing Business Sector
Restructuring of enterprises
    Excessive debts and the low profitability of enterprises may be behind the prolonged Japanese economic slump since the 1990s. In order to confirm progress in the reduction of excessive debts and the improvement of earning capacity in the business sector, we would like to analyze "the tangible fixed assets turnover (sales divided by tangible fixed assets)," "the break-even point ratio," and "the debt/cash flow ratio" for all industries in Japan since the late 1990s. A rise in the tangible fixed assets turnover indicates an increase in the earning capacity of equipment. A fall in the break-even point ratio shows that enterprises have reduced personnel and other fixed costs to lower break-even point sales and become more profitable. A drop in the debt/cash flow ratio signals progress in debt repayment in comparison with earnings(29) (see Figure 2-3-1 (1)).
    The features of these figures are summarized below:
    First, the tangible fixed assets turnover declined sharply in the second half of the 1990s and has been recovering somewhat since fiscal 1999. The recovery apparently reflects a decrease in tangible fixed assets that might have come on restraints on equipment investment and manufacturers' removal of some equipment. On the other hand, the break-even point ratio has been falling smoothly since the second half of the 1990s. This is because fixed costs have been reduced to more than offset the upward pressure exerted on the ratio by the decline in sales.
    Second, the debt/cash flow ratio has been falling since fiscal 1996. Both debt repayment and cash flow increase have contributed to lowering the ratio. Since fiscal 1999, debt repayments' contribution has been greater, indicating some progress in repayment of excessive debts. However, there have been some balance sheet adjustment gaps between industries. For example, capital ratios based on market prices have recovered or exceeded their levels in the first half of the 1980s for large, medium and small manufacturers (see Figure 2-3-1 (2)). But capital ratios have generally deteriorated for non-manufacturing enterprises, especially for real estate, construction, and wholesale and retail industries, or for small and medium enterprises. This indicates that non-manufacturing enterprises have yet to make progress in balance sheet adjustment(30).
    In this way, the business sector as a whole has restricted investment, lowered break-even point sales and reduced excessive debts to adjust balance sheets, while sales have declined. However, the balance sheet adjustment is still a major challenge for the construction, real estate, and wholesale and retail industries, and for small and medium non-manufacturing enterprises.
Figure 2-3-1 Progress in Restructuring of Enterprises (all industries)

Challenges facing business sector
    Measures to reduce excessive debts include consolidation and restructuring of enterprises. Corporate restructuring is important for preventing business resources from being scattered. In order to increase profitability, enterprises may have to go beyond simple reconstruction and take advantage of mergers and acquisitions to promptly respond to changes.
    Given these points, the challenges facing Japan's business sector for the immediate future include (i) the restructuring of excessively indebted enterprises and (ii) the enhancement of efforts to improve enterprise value.
    We will first discuss restructuring of excessively indebted enterprises. We will note that since the main bank system has seen a reduction in its function of rescuing enterprises, new mechanisms for rapid corporate restructuring must be developed to replace the main bank system. Next, we will analyze the present state of out-of-court workout in regard to restructuring of excessively indebted enterprises and introduce overseas cases of corporate restructuring within public frameworks. Last, we will review environmental changes for Japan's business sector in regard to the enhancement of earning capacity for enterprises and analyze mergers and acquisitions as a specific effort to increase profitability.

2. Restructuring Excessively Indebted Firms

(1) Decline in Main Banks' Enterprise-Rescuing Functions
Change in profit-stabilizing function
    When borrowers plunged into financial difficulties under the main bank system, main banks exploited financial information accumulated through long-term trading relations with the borrowers to check whether the difficulties would be temporary or whether the borrowers could not be turned around. When the difficulties were identified as temporary, the main banks supported the reconstruction of the borrowers with financial assistance like the reduction of interest payment cost or the waiver of loans. When the borrowers could not be turned around, the main banks mediated between creditors for the liquidation of the borrowers. The main banks thus had two coordination functions.
    In recent years, however, the non-performing loan problem has reduced financial institutions' risk-tolerating capacity. This might have led to changes in main banks' functions. Main banks had usually had a profit-stabilizing function(31) where they had reduced borrowers' interest payments on loans to help stabilize their ordinary profit. We have conducted a cross-section analysis of listed enterprises to find how the profit-stabilizing function changed from the first half of the 1990s to the second half (see Appended Note 2-2).
    Our findings follow:
    First, main and other banks as a whole performed the function of stabilizing profit for normal enterprises (excluding heavily indebted enterprises with debt ratios above the industry average and bad-performing enterprises that cannot cover interest payments with operating profit) in both the first and second halves of the 1990s. But main banks played no special role.
    Second, a change was seen in main banks' profit-stabilizing function from the first half to the second for debt-increasing enterprises (enterprises with deteriorated balance sheet). In the first half of the 1990s, main banks performed the profit-stabilizing function for all such enterprises. In the second half, however, they performed the function only for good-performing enterprises selected from debt-increasing companies. The profit-stabilizing function was provided for enterprises that were earning robust profit in their core business areas while being saddled with heavy debts due to past investment failures.
    Third, main banks performed the profit-stabilizing function for bad-performing enterprises (enterprises with deteriorated income statement) in the first half of the 1990s, but failed to do so in the second half.(32) The diminishment of main bank support for bad-performing enterprises coincided with a remarkable increase in the number of recession-caused bankruptcies in the second half of the 1990s.
    As financial institutions' risk-tolerating capacity declined in the second half of the 1990s, main banks apparently shifted away from their profit-stabilizing function for a wide range of enterprises and focused such function on enterprises that enjoyed robust cash flow performances even with excessive debts in stock.
    Meanwhile, enterprises excluding manufacturers increased their dependence on loans from financial institutions in general from the first half of the 1990s to the second. At the same time, main-bank loans' share of overall bank loans at these enterprises rose, indicating their greater dependence on main banks (see Figure 2-3-2).
Figure 2-3-2 Bank Loans' Shares of Total Debts and Dependence on Main Banks

Enterprises requiring restructuring
    Of the 2,141 listed enterprises that existed in the second half of the 1990s and were sampled for our analysis, debt-increasing, bad-performing enterprises accounted for 227 firms (11%). Since the main banks of these enterprises failed to perform the profit-stabilizing function in the second half of the 1990s, they may have basically required restructuring (see Table 2-3-3). In fact, as of June 2003, 42% (95 firms) of these enterprises were subjected to legal bankruptcy (35 firms), mergers, acquisitions or delisting (32 firms), or reconstruction, deterioration of finance or debt waivers (28 firms).
    Debt-increasing, good-performing enterprises that were still subject to main banks' profit-stabilizing function in the second half of the 1990s accounted for 783 firms (37%) from the samples. Of them, 11% (83 firms) were subject to legal bankruptcy (30 firms), out-of-court workout (17 firms), or mergers or acquisitions (36 firms).
    Debt-increasing, bad-performing enterprises (227 firms) and debt-increasing, good-performing enterprises in restructuring processes (83 firms) totaled 310 firms, accounting for some 15% of the samples. If these firms are those that should be subjected to restructuring, 132 firms (some 6% of the samples) other than the 178 firms in restructuring processes might have to be restructured promptly. Incentives for faster restructuring may have to be given to both these enterprises and their creditor banks.
    What restructuring measures have been taken for good-performing enterprises that are plagued with excessive debts and need financial assistance including debt waivers? In this respect, we would like to consider main bank-led out-of-court workout of these enterprises.
Figure 2-3-3 Changes Seen in Main Banks' Profit-Stabilizing Function

(2) Present State of out-of-court workout and Relevant Problems
Restructuring measures
    Enterprise restructuring includes liquidation and reconstruction. Liquidation means dissolution of an enterprise after selling all its assets and using proceeds to repay debts. In reconstruction, actions like sales of unprofitable divisions or reduction of jobs are implemented under rehabilitation or reconstructions plans (see Figure 2-3-4).
    We would now like to consider the significance of out-of-court workout among reconstruction-oriented restructuring measures and review the development of efforts and institutions to supplement main banks' traditional interest coordination function.
Figure 2-3-4 Classification of Enterprises and Business Operations

Significance of and limits on out-of-court workout
    When enterprises are reconstructed under legal procedures based on the Civil Rehabilitation Law or the Corporate Reorganization Law, their business bases may be depleted on the deterioration of brand images and product-supplying capacity. Therefore, it is important for enterprises to take advantage of the out-of-court workout framework including debt waivers before being forced to resort to legal procedures. The out-of-court workout could allow enterprises to achieve a turnaround while preventing their business resources from being scattered.
    In order to be qualified for reconstruction-oriented out-of-court workout, enterprises have to meet some conditions. Enterprises may have to demonstrate (i) that their continuation of business activities has market value, and (ii) reconstruction is economically reasonable for their creditors. If they are willing to be subject to restructuring, enterprises will also be required to work out reasonable reconstruction plans.
    Sufficient reduction of debts through financial institutions' debt waivers is important for the reconstruction of enterprises. At the same time, enterprises may have to exploit debt-for-equity swaps to recapitalize themselves and give relevant shareholders opportunities to benefit from their reconstruction.
    On the other hand, out-of-court workout has some disadvantages in comparison with legal bankruptcy. First, creditors have no clear means to secure the economic rationality of out-of-court workout and the appropriateness of reconstruction plans. Second, no measures are in place to prohibit liquidation, protect assets and counter creditors' exercise of security rights. Third, out-of-court workout has no legal binding power, failing to change rights of creditors who do not agree to reconstruction plans adopted by the majority.(33)

Developing out-of-court workout frameworks
    The Emergency Economic Package in April 2001 called for developing principles on debt waivers in out-of-court workout and increasing the transparency of procedures for coordination among creditors in order to overcome the disadvantages of out-of-court workout and facilitate reconstruction of ailing enterprises. Under the auspices of the government, representatives from financial and non-financial industries created Guideline for Multi-Creditor Out-of-Court Workouts (hereinafter referred to as "the Guideline") in September 2001 (see Table 2-3-5).
Table 2-3-5 Outline of Guideline on Out-of-Court Workout
    As a matter of course, no enterprise is required to abide by the guideline in out-of-court workout including debt waivers. Indeed, the guideline has not been adopted for many debt waiver cases. Between the creation of the guideline in September 2001 and the end of August 2003, the guideline was used only for 10 out-of-court workout cases including those still under coordination.
    This may be because (i) the model reconstruction plan in the guideline sets tough requirements regarding responsibilities of shareholders and enterprise managers and fail to encourage debtors to adopt the guideline,(34) and (ii) enterprises depend primarily on main banks for actual coordination of interests. If main banks' function of coordination of interests between creditors weakened, out-of-court workout could be difficult. In such case, enterprises' restructuring would be postponed, leading to these firms losing enterprise value. Eventually, these enterprises that can be turned around at present could become those that cannot be done so.
    In consideration of these problems, the Ministry of Economy, Trade and Industry came up with a rapid corporate restructuring guideline in February 2003, calling for the promotion of prepackaged business turnarounds. Under the proposed package, managers of ailing enterprises may take the initiative in developing appropriate reconstruction plans, secure reimbursements to small creditors, and try to reach agreement with major creditors on the plans. If some creditors' opposition impedes full agreement, these enterprises may resort to legal procedures.
    Corporation reconstruction funds as part of investment funds as discussed later, business restructuring services of the Resolution and Collection Corporation, and the Industrial Revitalization Corporation of Japan as launched in May 2003 are expected to effectively reinforce main banks' interest coordination function.

Characteristics of enterprises subject to debt waivers
    Next, we will discuss the present state of out-of-court workout and the characteristics of enterprises subjected to debt waivers.
    A total of 192 enterprises subjected to debt waivers between fiscal 2000 and May 2003 had the following characteristics:
    First, debt waivers since fiscal 2000 have focused on large enterprises (capitalized at ¥1 billion or more) and leading medium-sized enterprises (capitalized at between ¥0.1 billion and ¥1 billion). Only a few small and medium enterprises (capitalized at less than ¥0.1 billion) have received debt waivers (see Figure 2-3-6 (1)).
    Second, debt waivers have four patterns. Debts are waived (i) by parent enterprises for their subsidiaries, (ii) by financial institutions for their affiliates, (iii) by financial institutions for borrowers, and (iv) by others. By enterprise size, nearly 50% of large enterprises have received debt waivers from financial institutions. But such share falls to some 20% for leading medium-sized enterprises. More than half of these enterprises have received debt waivers from large enterprises as their parents(35) (see Figure 2-3-6 (2)).
Figure 2-3-6 Breakdown of Debt Waiver Patterns by Business Size
    Third, in order to check whether debt forgiveness was easily provided, we used enterprise ratings given by a private credit agency(36) to look into relations between ratings for enterprises before debt forgiveness, debt waiver patterns and enterprise sizes, and we found that ratings for enterprises that received debt forgiveness from financial institutions were relatively higher than other debt forgiveness receivers. By enterprise size, ratings for large enterprises were higher than for leading medium-sized enterprises(37) (see Figure 2-3-7 (1)).
    Fourth, large enterprises since fiscal 2001 have increasingly tended to post sharp net profit declines for years when they received debt forgiveness from financial institutions (see Figure 2-3-7 (2)). Possible reasons for such tendency are (i) that financial institutions have come up with tough debt waiver conditions including enterprises' treatment of deterioration of assets as special losses, and (ii) that the guideline on out-of-court workout has led to enhanced surveillance by the market on easy debt forgiveness.
    Fifth, relations between debt waiver amounts and job reductions (from fiscal 1999 to the latest fiscal year) for large enterprises that have received debt forgiveness from financial institutions indicate that larger debt waiver amounts have led to faster job reductions or severer workforce restructuring(38) (see Figure 2-3-7 (3)).
    The above findings indicate (i) that financial institutions forgive debts primarily for large enterprises that have higher ratings than small and medium enterprises before debt waivers, and (ii) that financial institutions usually require enterprises subject to debt forgiveness to book massive special losses and accelerate job reductions. Although the samples for drawing these findings are limited, we cannot necessarily conclude that financial institutions easily waived debts at borrowers only to postpone their liquidation in the period under review.
    On the other hand, there is a possibility that some enterprises that must be turned around have yet to launch any reconstruction-oriented restructuring process, as discussed earlier. Therefore, enterprises that can be reconstructed should be selected strictly and those that are suitable for reconstruction-oriented out-of-court workout should promptly be subjected to coordination of interests between creditors for an early turnaround. In this respect, it is important to take advantage of government-initiated corporate restructuring frameworks including the Development Bank of Japan's investment in corporation reconstruction funds, the Resolution and Collection Corporation's corporate restructuring services, and the Industrial Revitalization Corporation of Japan. Next, we will look at corporate restructuring schemes exploiting public frameworks.
Figure 2-3-7 Features of Financial Institutions' Debt Waivers

3. Corporate Restructuring Using Public Frameworks
(1) Roles of Industrial Revitalization Corporation of Japan
    The Industrial Revitalization Corporation of Japan (hereinafter referred to as IRCJ) launched operations on May 8, 2003, to purchase loans from financial institutions and support enterprise reconstruction for the integrated revitalization of finance and industry.
    The IRCJ's corporate restructuring procedures follow: First, enterprises must attach restructuring plans to their applications for IRCJ support. They and their main banks must sign these plans. The IRCJ's Industrial Revitalization Committee may decide to support plans that are identified as highly feasible. If such decision is made, the IRCJ will ask relevant creditors other than main banks to choose to sell loans to the IRCJ or accept the plans within a particular period of time (up to three months) after the decision. If relevant creditors' execution of their rights, including collection of loans, is likely to affect the planned restructuring during that period, the ICRJ may ask these creditors to suspend the execution to protect assets of enterprises for restructuring.
    The IRCJ will purchase up to ¥10 trillion in (i) bank loans to borrowers needing attention and (ii) bank-held bonds. It will intensify purchases within a period to the end of March 2005 and provide loans, debt guarantees and investment to the selected enterprises if necessary for their restructuring. The IRCJ will resell loans purchased from financial institutions within three years in principle. The IRCJ will exist for five years.
    A major advantage of the IRCJ framework is that the IRCJ can easily put together loans for an enterprise by exploiting its neutral position to coordinate interests among financial institutions and other creditors which is usually difficult to make among creditors alone.(39) A key point is that creditors other than main banks are asked to decide to sell loans to the IRCJ or accept the restructuring plans within a particular period of time after the IRCJ decides to support the plans that are submitted by enterprises and their main banks and identified by the IRCJ as feasible. If a large number of creditors exist for an ailing enterprise, when main creditors ask smaller creditors to forgive their loans, each smaller creditor may conceive that others should meet the request in order to keep the enterprise afloat. In out-of-court workout procedures, it may be difficult for main creditors to eliminate smaller creditors that reject loan forgiveness requests in anticipation of rises in their loan value. So the involvement of the IRCJ, which is an official entity while being an incorporated company, is expected to facilitate coordination of interests among creditors.

(2) Overseas Cases
North European and Asian cases
    Public asset management companies similar to Japan's IRCJ have been seen in foreign countries (see Table 2-3-8).
Table 2-3-8 Major Foreign Public Asset Management Companies
    The United States created the Resolution Trust Corporation to promote sales of non-performing loans at financial institutions in response to what was called the S&L crisis that emerged in the late 1980s. In North European countries like Sweden and Finland, as well as South Korea and other nations hit by the Asian Financial Crisis, governments went beyond purchases of non-performing loans from financial institutions to positively promote restructuring of excessively indebted enterprises and recover loans by selling assets they purchased. These countries created public asset management companies to improve balance sheets of financial institutions and step up restructuring of excessively indebted enterprises. North European and Asian cases where governments collected loans and positively promoted restructuring of excessively indebted enterprises are good corporate restructuring precedents for Japan.(40)
    Factors behind the North European and Asian cases are as follows:
    First, North European and Asian financial crises were very serious. In order to dispose of non-performing loans, purchasers were required for these loans. Under financial crises that reduced the risk-tolerating capacity of all economic units, however, disposal of NPLs was very difficult to achieve.
    The Korea Asset Management Corporation (KAMCO), modeled after the U.S. RTC, had initially planned to undertake early disposal of NPLs. Later, however, it began to enhance its corporate restructuring function. In North European and Asian countries hit by systemic financial crises, sales of real estate assets as security for NPLs were expected to increase deflationary pressures on their economies. Sweden created Securum to dispose of NPLs. Its mission was not limited to NPL sales. Securum was also aimed at preventing real estate dumping to help stabilize asset markets.
    Second, their private sector lacked corporate restructuring know-how and experience. Therefore, North European and Asian countries created public AMCs and developed guidelines for out-of-court workout of ailing enterprises under their governments' initiative in order to promptly resolve NPL problems. (41)

Conditions for successful corporate restructuring
    How did these official AMCs in foreign countries function? We will now discuss common features of corporate restructuring through public AMCs.

(i) Purchases at market prices in principle
    When public AMCs purchase non-performing loans, it is important to set purchase prices at appropriate levels meeting market prices. If public AMCs purchase NPLs at higher prices than market levels, it will mean an effective injection of public funds to cause transparency and moral hazard problems. The adoption of market prices for purchases can contribute to preventing NPLs from being dumped to lower prices further.
    When purchasing NPLs at market prices, South Korea's KAMCO and Malaysia's Danaharta gave financial institutions incentives to sell NPLs. Danaharta returned 80% of gains on resale of NPLs to financial institutions and shouldered any losses. KAMCO provided banks with an option to buy back NPLs if their prices after borrowers' turnaround are higher than those for financial institutions' sales to KAMCO.

(ii) Considerations given to fairness and promptness of NPL purchases
    In overseas cases, public AMCs bought NPLs from failed financial institutions or viable financial institutions faced with financial difficulties, or from both. When purchasing NPLs from failed financial institutions, public AMCs usually took over debts as well for protecting deposits. When buying NPLs from viable financial institutions, overseas public AMCs gave considerations to fairness regarding financial institutions that did not sell NPLs to AMCs.
    Overseas public AMCs refrained from purchasing loans that financial institutions can collect on their own. They avoided unlimited purchases and left recoverable loans at financial institutions with a view to preventing moral hazards.
    It would be desirable for public AMCs to limit NPLs for their purchases in volume and type. North European and Asian countries limited purchases to large NPLs. This led to quick disposal of NPLs. In Finland, however, NPLs were purchased unlimitedly irrespective of types or sizes and their final disposal was reportedly very difficult.

(iii) Utilization of foreign firms
    In some overseas NPL disposal cases, foreign companies or specialists were employed for corporate restructuring.
    Overseas official AMCs can not only have their own funds but also raise funds from foreign investment banks. In South Korea, KAMCO has been authorized to raise funds through government-guaranteed bond issues, and foreign funds have been raised for corporate restructuring through corporate restructuring companies (CRCs) and corporate restructuring vehicles (CRVs).
    Corporate restructuring specialists (insolvency experts, appraisers, financial analysts and actuaries) are also important. These specialists' share of the national population is excellently high in the United States and far lower in other countries (see Table 2-3-9). In countries other than the United States, therefore, it may be useful to employ foreign companies in order to get easy access to these specialists. In fact, Sweden, Finland, South Korea and Malaysia have employed U.S. investment companies, consulting firms and audit corporations as advisers. As indicated by these cases, it will be important to use private sector funds and know-how, including foreign companies and specialists, for corporate restructuring.
Figure 2-3-9 Corporate Restructuring Specialists' Shares of Population

4. Improvement of Enterprise Value and M&A
    We noted earlier that as main banks' function of saving enterprises has declined, while new risk-sharing systems and mechanisms for quick corporate restructuring have been growing more important. In this respect, we have found that some 15% of listed enterprises in Japan can be subjected to corporate restructuring and that about 6% have yet to enter any restructuring process.
    Are the remaining 85% safe? In a bid to consider this question, we would now like to review the present situation of Japan's business sector and use merger and acquisition (M&A) developments to look into enterprises' efforts to enhance their profitability.

(1) Changes in Environment Surrounding Business Sector
    As the buzzword for Japan's business sector shifted from business diversification (integration) in the late 1980s to reorganization (selection and concentration) in the late 1990s, the environment surrounding Japan's business sector has been changing dramatically.
    The changes include (i) changes in important business resources for competitiveness of enterprises, (ii) changes in enterprise management focuses, (iii) growing recognition of the importance of the concept of time (speed), (iv) improvement of the legal system to make corporate reorganization easier, and (v) emergence of investment funds as financial supporters. We will now discuss these changes more specifically.
    First, important business resources for enterprises' competitiveness have changed.(42) As enterprises have departed away from upsizing efforts, the relative importance of tangible assets as business resources has declined and intangible assets have grown more important for enterprises' competitiveness.
    Second, enterprise management focuses have been shifting to cash flow and profitability indicators including the return on equity and the return on assets. In order to improve business efficiency and increase business value, enterprises may be required to (i) reorganize their business mix by retreating from or selling slumping business divisions and acquiring divisions that can perform a synergy with existing divisions, (ii) and to increase business management efficiency to boost the profitability of each business division.
    Third, the concept of time (speed) has growingly been recognized as important. As the business environment changes rapidly and continuously, business managers cannot afford to accumulate the necessary business resources. Therefore, it is becoming more important for enterprises to quickly acquire the necessary business resources and spin off unnecessary ones in order to establish their competitive advantage. Specifically, enterprises are now required to purchase business resources as developed by others and sell or lease unprofitable business divisions to quickly recover invested capital.
    Fourth, legal systems have been improved to make corporate reorganization easier. Legal systems have been gradually established to allow enterprises to choose appropriate organizations meeting a review and a reshuffle of business resources (see Column 2-1). These systems enable enterprises to exploit M&A more easily, providing specific options for boosting enterprise value.
    Fifth, investment funds have emerged as financial supporters. Investment funds collect investments from investors and allocate investment returns to investors. Activities of investment funds include (i) management buyout where business division managers and employees at an enterprise raise funds from investment funds to purchase equity shares of the enterprise or found a new company to take over business operations from the enterprise, (ii) provision of funds for enterprises to implement M&A for their business expansion, (iii) purchasing and reconstructing non-core business divisions that enterprises spin off, and (iv) purchases of privately held companies for future initial public offerings or for privileged acquisition of equity shares.
    Corporation reconstruction funds are part of these investment funds. They raise funds from investors in anticipation of gains on turning around failed enterprises or slumping enterprises with excessive debts and unprofitable divisions.

Column 2-1
Development of Enterprise Reorganization Methods

    Recent legal system improvement has allowed enterprises to effectively utilize reorganization methods.

Antimonopoly Law Revision (Implemented in December 1997)
    The establishment of and the transformation into holdings companies had been prohibited in Japan. This revision lifted the ban on the establishment of and the transformation into holding companies, which do not constitute excessive market dominance.(43) The revision came as all consolidated groups were required to make prompt decisions and reorganize their business mix easily in order to increase the efficiency of each business under a holding company while each business unit tries to boost its efficiency.

Commercial Code Revision (Implemented in October 1999)
    The revision allowed enterprises to establish complete parent-subsidiary relations through equity swaps or transfers more easily(44) and enabled a parent to buy out a subsidiary through allotment of equity shares.(45) This revision has given enterprises a financial advantage that eliminates the requirement for funds to be raised for acquisitions.
    - Equity swap: All shareholders of an enterprise transfer shares to another company (to become the parent of the enterprise) and receive shares issued by the other company. A complete parent-subsidiary relation can be established in this way.(46)
    - Equity transfer: All shareholders of an enterprise transfer shares to a new company that would wholly own the enterprise and receive shares issued by the new company. In this way, a complete parent-subsidiary relationship can be established. If a holding company were to implement a decision at a subsidiary quickly and efficiently, a reasonable option would be to wholly own the subsidiary with minor shareholders eliminated.

Commercial Code Revision for Corporate Divestiture System (Implemented in April 2001)
    The corporate divestiture system was established as an enterprise reorganization method for an enterprise to separate some divisions as companies. This can facilitate reorganization within any business group as well as any individual enterprise. The divestiture includes the establishment of a new company to take over separated divisions ("divestiture through a new company") and an existing company's absorption of separated divisions ("divestiture through an absorber"). Shares of the new company or the absorber may be allotted to the division-separating enterprise or its shareholders.

Tax System for Enterprise Reorganization (Implemented in April 2001)
    The system contributes to reducing tax costs for business group reorganization. Specifically, the system is designed to defer tax on gains on asset sales and cut registration and license tax in regard to mergers, divestiture and investment in kind as far as relevant parties are qualified under law. Lower-cost reorganization has been made possible.

Commercial Code Revision (Implemented in April 2003)
    Regarding special resolutions at general meetings of shareholders as required for deciding on enterprise reorganization methods, the revision has simplified procedures for convening general meetings of shareholders and eased quorum requirements involving the adoption of such resolution to help speed up enterprise reorganization. The revision has also allowed enterprises to issue special equity shares (including those with a forced conversion feature and those with restricted voting rights), making it easier for enterprises to diversify fund-raising means in consideration of the various needs of stakeholders.

Revision to Law on Special Measures for Industrial Revitalization (Implemented in April 2003)
    The revision has introduced three new reorganization plans in addition to the traditional "business reconstruction plan" and subjected them to special tax measures. The three are the "joint business reorganization plan" for the joint reorganization of plural companies, the "business resources reutilization plan" for an enterprise's transfer of some business resources to another for effective utilization, and the "business innovation equipment introduction plan" for the introduction of innovative equipment. The revision is expected to contribute to lowering costs for business reorganization and speeding up such reorganization.

   In addition, bankruptcy laws have been revised as follows:
Civil Rehabilitation Law (Implemented in April 2000)
    The law has set simpler conditions and procedures than the Composition Law to launch corporate reconstruction more promptly. It has also allowed enterprises to sell operations without rehabilitation plans. As a result, enterprises can sell good-performing divisions to raise funds for repaying debts in order to complete rehabilitation procedures more quickly.

Revised Corporate Reorganization Law (Implemented in April 2003)
    The revised law has allowed enterprises to sell operations under approval by court and outside rehabilitation plans and has set the same conditions as the Civil Rehabilitation Law for launching rehabilitation procedures in order to allow such procedures to be started more quickly.


(2) Recent M&A Trends
Features of Recent M&A
    The changes in business managers' perceptions and in institutions might have been symbolically reflected in recent M&A trends(47). M&A means mergers and acquisitions of enterprises. At present, however, M&A also cover a wide range of business alliance deals including transfers of business operations and equity shares, and capital tie-ups. Purchasers can take advantage of M&A deals to save time and obtain strategic intangible assets (including technologies and human resources), while sellers can exploit such deals to easily retreat from certain business operations and quickly recover invested capital.
    Japanese enterprises' M&A deals have continued an upward trend since 1992. Their features follow:
    First, the focus of M&A deals has shifted from acquisitions and capital participation in the first half of the 1990s to mergers and sales of business operations. M&A in the bubble period predominantly involved foreign companies. But the weight for M&A deals between Japanese enterprises has tended to increase, indicating the activation of business reorganization (see Figure 2-3-10).
Figure 2-3-10 Breakdown of M&A Deals by Category
    Second, the number of M&A deals has tended to increase. To divide M&A deals into those within business groups and across group boundaries, we can find that mergers are dominant among M&A within groups, while acquisitions, capital alliances and other deals involving equity purchases are conspicuously abundant among M&A across group boundaries (see Figure 2-3-11). This may be because mergers are easier to adopt in terms of decision-making and internal controls within groups. Beyond group boundaries, business alliances through equity purchase may be easier to implement for joint actions between enterprises.
Figure 2-3-11 Breakdown of 1993-2002 M&A Deals by Pattern
    Third, a breakdown of M&A deals by purpose in 2002 indicates that enhancement of existing operations was the most dominant purpose, followed by buyout and investment, expansion of peripheral operations, and enhancement of business relations. In contrast, M&A for new operations, diversification and other business expansion purposes were very limited (see Figure 2-3-12).
Figure 2-3-12 Breakdown of M&A Deals by Purpose

Market evaluation of mergers
    How can we interpret the increasing number of M&A for enhancement of existing operations?
    If the increase in M&A were to represent management innovations to improve enterprise value, it should be reflected in stock prices. We will now look into market evaluation of mergers since the 1990s. Specifically, we will pay attention to relative stock price returns for continuous companies for 92 merger deals between listed enterprises from 1993 to 2002.(48) The stock price returns can be interpreted as indicating market responses to merger announcements (the announcement effect).
    In mergers in and before 1998, stock price returns were mostly negative and limited to a small range (see Figure 2-3-13). This may be because the purposes of mergers included bailout and sectoral reorganization.(49)
    As the number of mergers increased in and after 1999, bailout-oriented mergers, which the stock market does not favor, diminished. Also, relative returns for reorganization-oriented mergers turned to positive in many cases.
    Contributing to the increase in mergers in and after 1999 was a rise in those for enhancement of existing operations and mutual supplementation. While the market responses to these mergers were various, the announcement effects apparently increased as a whole. Although market responses to specific merger deals were not uniform, the stock market tended to positively evaluate mergers for enhancement of existing operations and mutual supplementation.
Figure 2-3-13 Merger Announcement Effects on Stock Market

Real effects of mergers
    We will now look into the real effects of mergers by comparing business performances before and after mergers. Specifically, we will analyze how the return on assets changed from the fiscal year before the merger to the first and second years after the merger year.(50)
    We have found that the first-year effects (ROA change from the fiscal year before the merger year to the first year after the merger) and the second-year effects (ROA change from the first year after the merger to the second year) were not uniform (see Figure 2-3-14). A small number of enterprises indicated significant second-year effects. No relations were seen between the effects of mergers and sector-by-sector characteristics. We may be able to conclude that the effects of mergers depend on management styles of individual enterprises.
Figure 2-3-14 ROA-Boosting Effects of Mergers

Features of business operations transfers
    Next, we will look at business operations transfers, which have grown more important along with mergers in recent years. Business operations transfers are classified into three categories-enhancement of business transferees' existing operations, establishment of new companies to integrate business operations, and others including transferees' diversification and entries into new business areas.
    In order to find out the types of companies that become business transferees, we will focus on relative ROA, or the gap between each transferee's ROA and the average ROA for a sector including the transferee before a business transfer. From 1993 to 1997, the number of transferees with above-average ROA tended to rise (see Figure 2-3-15). As business operations transfers increased fast in and after 1999, relative ROA grew more various. At the same time, enterprises with ROA below the sectoral averages increasingly became transferees.
    Business operations transfers include cases where enterprises transfer business operations in order to withdraw from these operations. Of the 159 sample business transfers where listed enterprises were transferees, 58 transfers, or 36.5%, involved withdrawals, Corporate Reorganization Law procedures or Civil Rehabilitation Law procedures.
Figure 2-3-15 Features of Business Operations Transferees
    Among business transferees in recent years have been many enterprises with below-average ROA. For these enterprises, ROA tended to increase in the first-year effect (ROA change from the pre-transfer year to the first year after the transfer)(51) (see Figure 2-3-16). Business transferees with very positive first-year effects tended to have positive second-year effects, or ROA rises from the first year after business transfers to the second year (see Figure 2-3-17).
    Since sampled business transferees had no special relations with sectoral characteristics, business transfer effects might have depended on the management styles of individual transferees, as seen in mergers. But ROA changes around business operations transfers apparently indicate that business operations transfers to enhance existing operations or integrate operations under new companies are suitable for revitalizing slumping enterprises.
Figure 2-3-16 ROA of Business Transferee
Figure 2-3-17 ROA-Boosting Effect for Business Transferee

Problems with M&A
    As discussed above, M&A deals have been increasing over the recent years. This apparently reflects a changing business management environment where business managers are required to reorganize business resources appropriately and quickly to meet changes in necessary business resources for improving enterprise value. The M&A growth has come as Japan has promoted deregulation and improved legal systems to make business reorganization easier in response to business managers' growing recognition of the importance of speed-oriented management.
    On the other hand, unwinding of cross shareholdings and other changes in relations between financial institutions and their corporate clients have required enterprises to give priority to enhancing shareholder value. As a result, enterprises are apparently prompted to select M&A methods in consideration of market evaluation. The decline in bailout-oriented mergers and an increase in mergers for sectoral reorganization may be reflecting such situation.
    It is difficult to measure the real effects of recent M&A deals since it is too early to find any effects. Probably, effects may depend not on the specific M&A methods adopted but on the purposes, that is, what management resources are to be acquired and what business fields are to be focused on for implementing the M&A deals. Therefore, the effects of M&A deals may vary depending on factors particular to the individual enterprises implementing such deals. But M&A deals may in effect work to increase ROA through selection and concentration, as seen in transfers of business operations. If positive effects of M&A deals are demonstrated in future, enterprises may adopt M&A deals more frequently.
    Since M&A deals are always accompanied by significant information gaps between business buyers and sellers, however, debts that are not identified upon the implementation of an M&A deal could emerge later. Therefore, due diligence on M&A targets to identify business, financial and legal risks accompanying M&A deals are expected to grow more important.

5. Rebuilding Business Sector
    We now have analyzed and considered the challenges facing Japan's business sector from the viewpoints including restructuring of excessively indebted enterprises and enhancement of enterprises' profitability. Finally, we would like to review these analyses, considerations and their implications in order to identify the direction for rebuilding the business sector.

Need for rapid corporate restructuring
    While enterprises grew more dependent on their main banks in the second half of the 1990s, main banks' client-rescuing function began to change. Main banks had provided their profit-stabilizing function to a wide range of enterprises faced with financial crises in the first half of the 1990s, but they began to limit targets to heavily indebted enterprises enjoying robust performances at their respective core divisions.
    Some half of troubled enterprises failing to receive main bank support started restructuring processes by June 2003. About 15% of listed enterprises are required to undergo restructuring, including some 9% that have already launched restructuring processes. The remainder, 6%, may have to be subjected to restructuring and other restructuring processes in the near future.
    This indicates that rapid corporate restructuring mechanisms are growing more important in place of the main bank system.

Effectiveness of reconstruction-oriented out-of-court workout
    Reconstruction-oriented out-of-court workout is usually quick and should be exploited widely. The problem is that bank-led out-of-court workout for their reconstruction is frequently conceived as including easy debt waivers to keep them afloat.
    Most companies that have received debt forgiveness mainly from financial institutions are large enterprises that have performed relatively better, and they have been requested by financial institutions to book massive special losses and reduce jobs upon debt forgiveness.
    Therefore, we can conclude that financial institutions have not necessarily provided easy debt forgiveness in order to keep trouble enterprises afloat and delay their liquidation, although the number of samples to draw this conclusion has been limited. Out-of-court workout of large enterprises has worked to prevent their bankruptcies and reduce debts at bankrupt firms. While urging financial institutions to refrain from exploiting debt waivers to delay the liquidation of troubled companies, Japan should try to promote out-of-court workout of such firms for their reconstruction.

Effectiveness of corporate restructuring through public frameworks
    A major advantage of using the Industrial Revitalization Corporation of Japan framework is that the IRCJ can put together loans and make corporate restructuring easier for bank-led out-of-court workout of troubled enterprises by exploiting its neutral position to make up for a decline in main banks' interest-coordinating function.
    Overseas public asset management companies, similar to the IRCJ, have commonly bought loans at market prices with some options, given consideration to the promptness of loan purchases and the equal treatment of financial institutions, and taken advantage of private-sector know-how and capital including foreign firms. Based on these overseas precedents, the IRCJ is expected to work well.

M&A deals to improve enterprise value
    Merger and acquisition deals have increased in recent years as (i) changes in business resources for improving enterprise value have forced enterprises to reorganize business resources appropriately and quickly, (ii) business managers have growingly recognized the importance of speedy management decisions, and (iii) legal systems have been developed to make reorganization of enterprises easier.
    It is difficult to measure the real effects of recent M&A deals since it is too early to find any effect. Generally, however, we can assume that the effects of M&A deals would vary depending on the respective conditions of the enterprises adopting such deals. Like transfers of business operations, some M&A deals are suitable for turning around slumping enterprises. If M&A deals are established as an effective means to obtain competitive advantages through selection and concentration of business resources, Japanese companies may adopt such deals more frequently.

    As discussed above, efforts have been launched to restructure and turn around excessively indebted enterprises and enhance the profitability of enterprises. We expect that rebuilding of enterprises will make further progress in future through appropriate exploitation of reconstruction-oriented out-of-court workout including debt waivers, M&A deals and other means that have been adopted, as their good reputations are established.


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