Capital Structure, Creditor Composition, and Insolvency Law in Japan

This article identifies potential relationships between the methods by which large firms in the business sector are externally financed and creditors’ determinations to resolve business failure through private negotiation or formal insolvency proceedings. Prior to the deregulation of Japan’s capital markets in the 1980s, large firms relied heavily on bank debt as a source of external capital. Consequently, their capital structures and their creditor compositions were relatively homogenous. Japanese banks appeared to primarily resolve the failure of their borrowers through private reorganizations or liquidations rather than court proceedings, and evidence suggests that creditor homogeneity was a favorable condition for the negotiated resolution of business failure. Japan’s corporate insolvency laws were used relatively infrequently and suffered from procedural and substantive defects that likely discouraged their use. The deregulation of Japan’s capital markets in the 1980s enabled large firms to raise debt capital by issuing bonds, which over time resulted in the diversification of firm capital structures and creditor compositions. This had significant consequences for the ability of creditors to negotiate the resolution of their borrowers’ business failure. Japan’s long recession in the 1990s pushed many firms close to insolvency, yet it appears that changes in capital structure and creditor composition adversely affected the availability of negotiated resolution of business failure, and Japan’s insolvency laws remained problematic. This article suggests that Japanese banks developed unusual and seemingly irrational lending strategies for distressed borrowers, given their inability to resolve business failure through private negotiations or formal insolvency proceedings. At the turn of the century, the Japanese legal community spearheaded significant reforms of Japan’s insolvency laws, and a prolonged surge in filing rates indicates that creditors quickly seized upon legal reforms to force reorganization of distressed borrowers. While this article’s findings are preliminary, it represents an agenda for further research on this topic