Corporate restructuring during performance declines in Japan

JOURNALOF

hnanc ELSEVIER

Journal of Financial Economics 46 (1997) 29-65

ECONOMICS

Corporate restructuring during performance declines in Japan 1 J u n - K o o Kang a, Anil Shivdasani *'b College of Business Administration, Korea Universio,, Seoul 136-701, South Korea bKenan-Flagler Business School, Universi O, of North Carolina. Chapel Hill. NC 27599, USA

Received 16 November 1993; received in revised form 4 February 1997

Abstract This paper documents the restructuring of 92 Japanese corporations that experienced a substantial decline in operating performance between 1986 and 1990. These firms implement a number of downsizing measures such as asset sales, plant closures, and employee layoffs. Firms also expand and diversify, and often restructure their internal operations. Compared to US firms with a similar decline in performance, however, Japanese firms are less likely to downsize, and layoffs affect a smaller fraction of their workforce. The frequency of asset downsizing and layoffs in Japanese firms increases with the ownership by the firm's main bank and other blockholders. Blockholders also increase the probability of management turnover, outside director removals and outside director additions, but decrease the likelihood of acquisitions. We document improvements in operating performance following downsizing actions in Japan. Keywords. Restructuring; Financial distress; Japanese corporate governance; Ownership

structure; Main bank system JEL classification: G32; G33; G34; L14

* Corresponding author. Tel.: + 1 919 962 3182; E-mail: [email protected] t We thank David Denis, Geoffrey Lysaught, Steve Kaplan (the referee), Bill Schwert (the editor) and seminar participants at Arizona, Indiana, Michigan State, North Carolina, Pittsburgh, and Purdue universities,the 1997 American Finance Association, and the 1997 Association of Financial Economists for helpful comments. We are grateful to Terry Ursacki for assisting in collecting some of the data used in this study. Shivdasani acknowledges support from the Center for International Business Education and Research and an All-University Research Grant at Michigan State University. 0304-405X/97/$17.00 ~, 1997 Elsevier Science S.A. All rights reserved PII S 0 3 0 4 - 4 0 5 ( 9 7 } 0 0 0 2 4 - X

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J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 2 9 6 5

1. Introduction The ability of firms to respond to a decline in performance, and the nature of these responses, are important factors that affect their organizational efficiency. In this paper, we investigate the nature of corporate reorganization activitie, s during poor performance for a sample of Japanese corporations. While there Js an extensive literature on the restructuring activities of US corporations, relatively little systematic evidence exists for Japanese firms. 2 Our analysis is motivated by the dramatically different nature of contractual relationships that govern Japanese corporations. In the United States, banks are restricted from owning equity of other firms) In contrast, Japanese banks are permitted to own up to 5% of the outstanding shares of their client firmsff Most Japanese firms maintain ties to a main bank, which is typically the firm's largest lender and also has a substantial equity ownership stake. In addition, firms also maintain close trading and ownership ties with other corporations. Sometimes, these lending, ownership, and trading ties arise from a firm's affiliation to an industrial group known as a keiretsu, although firms not affiliated with a keiretsu also maintain ties to a main bank and other shareholders. The extent of external takeover activity also differs dramatically between the US and Japan. In contrast to the extensive takeover market in the US, tender offers, mergers, and proxy contests are virtually unknown among large Japanese corporations. 5 Several authors have argued that the external takeover market plays an important role in the restructuring of US firms. Bhagat et al. (1990) and Berger and Ofek (1996a) document that successfully acquired firms usually undergo an extensive restructuring involving asset sales, plant closures, and layoffs. Mitchell and Lehn (1990) tind tha! targets of takeover attempts often divest prior acquisitions that were viewed unfavorably by the market. In addition, Berger and Ofek (1996b), and Denis et al. (1997) argue that firms that implement corporate refocusing programs often do so in the presence of external control pressures such as takeover' attempis and block share purchases. Given the importance of external corporate control activity in the restructuring of US corporations and the absence of such activity for Japanese firms, we examine how the extent and nature of restructuring activities among Japanese

2See for example, Gilson (1990), Gilson et al. (1990~,John et al. 11992),Ofek (1993), Brown et al. (1993, 1994), Asquith et al. (1994), and Lang et al. (1995). 3Roe (1990) provides a detailed discussion. Prior to 1987,the Japanese Anti-MonopolyLaw allowed banks to own up to 10% of a firm's outstanding equity. Since 1987, the legal limit has been lowered to 5% of the outstanding shares. 5See Kester (1991), Kaplan (1994), and Kang and Yamada (1996~for evidence on the takeover market in Japan.

J-K. Kang, A. Shivdasani/Journat of Financial Economics 46 (199 D 2 ~ 6 5

31

firms compares with that of US firms. Our analysis compares 92 publicly traded Japanese manufacturing firms and 114 publicly traded US manufacturing firms that were initially healthy, hut suffered a substantial decline in their operating performance in a given year during 1985 to 1990. We find that, in many respects, the responses of Japanese firms are surprisingly similar to those of US firms. Over 20% of the Japanese firms engage in some form of contraction of their assets or operations, such as asset sales, plant closures, or the withdrawal from a line of business. Almost 30% of the firms implement significant changes in their employment practices such as layoffs, early retirement incentives, or the', reduction in salary and bonuses. One-third of the firms experience turnover of the top executive, and in one-third of these cases, the successor is appointed from outside the firm. There is however, heterogeneity in the manner in which firms react. Some firms expand their operations, while some downsize, and several do both. Some firms undertake actions to reduce operating costs and increase production efficiencies, while others respond by cutting inventories and selling marketable securities. These changes occur in the absence of takeover attempts or threats, and outside of formal workouts and court-supervised proceedings. Comparison of the Japanese responses to those of US firms also suggests some important differences. First, while downsizing of assets occurs in about 23% of the Japanese firms, the corresponding frequency is almost 50% for US firms. In addition, layoffs in Japanese corporations resul~Lin a smaller change in firm employment than do layoff's in US firms. For US firms that announce layoffs, employment drops by almost 15% in the two years surrounding the performance drop; the comparable drop is only 4.7% for Japanese firms. Japanese firms also appear more likely to expand their operations than US firms. Of the Japanese firms in the sample, 76% undertake some expansion activity, compared to 55% for the US sample. There is also some evidence that the Japanese expansions, particularly those thin occur by means of an acquisition, are likely to represent diversification activities. In contrast, the majority of acquisitions by US firms occur in related industries. Consistent with prior studies on restructuring of US corporations, we find that our sample of US firms experiences a high incidence of external takeover activity. Given the absence of this activity for Japanese firms, we investigate whether alternative mechanisms that facilitate restructuring exist in Japan. Our results suggest that the Japanese actions are systematically related to the distribution of ownership claims. Firms with greater equity ownership by the main bank are more likely to engage in contraction policies by the use of asset sales, plant closures, and discontinuation of operations. In addition, greater equity ownership by the main bank also increases the probability of employee layoffs and the removal of outside directors from the board. We also find that blockholders other than the main bank play a very important role in influencing the probability that certain operational actions will be taken in response to the

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J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

performance decline. Increased blockholder ownership is associated wilh a greater likelihood of downsizing, and a reduction in the likelihood of makirLg acquisitions. Blockholders also play an important role in the likelihood of control change in our sample firms. We document that ownership by blockholders increases the likelihood of management change, the likelihood that the incumbent president is replaced with a successor from outside the firm, the probability of removal of outside members of the board, and the probability that new outside directors are appointed to the board. Our evidence is consistent with recent theoretical arguments. Admati and Pfleiderer (1994) consider an entrepreneur who has an incentive to continue projects even when it is optimal to terminate them. They demonstrate that such suboptimal decisions will be avoided with a presence of an informed creditor with a fixed fraction claim, such as equity. Admati and Pfleiderer (1994) suggest that venture capital organizations and Japanese banks and blockholders represent examples of such informed investors. In a similar vein, Jensen (1989) compares the Japanese main bank system to that of LBO partnerships in the US. He argues that the joint ownership of debt and equity claims by informed investors results in stringent managerial monitoring and creates strong ince~atives for managers to make value-maximizing decisions. Our analysis confirms and extends related work by Kaplan (1994), Kaplan and Minton (1994), and Kang and Shivdasani (1995) who examine changes in the control rights in Japanese firms. Kaplan (1994) finds that the probability of top management turnover in Japan is negatively and significantly related Lo various measures of firm performance. Kang and Shivdasani (1995) find that the relation between turnover and performance is stronger for firms with close ties to a main bank. Kaplan and Minton (1994) document that appointments of outsiders to the boards of Japanese corporations are more likely to occur when performance is poor. This paper extends this literature by examining how the investment and operating decisions of Japanese corporations compare to US firms during poor performance. Consistent with the role of Japanese banks and blockholders during turnover events documented by these prior studies, we find that they also have an important influence on operating and investment decisions during periods of poor performance. In this respect, Japanese banks and blockholders perform some of the functions generally thought to be performed by the takeover market in the US. Our paper is also related to previous work by Hoshi et al. (1990) and Sheard (1994) who examine the role of Japanese banks when firms are financially distressed. Both studies document that the main bank plays a crucial role in restructuring client firms during periods of prolonged financial distress. Unlike these studies however, our sample firms experience at least one year of poor operating performance but most do not experience a prolonged bout of financi~al distress. Further, our results continue to hold when we exclude the six firms in our sample that become financially distressed as a result of the performance

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

33

decline. To the extent that observed actions such as downsizing and layoffs represent optimal responses to a shrinking investment opportunity set, our results suggest that main banks and blockholders help preserve firm value by triggering responses even when firms are not financially distressed. Thus, while main banks unarguably assume a critical role during financial distress in Japan, our results imply that the role of main banks is important even when firms are not in financial distress. This interpretation accords with Kaplan (1994) and Kaplan and Minton (1994) who also suggest that main bank monitoring can be important even when firms earn enough to satisfy debt payments. The paper is organized as follows. Section 2 describes the data. The responses of firms subsequent to the earnings shock are described in Section 3. In Section 4 we conduct a multivariate analysis of firm responses. Section 5 examines the changes in performance of Japanese firms subsequent to the performance drop. Section 6 concludes.

2. Data

In this section, we discuss our sample selection criteria for Japanese and US firms and describe the performance of the sample firms.

2. l. Sample We construct our sample using data from the Pacific-Basin Capital Markets (PACAP) Research Center data base. Our objective is to identify a set of firms that were initially healthy, but suffer a material drop in performance. Since we are interested in documenting the nature of firm responses, it is important to identify firms at the onset of their poor performance. With this objective in mind, we first identify all manufacturing firms listed on the First Section of the Tokyo Stock Exchange (TSE) during 1985 to 1989 that have a ratio ofpretax operating income to assets that exceeds the industry median. To avoid including firms that may be financially distressed prior to the performance shock, we also require that the ratio of operating income to interest expense be greater than one. For this set of 'healthy' firms in a particular year, 'we examine the subset o f firms that experienced a decline of at least 50% in their pretax operating income in the subsequent year. Thus, sample firms experience a performance decline in at least one year in the 1986 to 1990 period. Henceforth, we also refer to the year of the performance decline as the shock year, and the year prior as the base or the pre-shock year. This procedure results in a sample of 92 firms. Although we do not impose any such a priori restriction, no firm enters our sample twice. Using the ratio of operating income to interest expense as an indicator of financial distress, 6 firms become financially distressed as a result of the performance decline. Of these, 5 firms have negative operating income in the year of the performance shock.

34

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29~65

Thus, fewer than 7% of our sample firms become financially distressed in the year of performance shock. In this regard, our sample differs substantially from that of Hoshi et al. (1990), who examine a sample of only financially distressed firms. Our sample selection allows the inclu,;ion of firms that performed poorly, but were possibly able to avoid becoming fnancially distressed due to subsequent restructuring. We use an accounting measure of performance, rather than stock returns, to identify* the onset of poor performance for two reasons. First, in principle, stock returns can incorporate the ability of certain governance structures to recover from performance declines. For example, if firms with strong ties to a main bank recover quickly from performance shocks, and if this information is reflected in stock returns, then, ceteris paribus, firms with strong bank ties will experience a smaller decline in stock returns, and are less likely to be represented in a sample selected according to stock return performance. Second, as documented in French and Poterba (1991), during our sample period, the average level of the Japanese stock market first rose appreciably, and then experienced a rapid drop. Several observers, referring to this as a 'bubble effect', have questioned the reliability of stock prices in Japan as an accurate measure of firm performance during this period. One issue of potential concern is whether our sampling procedure introduces any selection bias. Since the PACAP data base does not contain information on firms that were acquired, went bankrupt, or were delisted, there is potential for surviw)rship bias in our sample. To investigate this issue, we identify firms that were delisted from the TSE by examining issues of the Japan Company Handbook from 1985 to 1990. Over this period, l0 firms were delisted from the First Section of the TSE. Of these, 6 firms were merged, 3 went bankrupt, and 1 changed listing to the Second Section of the TSE. However, using data from the Japan Company Handbook prior to their delisting, none of these firms satisfied the criterion for inclusion in the sample. Thus, our sample appears to be free from survivorship bias. Table 1 presents summary statistics on the sample firms for the year prior 'm (Year - 1), and the year of (Year 0) the performance shock. For interpretational convenience, values in Japanese yen are converted to US dollars using the month-end exchange rate at the end of the firms' fiscal year. In the pre-shock year, the mean (median) value of assets is $1017 ($368) million, and the mean (median) market value of outstanding equilLy is $869 ($438) million. The market value of equity of the largest firm in our sample is $9069 million, while that for the smallest firm is $56 million. While the median firm size is small, our sample includes several well known firms, such as. Toshiba Ceramics, Suzuki Motors, Kawasaki Steel, and Nippon Steel. Using the ratio of pretax operating income to assets as an accounting measure of performance, the sample firms appear profitable prior to the performance shock. The median return on assets for Year - 1 is 6.9%, and the sample firms

J-K. Kang, A. Shivdasani/'Journal of Financia! Economics 46 (1997) 29-65

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J-K_ Kang. A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

outperform the industry by 1.6% using this measure. In Year 0, median return on assets declines substantially to 2.5%, and the sample firms underperform the industry by 1.3%. The performance shock appears to alter the probability of encountering financial distress. The median ratio of operating income to interest expense in Year -- 1 is 4.76; this ratio drops to 1.26 in the year of the performance shock. Interestingly, the current ratio actually increases in the shock year. One explanation for this increase is that firms engage in actions l:o improve their liquidity in response to the shock. Overall, these statistics suggest that the sample contains firms that are initially healthy, but suffer a significant decline in performance in Year 0. As a basis for comparison, we also construct a sample of US manufacturing corporations listed on the NYSE or AMEX that experienced a similar performance decline between 1986 and 1990. To enter into the sample, we require that a firm have an operating income to assets ratio that exceeds the industry median in the base year, have an interest coverage ratio that exceeds one in the base year, and that operating income decline by at least 50% in the shock year. The performance data for US firms is obtained from Compustat. As with the Japanese sample, no US firm enters our sample twice. Table 1 shows that the US firms are smaller than the Japanese firms wi~:h mean (median) assets of $642 ($114) million. As with the Japanese sample, US firms experience a substantial drop in performance during the shock year. US firms have median operating return on assets of 16.7% in the base year, and this declines to 5.6% in the performance shock year. The median firm outperforms the industry by 3.8°/; in the base year, but underperforms the industry by 4 % in the performance shock year. Using the ratio of operating income to interest expense as an indicator of financial distress, 39 US firms become distressed as a result of the performance decline. Of these, 20 firms experience negative operating income in Year 0. Thus, compared to the Japanese sample, the US sample consists of a much larger proportion of firms that become financially distressed as a result of the performance decline. 2.2. D a t a on f i r m r e s p o n s e s

To examine the responses of Japanese firms during the performance decline, we collect data on corporate actions from a variety of sources, including the Nihon Keizai Shinbun, Nihon Sangyo Shinbun, Asian Wall Street Journal, Japan Economic Times, Lexis-Nexis, and the Wall Street Journal. Of these sources, the Nihon Keizai Shinbun and Nihon Sangyo Shinbun appear to provide the most detail on firm responses. 6 All sources are examined for stories

6 Nonetheless, the level of detail appears to be less than what is typically available for US corporations. For example, in several cases, the newspaper articles do not specifywhich assets are

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

37

in the year of, and the year subsequent to the performance shock. Similar data on US firms is obtained from the Wall Street Journal, Dow Jones News Retrieval Service, and Lexis-Nexis. We also collect data on the reported reasons for the performance decline. These reasons are summarized in Table 2. While some firms identify a single primary cause for the earnings shock, several firms report multiple reasons. Thus, the classifications are not mutually exclusive. For Japanese firms, the appreciation in the strength of the yen is cited with the highest frequency. This reason is noted in 55 of the 92 cases, representing almost 60% of the sample. In 42 instances, firms blame other exogenous factors such as poor economy-wide or industry conditions, a low demand, or a low price for their products. In 4 cases, firms identify the poor performance of their major customers as a reason for the shock. Overall, 70 Japanese firms, representing 76% of the sample, cite an exogenous reason for the decline. Nonetheless, the performance drop in Japanese firms is not solely due to exogenous factors. Several firms note other factors contributing to the decline. In 12 cases, high operating, distribution, depreciation, or inventory costs are blamed. In 2 cases (Toshiba Machine and Kyocera Corp.), the performance decline is due to aftershocks of illegal trading practices at the firm. 7 Two pharmaceutical firms in the sample attribute the decline to poor performance of certain key drug products. Finally, one firm reports substantial cost overruns at a new plant, while lawsuits and losses on foreign exchange forward contracts are blamed by another three firms. Endogenous factors are cited by 17% of the firms, while in 4 of the firms, an endogenous factor is the only reason mentioned in the newspaper articles. While managers probably have an incentive to blame the performance shock on exogenous factors, analysis of the reasons nonetheless indicates that a wide variety of factors is likely responsible for the performance decline of our sample firms. Consistent with the findings of John et al. (1992), a substantial fraction of the US firms also blame exogenous factors such as poor economy or industry conditions for the drop in performance. The impact of such exogenous factors are noted by 68 (61%) of the US firms. However, 23% of the firms also state high operating costs as a factor contributing to poor performance. Overall, 35 (31%)

sold, the proceeds from asset sales, or the intended use of the proceeds. These omissions complicate the analysis because when several data sources cite asset sales, we are anable to verify whether they all refer to the same set of assets, or refer to several independent events. Thus, we are typically only able to determine whether or not a particular firm engages ill a given action such as an asset sale, but not the exact numbers of events involved or the magnitude of the transaction. 7 In the most notorious of these, Toshiba Machine Corp. was accused of violating Coordinating Committee for Controls on Exports to Communist Block (COCOM) rules due to clandestine sales of US submarine propeller technology to the Soviet Union. In response to these violations, the US Senate passed a bill calling for sanctions on Toshiba Machine, and banning its exports to the US.

38

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

Table 2 Reported reasons for performance decline. The sample consists of 92 Japanese manufacturing firms listed on the First Section of the Tokyo Stock Exchange and 114 US manufacturing firms listed on the New York or American Stock Exchange during 1986 to 1990. Sample firms have a ratio of pretax operating income to assets that exceeds the industry median in a given year and experience a decline of at least 50% in operating income in the subsequent year. Data on reported reasons for Japanese firms are obtained from the Nihon Keizai Shinbun, Nihon Sangyo Shinbun, Asian Wall Street Journal, Japan Economic Times, and Lexis-Nexis. 1)ata on reported reasons for US firms are obtained from the Wall Street Journal, Dow Jones News Retrieval, and Lexis-Nexis. The classification of reasons is not mutually exclusive, so firms reporting multiple reasons are indicated more than once in the table Japanese firms Reason

US firms

Number

(%)

Number

(%)

55 14 13 15 4 2

(59.8)

2

(1.8)

[15.2) (14.l) (16.3) [4.3) (2.2)

26 37 20 0 8

(22.8) (32.5) (17.51 (0.0) (7.0)

5 3 2 2 2 2 2 1 l 0

(5.4) 0.3) [2.2) (2.2) (2.2) (2.2) (2.2) (1.1) (1.1) (0.0)

1 26 3 7 1 0 0 0 2 1

(0.1) (22.8) (2.61 (6.1) (0.1) (0.0) (0.0) (0.0) (l.8) (0.1)

Exogeneous factors Unfavorable exchange rates Declining demand/low sales of products Poor economy or industry conditions Lower prices for products Poor performance of major customers Competition

Endoyeneousfactors High depreciation costs High operating costs High distribution costs Excessive inventories Illegal business practices Efficiency of drug downgraded Losses in forward markets Startup costs at new plant Lawsuits Past acquisitions

of the US firms mention an endogenous factor, and in 16 (14%) firms, an endogenous factor is the only reason identified for the decline in performance.

3. Responses to performance shock

In this section, we describe the operational actions of the Japanese and US firms that we study, and discuss the actions taken by the sample firms. We analyze changes in firm size and employment surrounding these operational responses, and also compare the changes in financial structure that occur around the performance decline.

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

39

3.1. Operational actions We classify the actions that the sample firms take in response to the performance decline into seven broad categories. (1) Asset contraction policies: These include the sale of assets, spinoffs of units, plant closures, and product or line withdrawals. Because the performance shock is likely due to either poor performance of some assets ,or operations, or due to a substantial shift in the firm's investment opportunity set, or both, we expect that some of the firm's operations are likely to be rendered economically unviable. Under this scenario, some contraction of the firm's operations is likely to be warranted. Using data on US firms, John and Ofi.~k(1995) find that firms that sell assets experience subsequent improvements in operating performance. (2) Changes in employment policies: These include employee layoffs, reductions in compensation or bonuses, and other actions that significantly affect the composition or compensation of the firm's employees. Layoffs of employees and other similar changes are likely to occur when firms downsize, or adopt more efficient or capital intensive production techniques. (3) Expansion policies: We document actions that enhance the scale or scope of operations for our sample firms. Such actions include joint ventures, acquisitions, construction of new plant,;, increased output or capital expenditures, etc. Expansion will be an optimal action if it represents a valuable investment opportunity such as a strategic acquisition, or a strengthening of distribution channels in response to declining sales. However, as suggested by Jensen (1986), expansion activities that represent diversification strategies or result in a loss of focus can be detrimental to firm value. (4) Internal reorganizations: Actions included in this category represent responses that involve a restructuring without a downsizing or enhancement of the scale of the firm's operations. Examples of such actions include changing production methods, incorporating technological advances in product development and design, and cost-cutting efforts. (5) Changes in control: We identify changes in control of the corporation by collecting data on the identity of the President for Japanese firms, who is similar to the CEO in US firms. For US firms, we track the identity of the CEO. Kaplan (1994) finds that the probability of management turnover in large Japanese firms is inversely related to firm performance. In addition, we examine the addition and removal of outside directors to the board. Kapl[an and Minton (1994) provide evidence that such directors perform an important governance function in Japanese corporations. We use the definition of outside directors adopted by Aoki et al. (1994) and Kaplan and Minton (1994) and ~;onsider those directors that have prior experience at other organizations to be outsiders. Retired government officials, non-Japanese directors, and auditors are not considered to be outside directors. Our results are unchanged if auditors are considered to be outsiders. For US firms, we define outside directors to be directors that are not

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J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

employees of the firm, nor have reported business, family, or prior employment ties with the firm. Unlike data on other responses that are collected from newspaper stories, data on board changes t0r Japanese firms are obtained from issues of Yakuin Shikiho and Kigyo Keiretsu Soran. For US firms, these data are obtained from proxy statements. (16) External takeover activity: We document instances where firms are the target of external takeover pressures. This includes successful and unsuccessful tender offers, merger and LBO proposals, and proxy contests. Because some firms may restructure in response to a takeover threat that does not materialize, we also tabulate the incidence of offers that are reported to be contemplated or in negotiation, as well as large block purchases of a company's stock. (7) Miscellaneous actions: This is a residual category of actions that do not fall in any of the categories above, and includes responses such as the sale of marketable securities, and corporate name changes. 3.1.1. ,Japanese responses The responses for Japanese firms are reported in Table 3. Of the various responses indicating a contraction, the reduction of capital expenditures occurs most frequently. Seven firms respond in this manner, and an additional four cut their production capacity, while two firms also suspend production. Four firms engage in asset sales, and tive firms engage in plant closures. Withdrawal from a li~e of business occurs in four firms, and in one case, a firm conducts a spinoff. Of the 92 firms in the sample, 21 (22.8%) engage in some form of asset contraction. Japanese firms also make substantial changes in their employment and compensation policies. The most frequently occurring form of such adjustments is via layoffs. This happens in 16 of the sample firms. In most cases, the number of employees laid off"represents a substantial fraction of the workforce. We are able to reliably assess the number of employees laid off for 15 firms. In these instances, the average number of employees laid off is 2521 and the median number of employees laid off is 440. For these firms, layoffs represent a mean of 20.9%, and a median of 20%, of their total workforce. The layoffs in our sample are typically implemented through early retirement programs and by the transfer of employees to affiliated firms. In some instances, the layoffs represent an important component of the restructuring program. For example, in the case of Nippon Steel, 19,000 of its 65,000 workers were laid off, 1500 of its blast furnace workers were reassigned to other divisions, and head office staff was reduced by 33%. The firm also simultaneously implemented a productivity wage system to tie worker salaries to productivity. The incidence of layoffs in our sample is, of course, correlated with the incidence of asset sales and plant closures. Of the 16 firms where employees are laid off, two firms sell assets and three firms close plants. However, such changes in asset structure are not a necessary condition for layoffs to occur in our sample. Nine of our sample firms layoff employees without engaging in any form of asset downsizing.

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

41

Table 3 Frequency of operational responses during the year of and the year following the performance decline. The sample consists of 92 Japanese manufacturing firms listed on the First Section of the Tokyo Stock Exchange and 114 US manufacturing firms listed on the New York or American Stock Exchanges during 1986 to 1990. Sample firms have a ratio of pretax operating income to assets that exceeds the industry median in a given year and experience a decline of at least 50% in operating income in the subsequent year. Data on reported actions for Japanese firms are obtained from the Nihon Keizai Shinbun, Nihon Sangyo Sfiinbun, Asian Wall Street Journal, Japan Economic Times, and Lexis-Nexis. Data on reported actions for US firms are obtained from the Wall Street Journal, Dow Jones News Retrieval, and Lexis-Nexis. The classification of actions is not mutually exclusive, so firms reporting multiple actions are indicated more than once in the table

Action Asset contraction actions Cut or postpone capital expenditures Withdraw from line of business Close plant Cut production capacity Asset sale Suspend production operations Spinoff unit Shutdown of offices/branch

Japanese firms

US firms

Number

Number

(%)

(%)

7 4 5 4 4 2 1 1

('7.6) (4.3) (:5.4) (4.3) (4.3) (2.2) (l.1) ( 1.1 )

4 4 18 3 42 10 4 4

(3.5) (3.5) (15.8) (2.6t (36.8t (8.8/ (3.5t (3.5)

Total

21

(2.2.8)

56

(49.1)

Employment chanoes Layoffs Reduce director salary or bonus Pay cut for managers or employees Lower mandatory retirement age or offer early retirement incentives

16 12 8 3

(17.4) (13.0~ (5.4) (3.3)

36 2 7 4

(31.6) (1.8) (6.1) (3.5)

Total

26

(2:8.3)

42

136.8)

31 25

(33.7) (27.2)

17 3

(14.9t (2.6)

19 17 12 11 10 9 8 6 4

(20.7) (18.5) (13.0) (12.0) (1'0.9) (9.8) (8.7) (6.5) (4.3)

9 5 4 5 7 37 3 0 3

(7.9) (4.4) (3.5~ (4.4) (6.1) (32.5) (2.61 (0.0) (2.6)

70

t76.1)

63

(55.3)

Expansion actions Joint venture Increase output or expand existing production facilities New facility construction Establish subsidiary Increase capital expenditures New production Partial acquisition Full acquisition Expand distribution channels Diversify Setup research lab or increase R&D Total

42

J-K. Kang, A. Shit:dasani,,'Journal of Financial Economics 46 (1997) 29-65

Table 3. (Continued). Japanese firms

US firms

Action

Number

(%)

Number

{%)

Internal reoryanization actions Cut operating costs Modernize production techniques/equipment Reorganize existing production processes Reorganize subsidiaries/units Input acquisition policy changed Change product design or line Lower inventory More in-house production More efficient asset management Change pricing policy Improve product or production quality Improve distributional efficiency

16 10 11 9 8 5 6 22 1 3 2 1

(15.2) (10.9) (12.0) 9.8) (8.7) (5.4) (6.5) (2.2) (l.ll (3.3) (2.2) (1.1)

16 8 11 3 1 2 1 0 2 5 0 8

114.4) (7.0) (9.7) (2.6) (0.9) (1.8) (0.9) (0.0) (1.8) (4.4) (0.0) (7.0)

Total

4";'

(51.1)

35

(30.7)

30 13

(33.0) (14.3)

22 9

(19.3) (7.9)

l1 28 31)

(12.1) (32.6) t40.0)

7 43 46

(6.7) (42.6) (50.6)

56

(60.9)

66

(57.9)

External control activity Takeover rumors or negotiation Shareholder activism Proxy contest Successfully acquired Unsolicited offers Block purchases Unsuccessful LBO offers Chapter 11 filing

0 0 0 0 0 0 0 0

(0.0t (0.0) (0.0) (0.0) /0.0) (0.0) (0.0) (0.0)

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5.3) 1.8) 3.5) 7.0) 8.8) 18.4) 1.8) 0.9)

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0

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42

(36.81

Miscellaneous actions Sold marketable securities Lower bank debt or interest payments Cancel bond or equity issue Change company name Change accounting system

6 4 3 3 1

(6.5) (4.3) (3.3) (3.3) (1.1)

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15

(13.2)

Chanyes in internal control Turnover of the president/CEO Turnover of president/Cl_!O without assuming position of board chairman Outside successor appointed Outside director(st added to the board Outside director[s) removed from the board

Total

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 2 ~ 6 5

43

In 12 instances, firms announce that they are reducing compensation for top level managers and directors, or both. In eight firms, such compensation cuts affect managers and employees that are below the level of the board of directors. Finally, three firms reduce their m a n d a t o r y retirement age to downsize their workforce through attrition. While reducing asset size, production, and employment are c o m m o n responses, expansionary actions occur with the highest frequency in the sample. In the sample, 70 firms report some form of expansionary response. Of these, formation of joint ventures is the most frequent response',, and occurs in 31 firms. The second most frequent response, evident in 25 cases, is increased production or enhancement of existing production facilities. Nineteen firms engage in the construction of new plants and production facilities, while 17 firms establish non-manufacturing subsidiary operations. Over 20% of the sample firms also engage in some acquisition activity. Interestingly, six tirms explicitly mention that they are expanding for diversification reasons. C o m m e n t and Jarrell (1995), Lang and Stulz (1994), Berger and Ofek (1995), and Servaes (1996), however, document that diversification activities adversely impact firm value in the US, and Lins and Servaes (1997) find that diversification is also detrimental to firm value in Japan. Since acquisitions provide a nalural mechanism for managers to pursue diversification policies, this observation raises the possibility that some of the acquisitions by our sample firms may not represent value-maximizing decisions, s The expansionary and contractionary policies evidenced by the sample of Japanese firms are not mutually exclusive. Of the 21 firms that engage in some form of contraction, 19 firms also respond by expanding. Of these, eight firms make an acquisition. Thus, in some instances, firms that we consider to be downsizing may actually experience increases in firm size, if, for example, they also make a large acquisition. Therefore, in the subsequent analysis, we also consider the subset of firms that downsize but do not make any acquisitions. Firms also respond with significant changes in board-level control rights. Thirty (33%) firms experience a change in the president over the two year interval. For comparison, Kaplan (1994) reports that for a sample of the largest Japanese firms, the average likelihood of president turnover during a two-year interval is 30.5%. Thus, the level of overall turnover activity does not appear to be particularly high. Kaplan (1994) suggests that president tenure follows a conveyer belt property in Japan, where presidents retire at regular intervals without regard to firm

s Ideally, we would like to compare the industries of the targets to those of the bidders to classify the Japanese acquisitions as related or unrelated. However, since most of the acquired entities are privately held firms, units, divisions, and foreign corporations, data limitations preclude us from investigating the industrial classifications of the targets and bidders for the Japanese firms.

44

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29-65

performance. He also finds that it is customary for the retiring president to become the chairman of the board. Accordingly, we examine instances where the president is removed and does not assume the position of chairman, as indicators of disciplinary turnover events. There are 13 (14%) such cases in our sample. This is markedly higher than the 3.86% frequency reported by Kaplan (11994). As an alternative measure of disciplinary turnover, we also examiv~Le outside succession events. Following Kang and Shivdasani (1995), we consider a successor to be an outside appointment if he has been with the firm for thre,e years or less. They find that the frequency of outside appointments in Japanese firms is approximately 2.7% over a two year interval. There are 11 such outside appointments in our sample, implying a outside succession frequency of 12%. Thus, outside succession is approximately four times as likely to occur in our sample. In summary, although the overall extent of turnover does not appear to be different, the turnover experienced by our sample firms appears more likely to be disciplinary in nature. We also examine board-level changes other than the president. Twenty-eight (33%) of our sample firms add outside directors to the board. Kaplan and Minton (1994) for comparison, document that 12.9% of their sample firms appoint outside directors in a given firm-year. This suggests that the frequency with which firms appoint outside directors is relatively high in our sample. [f these additions represent the functioning of disciplinary mechanisms, we would expect that they are also associated with removals of incumbent outside directors. We are able to obtain data on outside director removals for 75 of our sample firms. Of these, outside directors depart in 30 (40%) firms. While we are not aware of a benchmark for comparison, this frequency of departures appears to be high. The incidence of outside director appointments is correlated with departures of incumbent outside directors. In 30 firms where outside directors are dropped, 18 (60%) firms appoint new outside directors. However, outside director appointments occur in only 8 (18%) of the 45 firms that do not experience removals of incumbent outside directors. Our sample firms also respond by taking other actions to reorganize their operations. Sixteen firms mention efforts to reduce their operating costs, and 11 firms discuss reorganization of their existing production processes. Ten firms also implement improved production techniques or modernize their equipment. The sample firms also take a number of other actions, such as changing product design, and changing input acquisition, asset management, inventory, distributional, and product pricing policies. 3.1.2. Comparison to US responses

Table 3 also summarizes the responses of US firms during poor performance. As we discuss below, eight US firms are successfully acquired in the year subsequent to the performance drop. For these firms, we collect data on restructuring activities up to the point that they are acquired, but not subsequent to the acquisition.

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 2 ~ 6 5

45

Almost 50% of the US firms engage in some form of downsizing. Asset sales represent the most frequently observed response (42 firms), followed by plant closures (18 firms), and the suspension of production (10 firms). Twelve firms also spinoff units, withdraw from a line of business or cut capital expenditures. Overall, 56 firms (49%) undertake asset contraction measures. Thus, US firms are over twice as likely to engage: in some form of asset contraction compared to Japanese firms, and certain actions, such as asset sales, occur almost 7 times more frequently among US firms. Layoffs are a frequent response among US firms, occurring in 36 (32%) firms. Six US firms also take other actions affecting their employees, such as pay reductions, or offering early retirement incentives. Overall, 37% of US firms make adjustments to their employment policies, compared to 28% for Japanese firms. US firms also frequently undertake expansionary actions, of which acquisitions are the most frequent form, occurring in 44 firm,;. We are able to obtain data on the Standard Industrial[ Classification (SIC) codes on both the bidder and the acquired firm, unit, division, or plant, for 30 acquisitions made by 25 firms. 9 Of these, the bidder and the acquired entity share the same four digit SIC code in 16 cases, the same three digit SIC code in 20 cases, and the same two digit SIC code in 22 cases. In an additional four cases, newspaper stories indicate that the operations of the acquired entity will be merged or integrated into the firm's existing operations. Further, we do not find any reference in newspaper reports indicating that these acquisitions reflect diversification strategies. Thus, unlike Japan, the majority of US acquisitions appear to be related to the bidder's existing line of business. Twenty-two (19%) firms in tile sample experience C E O turnover. For comparison, Weisbach (1988) documents an annual C E O turnover rate of 7.8%, Denis and Denis (1995) find a 9.3% rate, and Kaplan (1L994) documents a 9.7% annual C E O turnover rate for unconditional samples of US firms, while John et al. (1992) find a 12.5% annual C E O turnover rate for poorly performing US firms. Thus, our sample of US firms does not appear to display an abnormally high frequency of C E O turnover. There are nine cases where the outgoing C F O does not become chairman of the board. In seven firms, the new C E O is hired from outside the firm. Outside directors depart in over 50% of the sample firms, while., in 43% of the firms, an outside director is added to the board. The frequency of outside director appointments in the sample is comparable to those reported by Hermalin and

9 Data on SIC codes are obtained from Dun and Bradstreet's Million Dollar Directory. Directory of Corporate Affiliations,Ward's Business Directory, Dun's Industrial Guide - The Metalworking Directory, and Manufacturing Directories Microfiche. Most of the acquired entities are units, divisions, subsidiaries, or plants of other firms.

46

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 2 ~ 6 5

Weisbach (1988) and Kaplan and Minton (1994) for US firms. Thus, unlike Japanese firms, US firms in the sample do not display evidence of abnormally high levels of turnover among outside directors. Unlike Japan, where we find no indication of any explicit corporate control actions, such takeover activity is prevalent among our sample of US firms. Eight firms are successfully acquired via a merger or tender offer, while four are targets of proxy contests. An additional 12 firms receive leveraged buyout proposals or unsolicited offers (some of which result in a formal tender offer or proposal) that do not succeed. Twenty-one firms experience unsolicited block purchases c.f their equity, while one firm in the sample fi~es for Chapter 11. Overall, 37% of the firms experience some explicit external takeover pressures. In summary, the analysis of responses indicates that Japanese firms frequently respond to poor performance by downsizing their assets and operations, engaging in employee layoffs, removing top executives and directors, and implementing a variety of internal reorganization actions. While they are frequent responses, downsizing and layoffs do not occur with the same frequency in Japanese firms as they do for US firms. US firms are at least twice as likely to engage in an asset contraction, and almost 1Lwiceas likely to lay off employees;. US and Japanese firms also differ in the nature of their expansion policies during poor performance. We find some evidence to suggest that Japanese firms make diversifying acquisitions. While US firms also frequently make acquisitions;, acquired entities are often in industries related to the acquirer.

3.2. Operational responses and changes in firm size and emplovment In this section, we examine changes in firm size and employment to assess the magnitude of the firm responses to poor performance. Panel A of Table 4 reports changes in firm size, and Panel B reports changes in employment for firms according to the observed responses. Because of the relatively small sample sizes in some of the categories, we concentrate our discussion on median changes. Firm size declines by 4.64% from Year - 1 to Year 0 for Japanese firms that downsize. In comparison, changes in firm size over this interval are not significant for firms that do not downsize. When the change in firm size is measured over the Year - 1 to Year + 1 interval, however, we find no evidence of a reduction in firm size for downsizing firms, whereas there is a significant increase in size for firms that do not downsize. Firms that announce layoffs also experience a significant drop in firm size'.. For these firms, total assets drop by 7.3% during the performance shock year and by 8.6% for the two years surrounding the performance shock. In comparison, firm size increases by 8.6% over the two years for firms not announcing layoffs. As a broader measure of downsizing, we also consider firms that either engage in asset contraction or layoffs. For the median firm in this category, firm

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

47

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size declines by 5.1% during Year - 1 to Year 0, and by 3.5% during Year - 1 to Year + 1. Firms that do not downsize, in contrast, experience a median increase of 7.5% in firm size during Year - 1 to Year + 1. Increases in size are evident for firms making acquisitions. Acquiring firms have a median increase in firm size of 14.3% from Year - 1 to Year + 1. There are nine firms that both downsize by asset contraction or layoffs and also make an acquisition. An alternative way to identify firms that downsize is to consider the set of firms that contract assets or lay off employees without engaging in an acquisition. There are 21 such firms in the sample. For these firms, firm size declines by 7.1% during the one year, and by 7.4% during the two years surrounding the performance decline. Thus, this latter group of firms makes substantial reductions in the size of their operations. Panel B shows that firms engaging in layoffs have a median reduction in employment of 2.3 % during the year of performance decline and a 7.4% decline over two years. In comparison, firms that do not make layoffs experience a median increase of 1.2% in the performance shock year, but a statistically insignificant change over the two year interval. The reduction in employment :is also pronounced for firms that engage in asset contractions or layoffs without making an acquisition. For these firms, employment declines by 4.7% during Year - 1 to Year + 1. Changes in firm size for US firms announcing asset contraction, layoffs, or both, are statistically insignificant. There is marginally significant evidence of increases in firm size for US firms that make acquisitions. For these firms, size increases by 5.1% during Year - 1 to Year 0, and by 6.7% during Year - 1 to Year + 1; these increases are significant at the 10% level. US firms that downsize without making an acquisition experience a significant 7.35% drop in size from Year - 1 to Year + 1. For this ,category of firms, the magnitude of reduction in firm size is similar across US and Japanese firms. Employment drops by 8.6% over two years for US firms announcing layoff's. US firms that downsize by asset contraction or layoff without making an acquisition experience a 14.8% reduction in employment over this period. This drop is approximately three times the change in employment experienced by Japanese firms that downsize without making acquisitions. Thus, layoffs in US firms that downsize affect a larger fraction of the workforce than in Japan. In summary, Japanese firms announcing contraction in assets and operations, and those implementing layoffs, experience statistically significant reductions in firm size in the years surrounding the drop in performance. Similar reductions are not observed for firms that do not take such actions. Japanese firms making acquisitions experience an increase in firm size. Thus, the decline in firm size is most pronounced for firms that downsize without a concurrent acquisition. Significant declines in employment are also observed for Japanese firms with reported layoffs, and those that engage in contraction or layoffs without making an acquisition.

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 2~65

49

3.3. Capital structure and governance changes In this section, we describe the firm-specific variables that we use in the subsequent analysis to explain the likelihood that certain restructuring actions will be observed. Table 5 reports summary statistics on these explanatory variables, and the changes in these variables over the pre- and post-shock years. 3.3.1. Leverage Jensen (1989) argues that highly leveraged firms are more likely to restructure when their value declines. We calculate leverage as the ratio of total debt to total assets. 3.3.2. Bank ties Bulow and Shoven (1978) and Gertner and Scharfstein (1991) note that freerider problems faced by diffuse investors eliminate the incentive for such debtholders to bear monitoring costs. The joint ownership of substantial debt and equity by main banks can, however, provide monitoring incentives that are lacking in diffuse investors. Following Kaplan (1994), we use the ratio of bank borrowings to total assets to measure the strength of a firm's ties to a main bank. In unreported tests, we also consider the fraction of bank debt from the largest lender, and obtain similar result,~. We also use the equity ownership by the firm's main bank to measure its financial incentive to monitor. Data on bank ties is collected from annual issues of Kigyo Keiretsu Soran. 3.3.3. Ownership structure Jensen and Meckling (1976) argue that increased equity ownership by managers provides them with incentives to make value-maximizing decisions. Accordingly, we use the equity ownership by the board of directors as an explanatory variable. In addition, Demsetz and Lehn (1985), Shleifer and Vishny (1986) and Jensen (1989) note that large shareholders have incentives to take actions that enhance firm value. Blockholders are often trading partners in Japan, and thus hold a stake in the firm similar to that of debt (Berglof and Perotti, 1994). Such a joint stake as trade creditors and large shareholders should, in theory, provide incentives for blockholders to take actions that preserve or enhance firm value. We measure the importance of blockholders by the ownership of the firm's ten largest shareholders. Because main banks are also typically blockholders, we exclude ownership by the main bank since the effect of their ownership is examined separately. Henceforth, any unqualified reference to blockholders refers to those other than the main bank. 3.3.4. Keiretsu affiliation We categorize the Japanese firms as either belonging to a keiretsu or as being independent of corporate groupings. We focus on the six major keiretsus of Mitsubishi, Mitsui, Sumitomo, Fuyo, DKB, and Sanwa. In unreported tests, we

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

50

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J-K. Kang, A. Shivdasani /Journal of Financial Economics 46 (1997) 29 65

5l

also consider firms to be part of a keiretsu if they are members of the group's president's council, or part of the Tokai, IBJ, Nippon Steel, Hitachi, Nissan, Toyota, Matushita, Toshiba, Tokyu or Seibu Saisan groups. Using both approaches, we obtain results similar to those presented in the paper. Data on keiretsu membership is obtained from Industrial Groupings in Japan (1985). Table 5 shows the median leverage ratio for Japanese firms in the pre-shock year is 61%, and bank debt represents 11% of the book value of assets. The mean equity ownership by the main bank is 3.5%, with a median of 3.8%. The main bank is among the firm's ten largest shareholders in 63 firms. Of these, it is the largest shareholder in 12 firms, the second largest shareholder in 17 firms, and the third largest shareholder in 14 firms. Although main banks are usually important stockholders, they do not always own substantial equity stakes. In 24 instances (or 26%), the main blink owns no equity in our sample firms. The average equity ownership by the board of directors in the sample is 3.9%, but board ownership is highly skewed with a median of only 0.5%. On average, the non-main bank blockholders own over 46% of the firm's equity. Finally, 30% of the firms belong to a keiretsu. While operational actions are a common response 1:o poor performance in Japan, changes in financial and ownership :structure: do not appear to be a common response. Significant changes arc," obserw:d for only the equity ownership by directors, which declines by an average of 0.5%. There is some statistically weak evidence of an increase in firm borrowings from the main bank. However, these changes do not appear to be economically large. Median changes in the ratio of bank debt to assets, main bank debt to assets, and fraction of bank debt from the main bank are all close to zero. For comparison, Table 5 also reports changes in financial and ownership structure for US firms. For US firms, we use the ratio of short-term debt to assets as a proxy for bank debt. As with the Japanese firms, there do not appear to be substantial changes in the financial structure of US firms surrounding the decline in earnings. However, consistent with the high incidence of block share purchases and takeover attempts for US firms, we find a significant increase in the fraction of equity held by 5% blockholders. 4. The likelihood of Japanese firm responses In this section we investigate whether the likelihood of Japanese actions during performance declines is influenced by the distribution of the firm's debt and equity claims. 4.1. Multivariate results

Table 6 reports the results from logistic regressions where the dependent variable equals one if a particular action occurs, and is zero otherwise. The

52

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

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J-K: Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

regressions control for firm size, measured as the logarithm of the book value of assets. We include firm size in the re~gressions because we classify firms according to whether or not they take a particular action. Thus, for larger firms that operate more plants and have higher employment, ceteris paribus, a plant closure or layoff is more likely to be observed. Since firm size is also correlated with several other explanatory variables, controlling for size helps avoid an omitted variables bias in other coefficient estimates. We also control for firncl performance in the year of the performance shock by including the ratio of pretax operating income to total assets irk the regressions. In addition, we control for industry performance by including the median ratio of pretax operating income to total assets for the industry. In column (1) of Table 6, we examine the factors that influence the probability that a firm downsizes its assets or operations in response to the performance shock. The dependent variable in this model equals one if a firm sells assets, spins off one or more units, withdraws from a line of business, closes one or more,' plants, cuts production or reduces its production capacity, or shuts down store,; or offices. The most striking result is that contraction likelihood increases with equity ownership by lhe firm's main bank, and with the equity ownership by the firm's blockholders. The coefficient on equity ownership by the main bank i,; positive and statistically significant at the 1% level. Thus, controlling for other factors, firms are more likely to downsize when the main bank holds a signifi-cant equity stake. Alternatively, if the equity ownership by the main bank is a proxy for the strength of the ties a firm has to a main bank, this result suggest,; that firms with close main bank ties are more likely to respond by assel: contraction policies. Our results also indicate that blockholders perform an important role by increasing the likelihood of asset contractions. This observa.tion is consistent with theoretical work on the role of blockownership by Demsetz and Lehn (1985) and Shleifer and VJishny (1986), and with the empirical evidence on the role of blockholders in Japan by Kaplan and Minton (1994) and Kang and Shivdasani (1995). The probability that a firm engages in layoffs is examined in column (2) oF Table 6. As with the results on asset contraction, the probability of layoffs is positively related to the equity ownership by the firm's main bank. The coeffi.cient on this variable is positive and marginally significant with a p-value of 0.06. Layoffs are more likely when ownership by the firm's blockholders is high; however, this relation is significant at only the 11% level. Layoffs are also more likely when firms perform poorly and are less likely when firms belong to a keiretsu. As a broader measure of downsizing, we examine the probability that a firm engages in either a contraction of its assets or layoffs. These results are presented in column (3) of Table 6. As with the previous results, equity ownership by the," main bank is positively and significantly related to the likelihood of downsizing. The results on ownership by blockholders are also corroborated. Firms are,'

J-K. Kang, A. Shirdasani/Journal of Financial Economics 46 (1997) 29- 65

55

more likely to downsize when ownership by blockholders is high. These results suggest that firms with strong ties to banks and blockholders are more likely to take actions that reduce the scale of their operations. Column (4) of Table 6 presents regression results for the probability of an expansion. The only variable that enters the regression significantly is firm size. The coefficient on firm size is positive and significant at the 1% level. Industry performance also has a positive and marginally significant coefficient with a p-value of 0.07, suggesting that firms are more likely to expand during favorable industry conditions. None of the other variables measuring ties to banks and blockholders are statistically significant. Thus, the decision to expand does not appear to be systematically related to the financial or ownership structure of our sample firms. Our results on expansion likelihood differ from Hoshi et al. (1990) who find that firms belonging to a keiretsu or those that maintain close ties with a main bank invest more during financial distress. They interpret this finding as evidence that keiretsu and main bank ties overcome Myers' (1977) underinvestment problem during periods of financial distress. One possible explanation for this difference is that not all expansionary actions in our sample may be enhance firm value. As discussed in Section 3.1.1, several firms explicitly cite a desire for diversifying the firm's operations as a motive underlying the expansion. If, as suggested by Lins and Servaes (1997), the value-reducing consequences of diversification documented for US firms also extend to Japan, some of the expansionary actions by our sample firms may be detrimental to shareholder wealth. In column (5) of Table 6, we investigate this issue in more detail. We assume that responses such as acquisitions are more likely to represent diversification strategies than other expansionary responses that simply expand the scale of the firm's existing operations, such as enhancing production capacity, increasing research and development and capital expenditures, and engaging in joint ventures. Thus, we are interested in determining whether main bank and blockholder ties control the proclivity of Japanese managers to diversify by means of an acquisition. The results in column {5) suggest that this is indeed the case. The coefficient on ownership by blockholders is negative and statistically significant, suggesting that blockholders reduce the probability of an acquisition. The coefficient on ownership by the main bank is also negative, but statistically insignificant. 1° As previously discussed, downsizing may not be a meaningful response if a firm simultaneously makes a large acquisition. Thus, in column (16) of Table 6

lo In unreported tests, we also estimate models for the likelihood that a firm will undertake an internal reorganization. None of the explanatory variables are significant in these regressions. For the sake of brevity, these results are not reported.

56

J-K. Kang, A. Shit~dasani//Journal o f Financial Economics 46 (1997) 29 65 %-.

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we examine the likelihood that a firm downsizes by either an asset contraction or layoff without acquiring other assets or firms. As with the previous results on downsizing, this probability increases with the equity ownership by the main bank and by other blockholders. The effects of both main bank and blockholder ownership are significant with p-values of 0.03 and 0.01, respectively. There is also marginally significant evidence that such downsizing is negatively related 1:o firm performance and leverage. In Table 7, we examine the effect of governance structure on the likelihood of changes in board-level control rights. In column (1) of Table 7 we consider tile probability of a change in the identity of the president. The dependent variable in this model equals one if there is a change in the president, and is zero otherwise. In this model, the estimated coefficient on ownership by blockholders is positive with a p-value of 0.04, while none of the other variables are significant. One potential concern is that some of the, observed managerial turnover may represent normal succession. Accordingly, to focus on turnover events that are more likely to be disciplinary, we consider' the probability that a president is replaced and does not become chairman, in column (2) of Table 7. As with the results for all turnover, the coefficient on ownership by blockholders is positive and significant with this specification. An alternative way to identify disciplinary turnover events is to examine the origin of the successor, since outside suezcession is more likely to indicate a disciplinary turnover event. We examine the likelihood of such turnover in column (3) and find that it is also related to blockholder ownerslhip. The coefficient on this variable is again positive and significant. Consistent with Kang and Shivdasani (1996), we also find that outside succession is less likely for larger firms and those that are affiliated with a keiretsu. In column (4) of Table 7, we examine the probability that an outside director is added to the board. These results show that the probability of outside director additions is positively related to leverage and ownership by blockholders; these effects are significant at the 6% and 1% level, respectively. These results are consistent with Kaplan and Minton (1994) who document that the likelihood of corporate director appointments increases with blockholder ownership. In column (5) of Table 7, we estimate the likelihood that outside directors will be removed from the board in response to the performance shock. We find th~Lt equity ownership by both the main bank and the firm's blockholders significantly increases this probability, while none of the other variables are statis~:ically significant. Thus, blockholders play a particularly important role in reorganizing the composition of the board by facilitating both the removal of incumbent outsiders and the appointment ,of new outside directors. To provide some perspective on the economic magnitudes of the effects of main bank and blockholder ownership on restructuring activities, Table 8 reports the estimated probabilities from the logit models of Tables 6 and 7 where all variables are set to their" median values, while varying ownership by

J-K. Kang, A. Shivdasani/Journal of Financial Economics 46 (1997) 29 65

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59

60

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main banks and blockholders from the 25th to the 75th percentile (i.e. (~4.97°/o and 31.47-55%, respectively). The effect of main bank ownership on the probability of asset sales and layoffs seems economically important. Varying main bank ownership from the 25th to 75th percentile increases the probability of asset contraction from 2.2% to 9.5%, while, the probability of layoffs increases from 8.2% to 20.3%. Varying blockholder ownership over the interquarti]e range increases the probability of an asset contraction from 4.4% to 13.5%, the probability of layoffs from 11.3% to 29.2%, the probability of disciplinary managerial turnover from 6.7% to 22.8%, and reduces the probability of an acquisition from 28.1% to 5.3%. The probability that a firm downsizes without making an acquisition is only 9.7% when blockholder ownership is at the 25th percentile, but increases to almost 36% at the 75th percentile. Thus, the effecls of ownership by banks and blockholders on the likelihood of operational responses appear to be economically impo~rtant.

4.2. Additional tests To check the robustness of the results, we conduct several checks of model specification in unreported tests. We briefly summarize the results of these test;s.

4.2.1. Financially distressed firms Hoshi et al. (1990), Pascale and Rohlen (1983), and Sheard (1994) show th~tt main banks perform a critical role during the restructuring of firms in financial distress. To examine whether our results are driven by firms in financial distress, we also estimate the logit models excluding the 6 firms that became financially distressed as a result of the performance drop. We obtain qualitatively identical results, suggesting that banks and blockholders in Japan perform an important monitoring function even when firms are not financially distressed.

4.2.2. Controlling Jor liquidity We examine whether the inclusion of liquidity changes the nature of the results documented in the previous section. We find that liquidity, measured by either the current ratio, or the quick ratio, !in the base year is not significant in any of the regressions, and does not alter the qualitative nature of the other variables in the model.

4.2.3. Controlling for firm size The reported tests control for firm size since size is correlated with several explanatory variables. When size is excluded from the model, the coefficient on equity ownership by blockholders is not significant at the 5% level in models (]) and (3) of Table 6, but retains statistical significance in models (5) and (6) of Table 6 and all models in Table 7. The estimates of all other explanatory variables in these tables are qualitatively similar.

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4.2.4. Nonlinear effbcts of management ownership Several studies (e.g., Morck et al., 1988; Wruck, 1989; McConnell and Servaes, 1990, 1995) document that management ownership has a non-monotonic impact on firm value in the US. We test for potential nonlinearities in the effect of ownership by Japanese boards in several ways. First, we include a squared term for board equity ownership. Second, we include a piecewise linear specification using 1% and 5% as turning points. Third, we include a dummy variable if board ownership exceeds 5%. With all approaches, we are unable to detect any evidence of a nonlinear relation., and the qualitative nature of the results is unchanged. 4.2.5. Equity ownership by banks and blockholders Because of the importance that is generally ascribed to main banks in Japan, the preceding tests separately consider the effects of equity ownership of the main bank and other blockholders. We have also estimaled the tests combining the ownership of the main banks and of other blockholders, and obtain results that essentially mirror those of non-main bank blockholders reported in Tables 6 and 7. In addition, we estimate our regressions including an interaction term to test for possible differential effects of ownership by blockholders that are financial institutions and those that are corporations. These tests do not reveal such differences. 4.2.6. Multivariate analysis of US firm responses We estimate regressions similar to those in Tables 6 and 7 for responses by US firms, using firm size, firm and industry performance, leverage, ownership by boards and blockholders, and a dummy variable to indicate the presence of an external takeover threat. We find that the likelihood that a firm downsizes is inversely related to firm performance, but positively related to industry performance. That downsizing and industry performance are related is consistent with arguments by Shleifer and Vishny (1992) who suggest that firms are less likely to sell assets when the industry is performing poorly. We also find that the likelihood of downsizing is unrelated to blockholder ownership, but is negatively related to ownership by the board of directors. The role of blockholders, therefore, appears to differ between the US and Japan. One potential explanation for this difference is that, as shown in Table 4, the average ownership of Japanese blockholders is much larger than that of US blockholders. Alternatively, as suggested by Jensen (1989) and Admati and Pfleiderer (1994), as informed investors of both debt and equity claims, Japanese blockholders have a stronger incentive to monitor than do blockholders in the US. Finally, the results show that the presence of an external control threat increase the probability that a firm downsizes. We also estimate regressions to predict the likelihood of expansions, acquisition, CEO turnover, outside succession, and outside director additions and

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removals. We find no evidence that such actions are related to firms' financial and ownership structure in the US.

5. Firm performance following restructuring actions In this section, we examine the effect of downsizing actions on the operating performance of Japanese firms. We investigate whether operational actions such as asset contraction and layoffs result in improvements in firm performance subsequent to the performance shock. Improvements in performance could result from the divestiture or closure of relatively unprofitable operations;, a reduction in labor expenses, or fi'om eliminating negative synergies between divested and existing operations. Table 9 compares the changes in the industry-adjusted ratio of operating income to assets for the three years following the performance decline according to reported downsizing actions. Over the three years following the performance shock, industry-adjusted operating return on assets improves by 1.47% for firms announcing asset contraction, and by 1.22% for firms announcing layoff,;. A sign-rank test indicates these increases are significant at the 10% level. An Table 9 Changes in firm performance subsequent to performance decline. The sample consists of 92 Japanese manufacturing firms listed on the First Section of the Tokyo Stock Exchange during 1986 to 1990. Sample firms had a ratio of pretax operating income to assets that exceeds the industry median in a given year and experience a decline of at least 50% in operating income in the subsequent year. Tl'e table reports changes in performance for all firms as well as for subsamples classified by restructucing activities. Year 0 denotes the year of the decline in performance. Data is obtained from file Pacific-Basin Capital Markets Research Center data base. Numbers in parentheses report p-values from a two-tailed t-test for means and sign rank test for medians. Change in industry-adjusted ratio of operating income to assets

Firms All firms

Year 0 to Year + l

Year 0 to Year + 2

Year 0 to Year + 3

Mean

Mean

Median

Mean

Median

0.17 (0.11 )

1.05 (0.00)

0.74 (0.00)

1.27 (0.00)

1.24 (0.00)

1.03 (0.14)

0.37 (0.28)

1.48 (0,07]

1.47 (0,05)

0.24 (0.33)

Median

Asset contraction

- 0.22 (0.67)

0.37 (0.66}

Layoffs

- 0.12 10.79)

- 0.23 (0.68}

0.30 {0.50)

0.37 10.601

0.95 (0.061

1.22 (0,071

Asset contraction or Layoffs

- 0.15 (0.71)

- 0.32 (0.61)

0.90 (0.08)

0.68 (0.14)

1.44 (0.02)

1,54 (0,01)

Asset contraction or layofl~ without acquisition

- 0.25 (0.60)

- 0.21 {0.70t

1.26 {0.03)

1.00 (0.02}

1.85 (0.01)

1,68 {0.01}

J-K. Kang, A. Shivdasani/Journal of Financial tfconomics .¢6 (1997) 2 9 65

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improvement in operating performance is also evident for firms that announce either layoffs or asset contraction. These firms experience a median 1.54% increase in performance over the ~,;ubsequent three years. For the subset of these firms that do not make an acquisition, the median change in operating performance over the subsequent three years is 1.68%, which is statistically significant at the 1% level. Thus, analysis of changes in operating performance indicates that Japanese firms that downsize experience subsequent improvements in performance.

6. Conclusions

In this paper, we compare the restructuring of a sample of Japanese and US manufacturing firms that had a substantial decline in operating performance in a given year. We find several similarities in the operational responses by firms subsequent to the performance decline. Both Japanese and US firms downsize their operations by selling assets, closing plants, reducing capital expenditures and production, and through employee layoffs. Both groups of firms also expand their operations and make acquisitions. The US responses are accompanied by frequent external takeover pressures, while such explicit pressures are absent for Japanese firms. There are also some notable differences in firm responses between Japan and the US. The overall frequency of asset contraction actions among US firms is roughly twice that of Japanese firms, and the frequency of asset sales is almost seven times that of Japanese firms. Layoffs also appear to affect a larger fraction of the firm's workforce in the US than in Japan. We find that the responses undertaken by Japanese firms are related to the distribution of equity ownership and debt claims. In particular, the likelihood of an asset downsizing, employee layoffs and remowal of outside directors increases with ownership by the firm's main bank and by the firm's other blockholders. Increased ownership by bloekhohlers also decreases the likelihood of acquisitions, and increases the probability of top management turnover, outside succession events, and addition of outside directors to the board. These results suggest that the nature of the restructuring process during poor performance is a function of the distribution of claims among the firm's investors and that main banks and blockholders in Japan perform an important role in this process. While our results provide evidence on the importance of financial and ownership structure on the restructuring process during performance declines in Japan, they also raise some important questions. For example, if concentrated ownership increases the ability to respond during poor performance, why do not all Japanese firms have highly concentrated ownership'? Under what circumstances do the costs of strong bank and blockholder ties outweigh the benefits? How does the economic efficiency of the restructuring process in Japanese firms compare with the takeover-induced restructurings observed in the US?

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