OVERVIEW OF THE DISTRESSED ASSET MARKETPLACE
In a country known for its frugal bureaucracy, changes brought about by the burst of the "bubble economy" is finally paving the way for western corporate stewardship and finance concepts to enter mainstream business. Mr Hakuo Yanagisawa, head of Japan's Financial Services Agency, is now ordering Japanese banks to dispose of more bad debt, frustrated by the banks' complacency following the March 1999 capital infusion. This is a profound change, considering that banks visited the Ministry of Finance hat-in-hand begging to book additional loan loss reserves not long ago.
Against this economic and regulatory backdrop, impaired assets (real estate and corporate) have been the first sector to see significant foreign investment. There is now a migration to debt and equity plays in healthier situations. As a leader in future investments, the authors' chronological perspectives on the corporate distressed market follows. The article is concluded with a discussion of structuring alternatives to encourage more investors to seek opportunities in the Japanese marketplace.
HISTORICAL DEVELOPMENTS
The most prominent feature of the distressed market has been the bulk sale of assets from Japanese banks to western funds and investment banks. While real estate bulks commenced in earnest in 1997, corporate bulks commenced in early 1998, with the sale of loan claims on Nippon Credit Bank subsidiaries. While these initial deals were small, they did whet the appetite of astute foreign investors and presented a potential solution for worried bureaucrats.
The dribble of deals in March 1998 turned into a wave in September 1998, as capital-strapped banks found themselves at the mercy of bureaucratic guidance in return for a bank rescue plan. The largest bulk sales fetched $100 million in market value. Prominent claims were the non-banks, including NCB subsidiaries and Hyogo Bank affiliates.
The March 1999 cycle started where September 1998 left off. Trading in Japan Leasing (JLC, a Long-Term Credit Bank (LTCB) affiliate and second largest leasing company after Orix) claims and the sponsorship of JLC were the big-ticket items, along with claims on other LTCB subsidiaries. However, momentum subsided in February with the realization that public funds were forthcoming to the banking sector.
The upshot of this was that September 1999 saw no big names and an abundance of small corporate and individual claims. This cycle also saw fresh investors seeking situations that were largely played out. Going forward, bulk returns would dwindle. It was time for the lead investors to go big-game hunting.
The big game was to be had in the banking and insurance sectors. On the banking side, LTCB and Nippon Credit Bank (NCB) were put on the block after being nationalized. Given a tenuous environment with systemic concerns, the Financial Supervisory Agency (FSA) sold both institutions with a put option on the loan book, allowing buyers to recoup subsequent deteriorations in the loan book from the FSA.
In the meantime, seven regional banks were declared insolvent and managed by administrators pending a sale. The last of these was finally settled with the sale of Tokyo Sowa in January this year. In these deals, no put option was offered; investors bid a fair value on the loan book (or a reserve request to the FSA), with the winner subsequently contributing capital to meet Bank for International Settlements (BIS) requirements. The availability of significant public funds to fill the hole in the loan book was the most significant factor allowing for the resolution of these situations.
Not to be outdone, insurers entered the carnage, succumbing to prolonged negative spreads caused by bank-friendly monetary policy. Some of these situations have yet to be resolved. Notably, most insurers held relatively healthy assets but were crippled by artificially low interest rates. While they can be faulted for poor asset/liability management (ALM) practices, this is a much less serious sin than the bad debt piled on by the banks.
To add insult to injury, the insurers do not have access to public funds but must use an industry-contributed fund (Policyholders Protection Corporation or PPC) to fill capital shortages upon the sale of failed insurers to foreign investors. The thought of handing over cash directly to foreign competition, combined with the reality that these entities may end up as wind-down vehicles (no new policies to be underwritten), lends some credence to an industry-sponsored wind-down in lieu of a sale.
FUTURE EVOLUTION
The debt overhang at Japanese banks has increased, with September 2000 financials placing classified claims at ¥30 trillion (US$250 billion) and ¥14 trillion for the 10 money-centre banks. Another infusion of public bank capital is being debated as feeble equity markets erode capital ahead of the ominous introduction of mark-to-market accounting. The country desperately needs more private risk capital.
In accepting the nomination as the distressed market fortune-teller, the authors find it useful to segment their views into a few discussion points, namely: asset types, players and environmental evolution.
Sub-performing claims now loom on the distressed scene. Bankrupt claims were just the tip of the iceberg. The real bad debts - the sub-performers - abound in retail, construction, trading, real estate and consumer finance, to name but a few sectors. The market will be in sponsoring restructurings as opposed to buying bulk sales. In a country with a dearth of turn-around talent, ties to strong management teams in specific industries is a key component of any investment strategy.
The players will be a combination of a sub-set of the current distressed investors, along with a new breed of private equity funds. Depending on the level of distress and the need for an active workout, these assets can play to the strength of private equity funds that are quickly converging on the scene. Not to be out-done, distressed investors have also gained knowledge and comfort with turnaround situations and are demonstrating an intimate feel for analyzing and valuing performing and sub-performing loans on the banks and insurers' books. A few distressed funds are already in the sponsorship business, although the jury is still out on whether they possess the requisite private equity skills. It is this lack of transportable Japanese turnaround expertise that strengthens the argument for working with incumbent management (MBO transactions).
On the environmental front, Japan has made itself more attractive to investment. Progress on the legal front is to be applauded. The amendments to the Commercial Code since 1997 are particularly notable. M&A transactions are easier to undertake and guidance on business combinations and spin-offs has been instituted. The new Civil Rehabilitation Code is another welcome change that will accelerate restructurings. Mirroring the US Chapter 11 process, this code provides a legal basis for debtor-in-possession (DIP) financing and pre-packaged bankruptcies. It is expected that a mini-market for corporate control (597 cases were filed from enactment of the Code in April 2000 to December 2000) will emerge, with investors making direct overtures to debtors that will be viewed as hostile by Japanese banks.
On a more negative note, Japan is in for some competition in attracting risk capital. Whilst it would seem only natural that some of the $100 billion being raised globally by the private equity funds will find its way over to Japan, other Asian economies have been more aggressive in cleaning up their act and selling their assets while the distressed and private equity opportunities are heating up in the US. Japanese banks need to show that significant dispositions are forthcoming if they are to continue to attract the attention of investors.
While it would be unwise to advocate loan sales as a solution to every situation, it is also important to bear in mind that unrealized losses do not diminish by sitting tight. More workout knowledge on the part of Japanese banks would shift the power balance in their favour. Sales negotiations would then be about attributing value to upside factors as opposed to haggling for discounts given the existing situation. This would significantly resolve the current divergence in price expectations that has frustrated the development of a sub-performing loan trading market.
STRUCTURING APPROACHES
In practice, investors in each of the troubled industries discussed have developed their own typical structures to enter the market. Structures used for the acquisition of banks, insurance companies, (impaired) assets and management/business buy-outs, and some of the major Japanese tax issues involved are discussed below.
Banking
The major transactions in the banking industry (long-term credit banks and regional banks) have generally involved the acquisition of shares of the troubled banks by groups of investors. The acquisition vehicles have been both overseas-based and domestic Japanese, organized by different consortia.
After being acquired and having their names changed, the various institutions continued under the same legal entity. Investors committed to provide additional equity (usually jointly with the industry protection fund) and obtained guarantees as to the value of the loan book via the earlier mentioned put option mechanisms.
From a tax perspective, continuing the existing legal entity provides for the use of net operating loss (NOL) carry-forwards. Very broadly, a change of ownership does not automatically cause the NOLs to become obsolete. This benefit can prove an important factor in the decision to step into an entity. Even though mark-to-market rules have been introduced for accounting, mark-to-market treatment is not automatically required for tax purposes. This allows some planning for the optimal use of NOLs.
Insurance
Structuring in (life) insurance transactions has been more complex. This is mainly the result of most life insurance companies being mutual companies, unable to raise equity capital freely in the open market. The numerous policyholders have to be directly involved in any conversion into joint stock companies. Demutualisation, although allowed for in the Japanese Insurance Business Law (IBL) is practically impossible. A change in the IBL to allow for a more flexible method of demutualisation is required.
Recent transactions in the industry have followed two patterns. Several transactions were structured as sales of infrastructure/distribution channels. Acquirers established new Japanese companies and exchanged shares for assets. The acquiring company would use the employees and infrastructure acquired to develop and write new business. The transferor company would merely maintain its existing block of business. Effectively, this meant a demutualisation of the troubled company, with a run-down period until the last administered policy in the old company expired or was surrendered.
Unfortunately, the troubled companies that followed this pattern were unable to survive. As a result, the Japanese acquiring company needed to acquire the blocks originally left behind as well. The consequences have been enormous for the policyholders. In the restructuring process, they lost substantial value in their policies. Moreover, the PPC industry fund had to allocate substantial funds in these transactions and acquirers were required to fill a remaining 'hole', the size of which was negotiated with the administrators appointed by the Life Insurance Association of Japan.
The accounting and tax aspects of these transactions were rather complex. The main issues are in the area of created or acquired intangible assets and related amortization under a combination of rules prevalent under the IBL, the Commercial Code of Japan and the various tax laws. Expected income flows need to be in line with additional expenses required to revive the business and amortization of intangible assets, avoiding expiration of NOLs. In addition, there are transactional taxes of which the consumption tax (5% in Japan) is always a difficult one for the insurance industry, it being a generally non-recoverable expense.
Remaining transactions have been structured either as a straight acquisition or as a straight capital injection in the troubled business. Acquirers have still attempted to insulate the troubled business from the writing of new business. For example, using a Japanese holding company structure in which the old' company is left to wind up and a new company is created to conduct all new business.
In terms of taxation, the issues are less complicated than in the first structure. The biggest issue being the lack of a consolidated tax-filing regime in Japan. It is hoped that consolidation rules would be introduced by April 1 2002.
Asset acquisitions
Generally referred to as asset workout structures, these are basically when foreign capital is used to acquire loans of varying quality (often asset backed) and real estate.
The nature of these funds (ie, risk capital) dictates their desire for minimal tax leakage from their investments. To date, the Japanese authorities have taken an ambiguous stance, with the tax authorities challenging several acquisition vehicles as being abusive. However, it is also known that foreign risk capital is required to keep the restructuring of the Japanese financial system going. Whether the Japanese authorities can reach a consensus position remains to be seen.
The main tax aspects are:
funding and mitigating tax leakage;
capital gains taxation; and
reduction of transactional taxes.
The amount of tax-efficient structures is numerous but a number of standard features, depending on the type of asset purchased, can be found. Partnership (tokumei kumiai or TK) and special purpose company (tokutei mokuteki kaisha or TMK) structures, as well as the direct acquisition of non-interest yielding assets where the capital gain is protected under a tax treaty, are common. A more detailed discussion of some of these structures can be found in the section of this article entitled Tax structuring for specific asset acquisitions (below).
Management buy-ins and buy-outs
The Japanese M&A market has been an interesting area over the last few years, marked by a number of high-profile transactions. There is undoubtedly much more activity to come.
In addition to these large acquisitions, restructuring at many Japanese companies opens up opportunities for buyers to pick up divisions or units that are no longer considered core. A number of domestic and foreign funds have set up in Japan to invest in and provide advice to such spun-off enterprises. The first of such transactions was recently concluded when a division of Nissan was taken private with the help of a foreign owned private equity fund.
Recent commercial code changes, corresponding changes in the tax law and accounting clarifications will assist in facilitating corporate restructuring via tax-free reorganizations.
After April 1 2001, when the new tax rules take effect, asset acquisitions will probably prevail. This will give leveraging opportunities and allow for amortization of any goodwill component. Only when the target business is contained in a company with substantial tax losses may an acquirer be interested in a share acquisition. As Japan does not allow for tax consolidation, use of a leveraged holding may not be desirable, assuming that holding would not have other taxable profits. The dividend distributed by a Japanese subsidiary company to its 100% Japanese parent company would generally be exempt from tax at the parent-company level.
The so-called 'merger with a tax-free step up in basis' opportunity is scheduled to be terminated after March 31 2001.
TAX STRUCTURING FOR SPECIFIC ASSET ACQUISITIONS
TK structure
Foreign investors in the Japanese assets market have used the TK arrangement. If properly implemented and monitored, this arrangement can provide investors with an effective means of expanding their Japanese businesses and implementing other domestic Japanese tax techniques.
A TK agreement is a contractual agreement between two parties under the Commercial Code, whereby one or more silent partners invest in a business conducted by a proprietor (usually a Japanese corporation). The profits and losses arising from the business are shared among the proprietor and the silent partners.
The TK is often used as a passive investment vehicle in Japan (the equivalent of the US limited partnership). One of the most common uses for TK arrangements continues to be in the leveraged lease market.
Tax treatment for TK structures
Under the domestic tax law, income derived by a silent partner from a TK agreement is treated as income from the use or possession of assets situated in Japan. However, the current position is that an investment into a TK as a silent partner does not in and of itself create a permanent establishment (PE).
Further, under some treaties, TK distributive income falls into the 'other income' article of such treaties. Generally taxation of such income is reserved exclusively for the recipient's country. Therefore, under these treaties, it seems possible to avoid Japanese national tax. Japanese treaties to which this treatment may apply include those signed with Belgium, Finland, France, the Netherlands, Norway, Spain and the UK.
Reactions from the tax authorities
The National Tax Authority (NTA) has begun in the past few years to vigorously challenge TK investment structures because of the extraordinary benefits that can be achieved. Recent news publications in Japan have clearly indicated the NTA's displeasure with what it perceives to be an abusive loophole. In the past several years, the NTA has even requested that the Tax Bureau of the Ministry of Finance (MOF) consider adopting tax revisions regarding the taxation of TK investors. To date, the NTA and MOF have not been able to agree on any revisions to the law.
Given that the NTA cannot rely upon revised tax laws to mitigate what it believes to a tax loophole, it is widely believed that the NTA will become increasingly more aggressive in its audit positions. Therefore, it is essential that any TK arrangement is based upon valid commercial rationale with economic substance and should not have as its principal objective the avoidance of income taxes.
TMK structures
The TMK structure was enacted under the Law Concerning Liquidation of Specified Assets by Special Purpose Company (the SPC Law) as a vehicle for the aggregated investment of multiple investors. It was intended for the liquidation of assets and was originally enacted on September 1 1998. However, due to the many impractical and restrictive conditions contained under the old SPC Law, it was never fully utilized as intended. In May 2000, with an effective date of November 30 2000, the SPC Law was amended to reflect the practical demands in the real estate securitization market.
The TMK is required to identify assets to be owned at the time of its formation and the structure must be liquidated at the time when all specified assets have been liquidated. Practically, this means that the TMK can not reinvest in new property and should be viewed as a limited life entity.
Tax treatment of TMK structures
Provided the TMK satisfies certain requirements, dividend distributions are deductible in determining its taxable income. The general requirements are as follows:
It must distribute more than 90% of its adjusted taxable income as dividends;
It must meet one of the following conditions:
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total issue price of specified bonds issued under a public offering is ¥100 million or more;
specified bonds issued are subscribed to only by qualified institutional investors (QIIs). QIIs are defined as those who possess knowledge and experience in investing in securities and are not considered to require a protection provided under the disclosures of the public offerings;
preferred investment certificates are subscribed to by 50 or more investors; or
preferred investment certificates are subscribed to only by QIIs.
More than 50% of the total issued specified bonds and more than 50% of the total issued preferred investment certificates are offered within Japan;
It is not a 'family corporation' at the end of the fiscal year (except for a TMK which meets either a) or b) above);
Borrowings other than specified bonds or specified commercial paper (specified loan) are financed from QIIs and not from the specified investment holders;
The fiscal year does not exceed one year;
It is formed in accordance with the SPC Law;
It conducts its business in accordance with the assets liquidation plan as prescribed under the SPC Law and does not conduct any other business;
It entrusts the management and disposal of its specified assets to a separate entity with knowledge and experience or places the specified assets into a trust; and
It does not own any assets other than specified assets.
Dividend distributions to TMK investors (specified investments and preferred investment certificates) are subject to withholding tax at the rate of 20% under domestic income tax law. Under most tax treaties, the reduced withholding tax rate will be available.
Capital gains treatment is available on the sale of TMK. Under some treaties, Japanese taxation on capital gains may be exempt. Distributions at the liquidation of the TMK are treated as a dividend distribution.
The TMK is also entitled to reductions in certain transactional taxes. Related to the registration of real property by the TMK, the registration and license tax is reduced to 2.5% from 5% and the real estate acquisition tax is reduced to 2% from 4%. Further, the TMK is exempt from the special land holding tax under certain situations.
Under a proposed tax bill, the registration and license tax would be further reduced to 1.6% for registrations made by March 31 2004 and the taxable basis for the real estate acquisition tax would be reduced to two-thirds (ie, the tax rate would be reduced to approximately 1.33%) for acquisitions made by March 31 2003.
The future for the TMK structure
The authors' experience indicates a strong preference towards the use of the TMK by the Japan authorities. One reason may be the many political careers that are hanging on the Japanese financial markets' ability to rebound. From the beginning, the TMK was to be a key component in the securitization wave. Whether or not this proves to be the case does not detract from the fact that as a 'sponsored' structure the TMK may be able to benefit from a window of tax obscurity. While the TK undergoes microscopic examination, the government agencies will be doing their best to encourage TMKs as a means of securing market capital.
Given this scenario, the future of the TMK is bright and, with the right structuring, it may provide a level of tax efficiency acceptable to even the most demanding of foreign investors.
