Japan’s Insolvency Regime Under Covid-19

In summary

The Japanese government has made provisions for special support to distressed companies during the covid-19 pandemic. However, Japan will face thousands of potential bankruptcy cases in the near future. This article outlines several strategies to resolve this critical situation.

Discussion points

• Japanese bankruptcy cases in 2019
• Impact of the pandemic and the government response towards the business sector in Japan
• Strategies to prepare for the flood of insolvencies

Referenced in this article

• Bankruptcy Act
• Civil Rehabilitation Act
• Corporate Reorganisation Act
• Act on Strengthening Industrial Competitiveness, etc

General overview

Situation until the end of 2019

The number of insolvency cases filed at the Tokyo District Court was 9,578 in the fiscal year 2019 (between 1 April 2018 and 31 March 2019). This was a 3 per cent decrease compared to the fiscal year 2018. The covid-19 pandemic will put an end to this downward trend. For the fiscal year 2020, the number of insolvency filings in Japan is expected to skyrocket even beyond the 24,476 filings of fiscal year 2008 when the Lehman Brothers collapse occurred.

Impact of the pandemic and government response

The Japanese government declared a state of emergency on 8 April 2020, which was lifted on 25 May 2020. During – and even after – that period, most of the Japanese economy suffered significantly and became ineffective, and the cash flow of companies fell dramatically. The government subsidised the distressed companies, and several governmental financial institutions lent special funds to them very quickly. The deadline for lending that money is the end of September 2020. When the deadline passes, we may face the situation where the companies will still struggle to recover their business, face a lack of cash, implement labour lay-offs, etc. Japan must prepare for a flood of filings for insolvency. Based on data collected by a Japanese research firm, the Japanese media has already reported that over 400 Japanese businesses have gone bankrupt owing to the covid-19 pandemic.^[1]

No special insolvency-related treatment has been issued by the Japanese government for the covid-19 pandemic, while actions have been taken countries such as Spain, India and Turkey, where treatment, such as suspension orders or amendments to insolvency law, has been adopted to suspend filings for insolvency.

Strategies to prepare for the flood of insolvencies

The following strategic treatment is required to support distressed companies.

First, special institutions that specialise in restructuring companies must be established. One good example is the Industrial Revitalisation Corporation (2003–2007), where non-performing loans were dealt with by the Corporation, and several distressed large companies survived with the help of the Corporation.

Second, there must be provisional loans that help the cash flow of distressed companies during the pandemic and that are needed for those companies to survive.

Third, insolvency mechanisms, such as those under insolvency law, out-of-court workouts, and practices, should be easy to file, easy to handle and quick to rehabilitate distressed companies.

Lastly, lists or pools of professionals who can deal with thousands of potential insolvency cases must be created.

Strategy one: establishing special institutions

Two main government institutions are involved in rehabilitating financially troubled companies: the Regional Economy Vitalisation Corporation of Japan (REVIC) for regional distressed companies and the small and medium-sized enterprises (SMEs) revitalisation support councils for distressed SMEs. The government also established a government-subsidised fund called the ‘Fund which strongly supports SME business’ to infuse equity into distressed SMEs in August 2020. The Japan Investment Corporation, which is also subsided by the government, was established to support corporate reorganisation and growth investment for relatively large companies that are healthy or distressed. The Business Rehabilitation alternative dispute resolution (ADR) process, which is a totally privately executed process, has already been established for medium-sized and large companies.

The issue on which the government-backed institutions have been criticised for over a decade is that these institutions and the government itself have made strong requests to Japanese banks, including mega banks and regional banks, to require their financially troubled borrowers to apply for assistance from a government-backed institution rather than to seek insolvency proceedings under the court system or an out-of-court workout through a private institution. These banks are supervised by the Financial Services Agency and are unable to defy this ‘order’, even though they may view that private sector-oriented turnaround professional companies would be more appropriate to rehabilitate these distressed companies.

Meanwhile, Japanese turnaround companies have been growing and becoming more sophisticated in the past 20 years, with a track record of restructuring many distressed companies. Government-backed institutions have sometimes been too slow to step in owing to the volume of distressed companies coming to them for assistance, which raised the risk of losing the opportunity to rehabilitate distressed companies. The principle of ‘early revitalisation’ remains essential to rehabilitating distressed companies.

We hope that the private sector and public sector will coordinate with each other to allocate potential cases for the purpose of efficient and early rehabilitation.

REVIC

REVIC was established in 2013 as the successor entity of the Enterprise Turnaround Initiative Corporation of Japan (ETIC), which was established in 2009. REVIC is funded both by the Japanese government and by Japanese financial institutions. Its main purpose had been to support medium-sized, financially troubled companies, with a focus on business rehabilitation; however, gradually, it has started to shift its focus to managing regional vitalisation funds with regional banks, deploying rehabilitation specialists to the banks.

REVIC should have completed its mandate to support financially troubled companies; however, because of the economic downturn owing to the pandemic, on 12 June 2020, the Japanese government decided to extend its role to support financially distressed companies. Therefore, REIVIC is again expected to support regional medium-sized companies in the future.

SME revitalisation support councils

SME revitalisation support councils, located in every prefecture in Japan, were formed to support business rehabilitation (eg, providing support to draw up a business rehabilitation plan and negotiating with banks) under the supervision of the Small and Medium Enterprise Agency. SME revitalisation support councils will also support regional SMEs in various ways since their branches are located in each prefecture. The professionals retained by those councils include tax accountants, certified public accountants, lawyers and business turnaround consultants. From their formation in 2002 to the end of March 2019, the total number of cases they have counselled is 44,391.

Turnaround ADR

History and system

Separate from the options offered by the government institutions discussed above, business rehabilitation ADR procedures through entirely private institutions engaging in business rehabilitation have also been gaining attention recently.

In 2001, a process under out-of-court workout guidelines was established in Japan. It was an out-of-court workout process for debtors with only financial institutions as creditors. This process, modelled on the INSOL Principles, INSOL being the world’s largest association of insolvency professionals, was the first formal out-of-court work out process adopted in Japan.

In 2007, to improve some demerits or inefficiencies of this process, the ‘turnaround ADR’ process was established. The turnaround ADR process was developed through the framework created by amendments to the Act on Special Measures for Industrial Revitalisation and Innovation of Industrial Activities^[2] in 2007, and further through provisions in the Act on Strengthening Industrial Competitiveness (the Industrial Competitiveness Act) of 2013.^[3] During the past 10 years, there have been 180 companies that have adopted business rehabilitation plans pursuant to the turnaround ADR process, representing 83 per cent of accepted applications.

The overall approach of the turnaround ADR process is to assist a debtor in financial difficulty to restructure the debts to its financial creditors, using a certified turnaround ADR provider as a neutral third party. The aim is early diversion to preserve the business before court proceedings become necessary. Because the turnaround ADR process does not include the claims of trade creditors, these claims benefit from the protection of full repayment when a debtor is rehabilitated using this process.

Regarding the participants of the turnaround ADR process, any legal entity may qualify as a debtor for the process, and only natural persons are excluded from eligibility as debtors for these purposes. Accordingly, large enterprises, such as Japan Airlines, medical corporations and educational institutions, are all eligible. Anticipated creditors are financial institutions, with particularly large trade creditors permitted on an exceptional basis where necessary, although this exception has not been applied to date. This is essentially a process in which trade creditors are not informed of the process, and modification of repayment terms, such as rescheduling or reduction of debt, is implemented with financial creditors.

To act as arbiter between the debtor and creditors involved in the process, the Japanese Association of Turnaround Professionals (JATP), a private organisation certified by both the Ministry of Economy, Trade and Industry and the Ministry of Justice, is permitted to act in this role. A panel of three process practitioners is usually elected to oversee the process.^[4] The panel is usually composed of one presiding lawyer, one accountant and one consultant or another lawyer, each with a background in business rehabilitation.

The process begins with a standstill notice to creditors to stop any action in relation to collecting money from the debtor, including filing lawsuits. The first creditors’ meeting is held within two weeks of the standstill notice. In the first meeting, the debtor explains its financial situation, proposing a draft rehabilitation plan, and asks the creditors to approve the standstill until the process is completed. The debtor negotiates and modifies the rehabilitation plan with the creditors. In the second meeting, the debtor proposes the final rehabilitation plan and receives comments and questions from the creditors. In the third creditors’ meeting, which is the final meeting, the creditors decide whether to approve the plan. The plan must be approved unanimously for it to be executed.

If the plan is not approved unanimously, the debtor turns to a legal insolvency process, such as the civil rehabilitation process or the corporate reorganisation process.

Strategy two: provisional loans from government financial institutions

To support the financing and prevention of their insolvency owing to the covid-19 pandemic, SMEs must obtain working capital for their business to use in their day-to-day operations, which may include rental fees, employment wages and the purchase of goods. The government has promoted lending by government financial institutions. A summary of each type of lending system is as follows.

Lending by the JFC

Funds provided by the Japan Finance Corporation (JFC) include:

• special lending to respond to the covid-19 pandemic: as the core of the lending system for responding to the pandemic and to support the strong financing of businesses that have suffered a decrease in sales as a result of the pandemic, the following provisions have been introduced:
  • the preparation of ¥60 million by the JFC and ¥300 million for small businesses, providing a relatively large amount of financing; and
  • the extension of repayment periods, with the repayment of funds for equipment to be completed within 20 years (with an instalment within five years) and the repayment of working capital within 15 years (with an instalment within five years), as well as flexible treatment in accordance with the debtor’s financing situation;
• funds to improve the management of small businesses: to support the financing of relatively small businesses, in addition to the usual lending limit of ¥20 million, it has been made possible to lend a further ¥10 million to respond to the pandemic, for a total ¥30 million, and with a lower rate of interest than normally applied,^[5] as well as provide a longer period for repayment; and
• a special loan to respond to drastic changes in the environment: this special loan is to provide support for funding in respect of the daily sanitary activities of hotel businesses, barbershops, public baths, restaurants and others that are susceptible to a downturn in business owing to the pandemic.^[6]

Safety net loans by the JFC

These loans are provided in response to major changes in the management environment and have been used in the past in respect of earthquakes and similar events. These will also be available in response to the covid-19 pandemic. The lending limit of ¥720 million for the Finance Corporation for Small Business allows for a broad scope of financing needs to be met.

Emergency response loans from the Shoko Chukin Bank

As a non-secured, non-guaranteed loan with a lending limit of ¥300 million, this assistance is characterised by the ability to disburse a relatively large loan. It is expected that certain specified businesses will be able to use the Interest Aid System,^[7] which will make it possible for those businesses to receive, effectively, a no-interest, non-secured loan.

CGGs

Japan, as is the case for many other countries, has a system of credit guarantee corporations (CGCs), which guarantee loans from private banks. With the guarantee of a CGC, even if the debtor goes insolvent, the bank can be certain that it can recover the guaranteed amount through the CGC. Normally, there is a maximum of ¥280 million for general guarantees; however, in light of the situation resulting from the pandemic, two layers of guarantees have been added: the safety net guarantee of ¥280 million and an ‘emergency-related guarantee’ of a further ¥280 million, giving a maximum total of ¥840 million.

By taking this action, the government can encourage lending by financial institutions. The CGC can guarantee repayment of the entire loan in the case of covid-19 pandemic-related loans. In normal times, the CGC guarantees provide for only up to 80 per cent of the amount of the loan.

Strategy three: insolvency mechanism

For the purpose of preparing for a potential flood of insolvencies, a framework and practice must be in place for an efficient route to resolution, whether in the form of court proceedings or out-of-court workouts.

Early action is essential to preserve enterprise value. For this purpose, companies can file for an out-of-court workout under Japan’s turnaround ADR process as a first step. Creditors of this process are mainly financial institutions. If they unanimously agree to the rehabilitation plan prepared by the debtor, this completes the process for a successful rehabilitation under which the company survives. However, because of the situation resulting from the covid-19 pandemic, the debtors may give up on the ADR process before completion because one or more creditors raise strong objection to their plans. In such a case, they would then file for a legal insolvency procedure, such as the civil rehabilitation procedure or corporate reorganisation procedure, under which the rehabilitation plan (the reorganisation plan) can be approved by a legal majority of the creditors, including financial creditors and trade creditors.

There have been several cases, such as the Japan Airline case, in which the debtor filed for the turnaround ADR process but then moved to legal insolvency procedures in Japan. In the Japan Airline case, the largest Japanese bankruptcy case in recent history, although the matter was ultimately moved to corporate reorganisation proceedings, turnaround ADR was initially pursued as a means to explore early restructuring through a private workout to preserve corporate value and for a swift reorganisation. In this way, turnaround ADR has become the first choice for the restructuring of medium-sized to large companies.

On the other hand, it is also true that there remain some issues with turnaround ADR. In particular, especially as businesses become increasingly global, the requirement to achieve unanimous consent of the creditors covered under the process will become increasingly untenable. To gain the acceptance of all creditors where the creditors are based in various countries, with differing fundamental goals and differing interests in the outcome, is an almost impossible prospect. Going forward, the challenge for turnaround ADR in this respect will be to establish a system for consent by a majority and to bind the objecting creditors to the result. Before accepting this new system, a more efficient practice for the legal insolvency system must be pursued.

Strategy four: capable turnaround professionals

For the Japanese legal system to be ready to respond to the flood of insolvencies expected to arise as a result of the pandemic, the legal community in Japan must urgently begin gathering and preparing insolvency professionals, such as lawyers, accountants and consultants, from both within and outside Japan to address the situation. In particular, the legal profession in Japan should coordinate with global associations, such as INSOL, the Turnaround Management Association, the International Insolvency Institute and the International Bar Association to pool recommended professionals with the expertise to handle the cross-border aspects of Japanese insolvency cases.

Conclusion

The covid-19 pandemic is on its way to causing a worldwide economic depression, the nature of which many expect will be completely different from that of both the Great Depression of the 1930s and the subprime mortgage crisis of 2008. We still have time to prepare for this depression. The Japanese government has enacted various emergency measures to stimulate the economy and support struggling businesses; however, the time will soon come when government funding will run out. When this happens, Japan’s insolvency professionals and institutions will face a tsunami of bankruptcy cases. Now is the time to prepare.

Notes