Nippon Credit Bank, which came under state control in December 1998, was sold last Friday to a consortium led by Internet investor Softbank Corp. The contract includes a controversial clause that says the buyer (the Softbank group) can request the seller (the government) to buy back troubled NCB loans that have fallen in value by more than 20 percent within three years of the sale.

The government made a similar loss-covering arrangement when it sold the Long-Term Credit Bank of Japan, now called Shinsei Bank, to a U.S. investment group in March this year. In June, Shinsei Bank requested the government to take over problem loans extended to the failed department store operator Sogo Co., saying their value had dropped more than 20 percent. The buyback deal was widely criticized because it would increase the bill paid by taxpayers.

The Financial Reconstruction Commission, the regulatory body, defended the loss-covering provision this way: According to civil law, real-estate sellers are liable for defects found after the sale. This logic applies to the government sale of a nationalized bank (loans that go sour after the sale are considered “defects”). Failure to honor this provision would lead to a loss of the buyer’s trust and consequently to the cancellation of the contract itself. A guarantee of loss protection was needed to ensure the prompt transfer of a nationalized bank to private owners. This explanation is plausible, but it is not credible.

The legal stipulation of seller liability for defects applies to cases such as this: The buyer of a housing plot discovers a large hole under the ground — a defect that makes it impossible to build a home. The buyer can either cancel the contract or request compensation from the seller, who is clearly liable for the defect.

If the LTCB had been sold shortly after its nationalization without close examination of bank assets, the government probably would have been held liable for loan losses. After all, the bank remained under state control for nearly two years, so the FRC had plenty of time to check on Sogo. In fact, Sogo loans were transferred to Shinsei Bank on the premise that the troubled retailer would recover in due course.

As it turned out, Sogo went bankrupt. The reason, according to the FRC, is that the company had misjudged the economic situation, particularly business prospects for the department-store industry — and not because of problems in the FRC screening of Sogo debt. If so, it would be unfair to hold only the seller liable. It would make business sense, as legal experts point out, to hold the buyer liable as well.

The buyback clause is a tacit admission on the part of the seller that asset assessment cannot be 100 percent accurate and that future loan losses cannot be ruled out. However, it also provides an explicit guarantee that the seller will cover such secondary losses unilaterally, albeit under given conditions. This puts an unfair burden on the government and thus distorts the loss-covering process.

The fair approach, and one that makes a lot of business sense, would be for the seller and buyer to share losses. In fact, such loss sharing is a common practice in the United States. But Japan’s Financial Rehabilitation Law, which sets rules for the nationalization and sale of failed banks, has no provisions for this. Under the circumstances, the FRC claims, buyback is the second-best approach. Considering, however, that secondary losses had been anticipated all along, the commission could have devised a better formula.

FRC officials acknowledge that the government had little say in the drafting of the Financial Reconstruction Law because the initiative was taken by legislators. That is a lame excuse. Legal experts say loss sharing is possible even if there is no explicit legal stipulation.

The buyback clause is defended by the buyer as well, on the grounds that there is not much incentive to purchase a nationalized bank unless future losses are protected. However, this provision gives the takeover bank undue benefits because problem loans can be shifted to the government. That could create “moral hazard” for the bank, giving it an alibi for laying its — and its clients’ — problems at the door of the government.

The NCB, renamed Aozora (blue sky) Bank, has received a massive infusion of public money — more than 3 trillion yen — to balance its books. The money will not be repaid, leaving taxpayers to pick up the tab. The bill could rise, depending on developments. Pending creation of a more reasonable loss-covering formula, such as loss sharing, the Softbank group, as well as the Financial Reconstruction Commission, needs to exercise the utmost discretion in applying the buyback rule.

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