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.

Purchasing Assets of Financially Distressed Companies in Japan

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.

Traditional Japanese Insolvency Practices

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.

Recent Insolvency Practices

1. Change in Environment.

(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.

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.

Impact of New Bankruptcy Legislation

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.

(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.

Reorganization Proceedings

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:

1. The debtor's business operations would be significantly impaired if the debtor were to pay its debts as they became due; or
2. An event of bankruptcy is likely to occur with respect to the debtor corporation.

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:

• The required court fees have not been paid.
• 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.
• 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.
• The filing was made for unfair purposes or otherwise lacked good faith.

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.

Conclusion

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.

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Footnotes

¹ 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. Return to article

² 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. Return to article