iOver the past year Japan has enacted a number of legislative initiatives in response to the global financial crisis, including an Act on Special Measures for Industrial Revitalization (the “Act”). Among other things, the Act establishes a process for consensual restructuring procedures for over-leveraged companies, commonly known as Rehabilitation Alternative Dispute Resolution (“ADR”). These procedures are designed to enable troubled companies to conclude out-of-court restructurings with certain targeted financial creditors.
Although ADR is less than a year old, a number of high-profile Japanese companies have initiated ADR proceedings, which have given rise to a great deal of interest in the investment community — and even more misunderstanding and confusion.
What ADR Is
• ADR is completely voluntary. A creditor receiving an ADR proposal cannot be forced to accept it.
• ADR involves the appointment of one or more disinterested mediators whose role is to facilitate negotiations between the debtor and a creditor group selected by the debtor. The mediators also evaluate the debtor’s rehabilitation plan for, among other things, fairness, feasibility and conformity with the law.
• ADR restructurings can involve principal and interest deferrals, debt forgiveness, and debt for equity conversions.
• ADR entails a staged process that provides flexibility for negotiations and extensions.
• Creditors can ask for and receive inducements such as interest rate increases, fees and collateral.
• In an ADR restructuring, all of the targeted creditors must consent to the rehabilitation plan the debtor proposes. That said, the debtor may achieve unanimous consent by removing from the process targeted creditors who object to the plan. A risk here is that targeted creditors, who originally supported the plan, might rethink their positions after objecting creditors are removed. Thus, a debtor will strive to persuade objecting creditors to change their position and consent.
• If the targeted creditors object to the debtor’s proposed plan, the debtor may abandon the ADR process and file for a special mediation proceeding, where a bankruptcy judge acts as the sole mediator, and may propose the debtor’s original plan as the plan in the mediation process. The creditors have the right to object to any such proposal and, again, the judge has no power to compel objecting creditors.
What ADR Is Not
• ADR is not an involuntary insolvency proceeding and does not involve any court or regulatory or administrative body (except when mediation has been initiated as noted above).
• The mediator(s) has no power to force either the debtor or any creditor to agree to a change in terms.
• A successful ADR restructuring does not mean that a debtor will necessarily avoid a court-supervised insolvency proceeding. If the ADR restructuring fails to resolve the debtor’s financial problems, the debtor or its creditors may commence a court-supervised insolvency proceeding under Japanese law or under the laws of any other jurisdiction, in each case, in accordance with applicable law.
• ADR involves only the targeted creditors and does not contemplate the involvement of all creditors (e.g., public bondholders). Because of the difficulties in obtaining the required consents, ADR procedures effectively do not involve public debt where the creditors are legion and widely dispersed.
The last point above explains why bank lenders are the primary targets of ADR and highlights the “free rider” problem inherent in ADR. As elsewhere in the world, in Japan creditors resist granting concessions when similarly situated creditors emerge unimpaired.
Conceivably, the targeted creditors could condition their consent to the ADR on a certain percentage of bondholders agreeing to an exchange offer by which the bondholders provide relief to the debtor similar to what the debtor has requested from the lenders. The prevailing view in the restructuring community here is that such conditions will not be sought.
Summary of ADR Steps
A debtor initiates ADR with a preliminary consultation with the Japanese Association of Turnaround Professionals (“JATP”), as of today the only organization licensed for this role. If JATP deems ADR suitable for the debtor, JATP grants a provisional acceptance of the ADR request, in which case the debtor often has an informal meeting with the prospective mediator (without any creditors in attendance), explains the situation, submits a rehabilitation plan in outline form and makes a formal application. JATP evaluates the feasibility of the submitted plan and, if it deems certain conditions are satisfied, grants formal acceptance.
Upon acceptance, the debtor sends a notice to those creditors it wants to participate in the restructuring. (Generally, these are financial institutions, licensed lenders and their assignees.) The notice is to include (i) the date of a First Creditors Meeting (which must be within two weeks of the date the notice is sent) and (ii) a request for a moratorium on any defaults arising between the date of the notice and the First Creditors Meeting. Notably, a creditor is not bound by such notice and remains free to exercise any available rights and remedies.
At the First Creditors Meeting the debtor explains the current status of the debtor’s assets and liabilities, presents the outline of a rehabilitation plan, and addresses creditor questions. In addition, upon unanimous consent of the creditors, a mediator(s) is selected and decisions are made with respect to the details and length of the moratorium period and the date, time and place of a Second and Third Creditors Meeting.
Even without unanimous creditor consent at the First Creditors Meeting, however, the ADR process still could continue. For example, if holders of 70 percent of the targeted debt (or even a lesser percentage) agree in principal, the debtor might be able to carve out the dissident creditors and proceed with the ADR process with a smaller group. There are at least two important qualifications. First, the mediator(s) would need to decide that the removal of the objecting creditors would not frustrate the implementation of the plan. Second, at the Third Creditors Meeting the remaining creditors would need to agree to the plan now excluding the objecting creditors. Of course, it is possible that the remaining creditors could, at the First Creditors Meeting, refuse to continue without the objecting creditors, in which case the process would collapse at that time.
Between the First and Second Creditors Meetings, the debtor drafts a restructuring plan. Thereafter, the debtor and the creditors, with the assistance of the mediator(s), negotiate the full terms of such plan. The parties have the option of extending the date of the Second Creditors Meeting or holding a “second” or even a “third” Second Creditors Meeting as they continue their negotiations.
By the date of the Second Creditors Meeting, the debtor must have proposed definitive terms for a restructuring plan. At the Second Creditors Meeting, the mediator(s) is to opine as to whether the plan is, among other things, fair and feasible. At the Third Creditors Meeting, the creditors vote. If the targeted creditors unanimously approve the plan, the restructuring takes effect. If there is not unanimous consent, it is conceivable that the objecting creditors may be removed and a second Third Creditors Meeting held.
Credit Default Swap Implications
ADR proceedings involving Aiful Corporation, a major non-bank consumer lender, and certain of its subsidiaries have resulted in at least three requests of ISDA’s Japan region Determination Committee (the “Committee”) to consider whether a “Credit Event” has occurred under the current iteration of the 2003 ISDA Credit Derivatives Definitions and the standard Japanese corporate terms for credit default swap contracts.
An ADR could give rise to at least three potential Credit Events under the Japanese Corporate Standard CDS (21 Sept. ed.):
• “Failure to Pay”
• “Restructuring”
• “Bankruptcy”
Whether a Credit Event has occurred is a fact-driven determination. For example, a Failure to Pay requires a payment default of at least JPY 100 million (approximately $US 1.1 million). The Restructuring and Bankruptcy Credit Events also require a careful factual examination to determine whether an event satisfies strictly defined terms. For example, in the case of a Restructuring, the basic rule is that, whether by vote or administrative fiat, creditors must be bound to a series of enumerated deteriorations in the payment terms of their debt.
The Bankruptcy Credit Event definition includes considerably more than simply that an entity files, or becomes the subject of, a statutory insolvency proceeding. As an example of what else is included, an entity must become “insolvent,” be “unable to pay its debts” or admit “in writing in a judicial, regulatory or administrative proceeding or filing its inability to pay its debts as they become due.”
This definition raises a number of questions, including whether either Aiful’s application to JATP or JATP’s acceptance thereof alone amounts to a Credit Event as Aiful’s written admission of its inability to pay its debt. A strict reading of the definition would seem to answer this question in the negative. ADR does not involve a Japanese court. Further, the mediator is not affiliated with any regulatory or administrative agency and does not have the power to bind any party. To date, there has been no Committee ruling on this.
Notably, given that the Act and ADR proceedings are quite new and to our knowledge have not been subject to any judicial interpretation, considerable uncertainty surrounds the foregoing analysis.
In addition to the substantive questions, there is also the procedural issue of presenting “Publicly Available Information” to the Determination Committee. Absent this, no Credit Event will be declared. In general, the information must come from the press or from the issuer itself and may not be confidential in nature. As the ADR process is private in nature, this may make it difficult for those seeking declaration of a Credit Event to prove their cases; it is worth noting that one of the attempts to have an Aiful Credit Event declared was rejected by the Committee on just this ground.
