Newly Published SME Restructuring Guidelines and Overview of Out-of-Court Workouts in Japan

Newly Published SME Restructuring Guidelines and Overview of Out-of-Court Workouts in Japan

By Kotaro Fuji (Nishimura & Asahi) 

Introduction

In Japan, the Guidelines for Restructuring of Small and Medium Enterprises (Chusho-kigyo no Jigyo-saisei-tou ni-kansuru Guidelines) (“SME Restructuring Guidelines”), prepared by representatives from financial institutions and SMEs, experts, and academics, were published on 4 March 2022 and became effective on 15 April 2022. Although the SME Restructuring Guidelines are not legally binding, they should be respected and referred to by parties involved in out-of-court workouts of SMEs in Japan and hence, they will have an impact on the SME restructuring practices in Japan.

In Japan, SMEs account for a very large proportion of all enterprises (99.7%), and the COVID-19 pandemic has, since 2020, adversely affected these SMEs, especially in terms of their business and financials. Although the Japanese government has implemented various support measures to mitigate the negative impacts of COVID-19, such as providing substantially interest-free, unsecured loans to SMEs, this will come to an end in the near future. Therefore, an effective framework for out-of-court workouts for SMEs was called for in order to tackle their increased debts and restructure their businesses, resulting in the formulation of the SME Restructuring Guidelines. 

Since many other countries are in a similar situation due to COVID-19, and given the likelihood that academics, experts, or policymakers in the restructuring/insolvency area are more interested in frameworks to enable efficient restructuring of financially distressed SMEs, this article provides an explanation of the new SME Restructuring Guidelines’ characteristics. Notably, the SME Restructuring Guidelines consist of (i) a section setting out the basic principles of SME restructuring and (ii) a section stipulating the procedures for SME out-of-court workouts based on the SME Restructuring Guidelines, whereas part (ii) bifurcates into (a) restructuring-type procedures and (b) liquidation-type procedures. This article focuses on part (ii) - (a) restructuring-type procedures.

To begin, an overview of out-of-court workouts in Japan is provided to the extent necessary for understanding the SME Restructuring Guidelines. 
    
Development of Rule-Based Out-of-Court Workouts in Japan

In order to understand the implications of the SME Restructuring Guidelines on the restructuring practices in Japan, it is necessary to first understand the development of out-of-court workouts (in particular, so-called “rule-based out-of-court workouts”) in Japan. In general, “rule-based out-of-court workouts” are out-of-court workouts conducted in accordance with certain rules established to ensure fairness and transparency for the parties concerned. The first framework for rule-based out-of-court workouts in Japan was the “Guidelines for Out-of-Court Workouts” (Shiteki-seiri Guidelines). It was formulated in 2001 by representatives from financial and business sectors, experts, and academics, similar to the SME Restructuring Guidelines. Subsequently, a number of frameworks for rule-based out-of-court workouts have been developed. The most commonly used frameworks are (i) the so-called Councils Scheme (Kyogikai Scheme) launched in 2003 and (ii) Turnaround ADR (Jigyo-saisei ADR) introduced in 2007. The Councils Scheme is a framework that involves SME Vitalization Councils (previously, SME Revitalization Support Councils), which are public institutions. It is used to support SME restructuring. On the other hand, Turnaround ADR is a framework that is presided over by the Japanese Association of Turnaround Professionals, a private organization. It is mainly used by large enterprises because of the relatively high procedural costs.

Characteristics of Rule-Based Out-of-Court Workouts in Japan

Generally speaking, in out-of-court workouts, it is more difficult to obtain approval for restructuring plans because the unanimous consent of all creditors involved (usually financial creditors) is required. However, out-of-court workouts have several advantages: generally, the process is confidential; trade creditors are typically not involved; in the case of listed companies, conducting an out-of-court workout does not constitute grounds for delisting unlike in-court insolvency proceedings; and thanks to these merits, debtors can maintain more going-concern value compared to in-court insolvency proceedings. 

Rule-based out-of-court workouts also have the same pros and cons mentioned above. In addition, although each of the rule-based out-of-court workout frameworks has its own features, there are common characteristics among them as follows:  

(i)    The steps to be taken in the proceedings are specifically stipulated in the rules. The flow of the proceedings is somewhat common among those frameworks and generally is as follows: (a) consulting with the third party presiding over the proceedings; (b) requesting that all financial creditors agree to a standstill; (c) preparing a restructuring plan; (d) explaining and discussing the proposed restructuring plan in multiple creditors’ meetings; and (e) having the restructuring plan adopted by the unanimous consent of all creditors concerned.

(ii)    Neutral third parties are involved in the proceedings. In the case of Turnaround ADR, the Turnaround ADR operator (tetsuzuki jisshi-sha), and in the case of the Councils Scheme, the review committee (kentou iin-kai), examine the restructuring plan proposed by the debtor from a fair and neutral standpoint and report the results of the examination to the creditors.

(iii)    Under those frameworks, there are certain substantive requirements for restructuring plans; for example, eliminating liabilities in excess of assets within a certain number of years (three to five years), bringing ordinary profit/loss into the black within a certain number of years (three to five years), clarifying how management responsibilities and shareholder responsibilities (if the proposed restructuring plan includes a debt haircut) will be handled, creditor equality, the best-interests-of-creditors test, and so forth.

These characteristics are regarded as contributing to ensuring the fairness and transparency of the proceedings and, consequently, to obtaining the consensus of creditors as compared to pure out-of-court workouts.

As a side note, in Japan, there is no “hybrid procedure” that combines elements from both out-of-court workouts and formal insolvency proceedings in a manner similar to a scheme of arrangement. In addition, the characteristics of the frameworks for rule-based out-of-court workouts in Japan are unique (especially point (iii) above) compared to other frameworks for workouts developed outside Japan such as the London Approach, the INSOL Principles, the Singapore Approach, etc. 

Characteristics of SME Restructuring Guidelines

The framework under the SME Restructuring Guidelines also has the same characteristics described above; thus, the SME Restructuring Guidelines can be regarded as a descendant of previous rule-based out-of-court workout frameworks. However, as the SME Restructuring Guidelines have been formulated particularly for SMEs, the framework thereunder has the following characteristics. 

A)    Third-Party Supporting Experts System (utilizing private-sector experts such as attorneys-at-law)

Independent organizations such as SME Vitalization Councils and the Japanese Association of Turnaround Professionals are not involved. However, the debtor appoints “third-party supporting experts” (daisansha shien senmon-ka) from the list of accredited experts, which is publicly available, with the consent of “major creditors” (shuyou saikensha) to examine whether the debtor’s proposed restructuring plan is reasonable from a fair and neutral standpoint.

B)    Relatively Flexible Substantive Requirements for Restructuring Plans

Although the SME Restructuring Guidelines have substantive requirements for restructuring plans, taking into consideration the actual circumstances of SMEs, some requirements in the SME Restructuring Guidelines are more generous than those in the Guidelines for Out-of-Court Workouts or Turnaround ADR (e.g., regarding the deadline for eliminating liabilities in excess of assets, three years for the former, and five years for the latter), several requirements can be construed flexibly depending on the debtor’s circumstances based on the SME Restructuring Guidelines. 

C)    Subsidies for Expert Costs

In the case where an out-of-court workout based on the SME Restructuring Guidelines is carried out, provided that certain requirements are satisfied, it is possible to apply to the Small and Medium Enterprises Agency (Chusho-kigyo Cho) for subsidies to cover two-thirds of the costs of outside experts and third-party supporting experts (up to JPY 7 million).

Comparison Table of Rule-Based Out-of-Court Workout Frameworks

 *Although there are some differences in the wording, each framework has some room for exceptions to such thresholds with legitimate reasons, such as characteristics of the debtor’s industry or any other unique circumstances. 

Over the past decade, a large proportion of SME out-of-court workouts has been conducted by SME Revitalization Support Councils (currently, SME Vitalization Councils) under the Councils Scheme. However, since the number of SMEs requiring restructuring by out-of-court workouts may increase due to the economic and social background mentioned in the Introduction, the SME Restructuring Guidelines should be paid attention to as they can provide another channel by the private sector for SME out-of-court workouts.

Conclusion

Given not only COVID-19 but also the Russia-Ukraine conflict, the rapid weakening of the yen, and the spike in raw material prices, Japanese SMEs will be in an even more severe situation in the future; therefore, the SME Restructuring Guidelines are expected to be used for swift and smooth SME restructuring.