No. 26 — July 7, 2000


Weekly Review

--- by Jon Choy

What began as a business effort to keep afloat a second-tier department store operator has turned into a very public test of the government's financial-market stabilization policies. The Financial Reconstruction Commission announced June 30 that the Deposit Insurance Corp. would buy ¥197.6 billion ($1.8 billion at ¥110=$1.00) worth of loans extended to technically bankrupt Sogo Co., Ltd. by what was Long-Term Credit Bank of Japan, Ltd. and immediately forgive ¥97 billion ($881.8 million) of the amount. Even though the DIC won concessions from Sogo and its main bank, Industrial Bank of Japan, Ltd., the use of public funds to erase the debts of a nonfinancial company — especially a midsize competitor in an industry divorced from Japan's economic future — has unleashed a heated debate about the meaning and the impact of this unprecedented action.

Like many Japanese companies, Sogo, whose main department stores are in Osaka, Kobe and Tokyo, embarked on an ambitious expansion plan in the late 1980s based on the expectation that the economy would continue to prosper. With the help of lead lender IBJ, it borrowed heavily to open more outlets at home and overseas. The bursting of the "bubble economy" and the decade-long recession that followed strained Sogo's finances to the breaking point. When accountants calculated the numbers this past April for the retailer's operations through February 2000, management reported shocking news: the company owed more than ¥1.7 trillion ($15.5 billion) and had a negative net worth of ¥580 billion ($5.3 billion). IBJ officials immediately began working on a restructuring plan, but they were trumped by a Sogo proposal that asked the firm's 73 lenders to write off ¥639 billion ($5.8 billion) of its debts. IBJ agreed to forgive notes with a face value of ¥18 billion ($163.6 million) and began rounding up support for the plan.

While most of the 73 banks that had lent to Sogo were willing to follow IBJ's lead, Shinsei Bank, Ltd. — the successor to LTCB — was not. And since it was being asked to surrender loans with a face value of ¥97 billion ($881.8 million), its participation was critical. Shinsei Bank officials decided that it was not in the bank's interest to join the bailout because it could get a better deal by exercising a clause in its pact with Tokyo that covered the purchase of LTCB's assets and the reopening of the lender (see JEI Report No. 24B, June 23, 2000). The government had agreed to buy from Shinsei Bank any loans made by LTCB if the collateral backing them fell in value by more than 20 percent from the time the loans were assumed by the relaunched institution — conditions met by Sogo's borrowing. If Shinsei Bank forgave even a part of these debts, it would forfeit its right to sell them to Tokyo at full face value.

With the 73-bank consortium tensely awaiting its decision, Shinsei Bank tossed the hot potato into Tokyo's lap, announcing June 29 that it had asked the DIC to buy its loans to Sogo as per the takeover agreement. After concurring that the collateral backing Shinsei Bank's Sogo notes had depreciated at least 20 percent, the DIC paid the full ¥197.6 billion ($1.8 billion) face value for the assets. However, it received the ¥99.9 billion ($908.2 million) that the lender had set aside to cover potential losses on its Sogo loans. Clearly indicating that the precedent-setting move had been discussed well in advance, the FRC debated participating in the Sogo debt-forgiveness plan for just a day before voting to allow the DIC to act.

DIC head Noboru Matsuda told reporters June 30 that his agency's action was "exceptional." He added that it was motivated by a desire to minimize the cost to taxpayers of Sogo's problems. Mr. Matsuda listed several factors that the government had considered before making its trailblazing decision. They included whether Sogo's restructuring proposal would have a better chance of success with debt forgiveness; whether the company would be forced into bankruptcy proceedings if Tokyo did not join the bailout plan; whether the retailer's bankruptcy would trigger failures among its 10,000 or so suppliers; whether Sogo had taken steps to clarify responsibility for its financial problems; and whether the company's creditors would be imperiled by the retailer's collapse. FRC and DIC officials apparently decided that all these questions could be answered in the affirmative, leaving the government no choice but to participate in the novel debt-forgiveness plan.

Under the terms of the deal, the DIC gave up its claim on ¥97 billion ($881.8 million) of the notes taken over from Shinsei Bank. It expects repayment of the remaining ¥100.6 billion ($914.5 million) over the next 12 years. This puts the DIC at the head of the creditor line since other banks have agreed to give Sogo 30 years to pay off its debts to them. Sogo will close five of its department stores but will retain at least eight unprofitable outlets. Its payroll surely will shrink from the current total of 9,900, and its suppliers will face tougher bargaining. The DIC also is pushing Sogo executives — particularly the architect of the firm's business empire, former chairman Hiroo Mizushima — to sell some personal assets and resign as part of the restitution.

While analysts said that they understood the reasoning of FRC and DIC decisionmakers, they disagree with them on several key points. For starters, many observers doubt that Sogo's restructuring plan ensures its return to profitability since the company still owes more than ¥1 trillion ($9.1 billion) and faces tough competition in an industry where new retail formats are taking business away from traditional department stores. Some experts also are concerned that now with Tokyo drawn into Sogo's predicament, the government could end up holding the bag if the retailer's financial condition worsens.

The central question is whether and under what circumstances public money should be used to save a nonfinancial firm from the consequences of its own poor business decisions. In defending their judgment, financial authorities suggested that the final outcome was unavoidable. Shinsei Bank did not want to take the blame for scuttling Sogo's rescue plan when every other creditor appeared to be willing to take a "haircut" to save the retailer. Playing the spoiler also would have damaged the bank's reputation, perhaps discouraging new business. At the same time, taking a big loss on its loans to a retailer with questionable survival prospects did not meet the good-business-sense standards that bank executives have said will guide their decisions. The soured-loan buyback provision of Shinsei Bank's takeover deal provided an easy out from this dilemma since it obligated Tokyo to purchase the devalued notes. This turned a bad asset into cold cash and lifted the burden of determining the fate of Sogo's rescue plan from the shoulders of bank officers. From Shinsei Bank's standpoint, therefore, the decision to force the DIC to purchase its loans to Sogo made sense from every angle.

Once it had possession of the Sogo loans, the government decided that it had to participate in the retailer's controversial debt-forgiveness scheme for several reasons. Nearly 10,000 people rely directly on the struggling retailer for jobs, a linkage shared indirectly by the many thousands who work for Sogo's suppliers. Tokyo feared that the unemployment rate, which has just started to descend from record-high levels, and corporate bankruptcies might both be boosted if Sogo were allowed to go under. Moreover, if its bankruptcy led to other failures, banks that had lent to the retailer and its suppliers would be forced to classify the entire amount of their affected notes as nonperforming. Authorities worried that some lenders were not prepared to absorb the losses and would turn to the government for help. By joining in Sogo's rescue and taking a hit up front, Tokyo hoped to avoid triggering a disastrous chain of events and to improve its chances of eventually collecting on the remaining debt.

Taxpayers understandably are incensed that "their" money is going to be used for the bailout and that no Sogo executive will face criminal charges. They also suspect that ex-chairman Mizushima deliberately hid the true state of Sogo's finances from auditors for many years and persuaded LTCB officers to lend generously to the company on the strength of his former employment with the bank. Since many businesses are said to face Sogo-type troubles, people have voiced great skepticism about the government's decisionmaking process and its exceptional response.

Economists in particular are worried about the fallout from Tokyo's action. One fear is that it will lead Sogo executives to take unwarranted business risks since the company now is backed by the government. This so-called moral hazard also could infect other troubled major employers, convincing them that Tokyo will come to their rescue rather than allow them to fold. Experts predict that two other Shinsei Bank customers saddled with huge loan repayments — Kumagai Gumi Co., Ltd. and Hazama Corp. — shortly will offer their own debt-forgiveness proposals. Not only do these two big contractors directly employ thousands of workers, they also support a large number of subcontractors and are politically powerful to boot.

The Financial Services Agency, which was launched July 1 when the Financial Supervisory Agency was combined with the Ministry of Finance's Financial System Planning Bureau, will be sorely tested by the Sogo precedent. FRC head Sadakazu Tanigaki sought to discourage other companies from adopting Sogo's strategy, telling reporters June 30 that "I do not think it is right for others to seek similar arrangements." Yet when asked what Tokyo's response would be to Sogo-like requests from firms such as Kumagai Gumi and Hazama, he left the door open to similar action by refusing to give a clear-cut answer.

Opposition parties, emboldened by their strong showings in the lower house elections (see JEI Report No. 25B, June 30, 2000), will hold the government's feet to the fire on this issue. With Japan's sovereign bond rating already under pressure because of the government's huge accumulated debts from fiscal stimulus efforts, the prospect that Tokyo will assume and then forgive the debts incurred by other major employers can only add to the concerns of credit-rating analysts.

The Sogo precedent also has reignited worries about the financial health of Japan's banks. If the DIC acted in part because it judged lenders unprepared to deal with the retailer's failure, what does that say about banks' financial stability? Moreover, since Sogo's technical bankruptcy was revealed by tougher accounting rules that are scheduled to be adopted universally, more than a few industry watchers wonder how many other companies will find themselves in Sogo's position. Pessimists predict that numerous corporations will follow in Sogo's pioneering footsteps, imperiling Japan's nascent economic recovery and further threatening the public sector's finances.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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