A comprehensive reform of Japanese insolvency law has ended with the introduction of the new Corporate Law (Kaisha Ho), which includes provisions on special liquidation (tokubetsu-seisan), along with the abolishment of corporate arrangement (kaisha-seirii).

Nine years after the Ministry of Justice undertook a project for comprehensive reform of Japanese insolvency law, the task will finally come to an end when the Law on Special Liquidation is revised and the Law concerning Corporate Arrangement is abolished with the enactment and enforcement of the new Corporate Law.

During these nine years, Japan has taken five distinct steps towards insolvency reform. The first outcome of the reform is the Civil Rehabilitation Law (Minji-Saizei Ho), as the replacement to the Composition Law (Wagi Ho), which was enacted in 1999 and put into effect in April 2000.

The Civil Rehabilitation Law was subsequently amended in 2000 to insert new chapters (chapters 10 and 13) regarding adjustment of debts of an individual with regular or continuous income. New proceedings for adjustment of consumer debts were established, collectively called kojin-saizei (that is, individual rehabilitation), with the effectuation of these chapters in April 2001.

At the same time, a new legal framework with regard to cross-border insolvency, modelled on the UNCITRAL Model Law on Cross-Border Insolvency, has been established by enactment of the Law on Recognition and Assistance of Foreign Insolvency Proceedings (Gaikoku-tosan-shori-tetsuzuki-no-shonin-enjo ni kansuru Horitsu) and amendments to the Bankruptcy Law, Civil Rehabilitation Law, and Corporate Reorganization Law. The former deals with "recognition and assistance proceedings for foreign insolvency proceedings," and the latter include international insolvency jurisdiction, status of foreigners and foreign entities, extraterritorial effects of Japanese insolvency proceedings, the hotch-pot rule, cooperation between trustees appointed in Japanese insolvency proceedings and foreign trustees, presumption of grounds for commencing Japanese insolvency proceedings, and rights of foreign trustees. These laws came into effect in April 2001.

The Corporate Reorganization Law (Kaisha-Kosei Ho) was totally renewed in December 2002, 35 years after its last substantial revision in 1967, and came into force in April 2003. The main aims of the renewal were to hasten and streamline proceedings, and to extend the devices for the reorganization of companies.

In 2004, the new Bankruptcy Law (Hasan Ho) was enacted to repeal the old Bankruptcy Law originally enacted in 1922. At the same time, substantive law that applies to insolvency cases, such as provisions concerning avoidance, limitation of setoff, treatment of tax and wages and so on, was also revised. The new law came into force on January 1 2005.

The final stage of insolvency reform is now under way.

Revision of bankruptcy proceedings

Three-quarters of a century after its enactment, the old Bankruptcy Law became obsolete to the extent that proceedings were too formal and time-consuming to dispose of a case speedily. In addition, it was designed only with companies in mind, and was unsuitable for consumer debt arrangements. The new Bankruptcy Law speeds up and rationalizes all steps in the procedure, including reporting and investigating claims, distributing dividends and creditors' meetings. The law also expands the power of the trustee to seize assets of bankrupt estates and the power of the bankruptcy court to issue injunctive orders to enhance proceedings. To modernize the proceedings, systems or devices such as a committee of creditors and representative agent are incorporated into the new law, as well as the right to inspect case documents, in line with civil rehabilitation and corporate reorganization.

To improve the process of consumer bankruptcy, the new law incorporates into bankruptcy proceedings the procedure for discharge, which was adopted in 1952 as a process independent to bankruptcy, and expands free assets, which belong not to the bankrupt estate but to the debtor to facilitate debtors' economic rehabilitation.

An important feature of the revisions lies in the right to claim for extinguishment of security rights with the trustee. Although security rights such as a special preferential right, pledge, hypothec or lien under the Commercial Code are deemed as rights of exclusive preference on a bankrupt estate (betsujoken) in the new law as well as in the old law, the trustee can file an application with the court for approval to extinguish all such security rights exiting on that property if it is desirable from the viewpoint of the general interest of creditors to sell it arbitrarily (that is to say, not by way of public sale as law enforcement), and as long as the sale does not unduly infringe on the interest of security right holders. The trustee may take a portion of the price of the sale as a share for the bankrupt estate, although it is necessary to consult on the amount before filing an application with the security right holders. A security right holder of the property may either file an application for auction as an execution or make an offer to purchase the property with more than a 5% premium on the price offered by the trustee. A security right holder has to take either action as a countermeasure within one month after service of the trustee's application, or the court will grant an approval for extinguishing the security rights on the property. This scheme for extinguishing security rights is incorporated to accelerate sales of properties under security not only by making use of the scheme, but also by facilitating trustees' negotiations with security holders on arbitrary selling.

Revisions to substantive law of insolvency

The new Bankruptcy Law revises provisions of substantive laws as well as those relating to proceedings. Moreover, substantive provisions in the Civil Rehabilitation Law and Corporate Reorganization Law were also changed with the enactment of the new Bankruptcy Law.

Among those revisions, the following might impact on ordinary transactions:

Lease and licence contracts

A variety of changes have been made concerning the treatment of lease contracts at the time of insolvency. Included among these are: the termination or cancellation of leases; perfectibility of advance payments of rent and assignment of rent claims; setoff of rent obligations for deposits or other claims; and priority claims for a part of the deposit with respect to civil rehabilitation procedures or corporate reorganization procedures.

As for cancellation, the new laws (that is, the new Bankruptcy Law, the new Civil Rehabilitation Law and the new Corporate Reorganization Law) stipulate that the provisions regarding termination of executory contracts, which empower a trustee or debtor-in-possession to cancel such a contract after the relevant insolvency proceedings begin, do not apply to lease contracts in cases when they are perfectible by means such as registration. Before the stipulation, there had been controversy regarding the applicability of provisions for termination of executory contracts to lease contracts.

It is the same for the treatment of licence contracts under the new laws. The exception clause for the provisions regarding termination of executory contracts covers a category of contracts, which creates rights for a party to use or make a profit in general. Therefore, licence contracts that are not perfectible by means such as registration can be terminated by a trustee or debtor-in-possession.

In respect of assignments of rent claims, the old laws acknowledged the perfectibility of assignments (as well as advance payments) against other creditors only for the current term and next term. This restricted acknowledgement of perfectibility was criticized as a hazard for securitization of rent claims, as securitization began to increase in popularity. The new laws abolished the restriction in response to this criticism, and to encourage securitization.

Concerning security deposits, change was made in the areas of civil rehabilitation and corporate reorganization. To facilitate rehabilitation, the new Civil Rehabilitation Law and the Corporate Reorganization Law limit cancellation by the lessee up to an amount of six months' rent, while under the new laws the security deposit made by the lessee becomes a priority claim when rent is paid after the procedure commences up to the amount paid.

Close-out netting

The new laws include more comprehensive provisions than the old law concerning the range of transactions that are to be rescinded and adjusted by law when the corresponding insolvency proceeding commences. Under the new laws, with respect to transactions involving merchandise or derivatives for which market prices exist, provided that it is meaningless to attain the object for which the contract has been entered into unless performance is effected at a specified time or within a specified period, the contract will be deemed to have been rescinded. The damages resulting from rescission will be calculated in accordance with the provisions of the master agreement if the parties so provide, in the master agreement executed to conduct transactions on a continuous and repeated basis, whereby the damages resulting from the rescission will be netted or adjusted as the difference between each party's damages arising from all transactions entered into under the master agreement. Among these transactions, currency swaps are included, while it is obvious that sales of cars or real estate are not. Whether or not derivatives such as forward transactions are included depends on characteristics of the trading, including the process of price determination.

Subordinated loans or bonds

The old Bankruptcy Law (and the pre-amendment Civil Rehabilitation Law and Corporate Reorganization Law) did not have provisions concerning subordinated claims based upon parties' agreements. So there was no difference in priority between a subordinated loan or bond and other claims. This could be problematic in connection with the BIS Rule on ratio of net worth or solvency margin ratios for insurance companies.

The new Bankruptcy Law and the amended Civil Rehabilitation Law and Corporate Reorganization Law stipulate the inferiority of subordinated loans or bonds. The new laws provide that, when there is a contractual agreement whereby, if a certain subordination event occurs, the principal amount and interest of the subordinated loans or bonds will not be paid unless any other senior liabilities are reimbursed, the subordinated loans or bonds with these conditions under the agreement are deemed as a "contractual subordinated bankruptcy (or reorganization or rehabilitation) claim." The contractual subordinated bankruptcy (or reorganization or rehabilitation) claim as set out in, and in accordance with, the provisions of the law, will be treated as being subordinate to other kinds of claims.

Debtor-in-possession financing

Debtor-in-possession financing has been deemed a claim for common benefit and is given preference. Even when the civil rehabilitation or corporate reorganization process fails and the court makes an adjudication of bankruptcy, loans made by the trustee or debtor-in-possession in the course of the process are still deemed as a superior obligation that the trustee of bankruptcy will pay outside the process of distributing dividends. However, DIP financing was inferior, in terms of priority of payment, to claims appertaining to bankrupt estates (zaidan-saiken), including taxes, which are given superiority under the old Bankruptcy Law.

The new Bankruptcy Law has removed this inferiority. Under the new law, only the costs of judicial proceedings and expenses related to management and disposal of the bankrupt estate are superior to other claims appertaining to the bankrupt estate, and DIP financing conducted in the course of the previous rehabilitation process has the same priority as the latter.

Right of avoidance

Various changes have been made in connection with the right of avoidance. The new Bankruptcy Law strengthens a trustee's right of avoidance in two ways. Under the old laws before the amendments in 2004, including the Civil Rehabilitation Law and the Corporate Reorganization Law, only payments or furnishings of securities made after suspension of a payment or an application for bankruptcy could be deemed as fraudulent preference. In contrast, the new laws stipulate that payments or provisions of securities made after the debtor has become insolvent (which is presumed from the fact of suspension of payment) from the viewpoint of ability to pay, as well as after an application for bankruptcy, can be deemed as fraudulent preference. The other change in the Bankruptcy Law concerning avoidance is incorporation of a summary process to exercise the right of avoidance, in which a ruling is made without a formal oral argument proceeding.

On the other hand, the new laws also limit the right of avoidance or exclude some kinds of transactions from the objectives of the right of avoidance. The new laws clarify the conditions necessary to avoid the sale of assets of an insolvent company or individual at a fair market price, so that one cannot avoid such sales. Under the new laws, the sale or disposal of properties at a fair market price is unavoidable unless: (i) disposal creates the real possibility that the seller or debtor will perform a prejudicial act to its creditors such as concealment, transfer without consideration and so on; (ii) at the time of disposal, the seller or debtor intends to perform such an act; (iii) at the time of disposal, the purchaser or counterparty to the disposal knows that the debtor has this intention. It is not an exaggeration to say that the new laws make it clear that usual sales conducted at a fair market price are unavoidable.

Another revision concerning limitation or exclusion of avoidance regards security interests created in lending for contemporaneous exchanges of new value. The new laws specify that only the establishment of securities for debts that have arisen out of causes existent before the establishment is avoidable. Before the revision it was said that lack of definite provisions excluding security interests from preferential transactions caused hesitation on the part of financial institutions to extend new loans to financially distressed persons and corporations. This revision is intended to remove this obstacle and promote financing to individuals or corporations experiencing financial difficulties.

Limitation of cancellation

As is the case with avoidance, the new laws revise the provisions concerning limitation of cancellation in insolvency. On one hand, the cases where setoffs are restricted are expanded. A creditor, who assumed an obligation or acquired a claim to the debtor before the suspension of the payment occurred or an application was filed for bankruptcy, could offset its obligation to the debtor against its claim to the debtor, even if the assumption of an obligation or acquisition of a claim occurred after the debtor became substantially insolvent. However, these setoffs can be restricted under the new laws as long as the creditor knows that the debtor has become substantially insolvent at the time they assumed an obligation or acquisition of a claim. On the other hand, the new laws exclude from the limitation of cancellation cases where a creditor who assumes an obligation to a debtor acquires a claim to the debtor afterwards by contract. This exclusion is stipulated so as not to deter doing business with a debtor in economic difficulty.

To ensure the smoothness of bankruptcy proceedings, the new Bankruptcy Law also authorizes the trustee to press a creditor into a decision on whether to offset claims and obligations of the bankrupt. If the creditor fails to reply in the prescribed term, which should be one month or over, the creditor can no longer claim cancellation.

Preference of labour claims and tax

Under the old Bankruptcy Law, taxes were treated as claims appertaining to the bankrupt estate (zaidan-saiken) on the whole, whereas labour claims such as unpaid wages, salaries or retirement allowance were deemed as preferred claims in bankruptcy (yusenteki-hasan-saiken). The latter, being preferred to other bankruptcy claims, were only paid by distribution of dividends and so were almost inferior to zaidan-saiken (which the trustee of bankruptcy should pay preferentially outside the process of distributing) or claims with rights of separation called betsujoken (which could be exercised without resorting to bankruptcy procedures).

The new Bankruptcy Law changed these priorities. Under the new law, only taxes (which arise from causes existent before bankruptcy commenced) that are not yet due or are within one year of their payment date at the time of adjudication for bankruptcy are to be treated as zaidan-saiken. Portions of labour claims such as wages, salaries or retirement allowance are treated as zaidan-saiken in the new law. Unpaid salaries or wages that are to be paid for the value of labour provided within three months before bankruptcy will be treated as zaidan-saiken. Retirement allowance will also be considered zaidan-saiken up to a total amount of three monthly payments before the time of retirement (or a total amount of three monthly payments before bankruptcy commenced if it is greater). Generally speaking, most other taxes and labour claims are to be treated as preferred claims (yusenteki-hasan-saiken) in the case of corporate bankruptcy.

The revision of the Special Liquidation Chapter of the Corporate Law

Although special liquidation was substantially stipulated in the Commercial Code and in part, with regard to procedural matters, in the Non-Contentious Cases Procedure Law (Hisho-jiken-tetsuzuki-Ho), it has been regarded as an insolvency proceeding. Various changes have been made to modernize the proceedings, modelled after civil rehabilitation and the new form of bankruptcy, as special liquidation was originally incorporated in 1938 and has not been broadly revised since then. However, the main characteristic or framework of special liquidation, which is a liquidation proceeding to arrange the interests of the concerned parties to prevent bankruptcy under the custody of the court, is preserved in the new law.

The main changes to the proceedings are as follows: First, the requirement of creditor consent is alleviated. Under the present Commercial Code, to adopt a settlement agreement, consent is required from a majority of the creditors entitled to vote who will hold claims equivalent to at least three-quarters of the votable claims. In contrast, the new Corporate Law requires two-thirds of the votable claims instead of three-quarters.

Second, the new law excludes a general preferential right and other claims having general priority such as labour claims and taxes from settlement agreements, although these claims are included in and affected by settlement agreements under the present Commercial Code.

Third, under the new law, the liquidator must either obtain approval from the court or consent of the supervising commissioner who is appointed by the court (kantoku-iin) to conduct an important act, such as disposal of property or borrowing money, but not the consent of inspection commissioners who are appointed by a resolution of the creditors' meeting (kansa-iin), or from a resolution of the creditors' meeting, which is required by the present Commercial Code.

Fourth, the new law enables a special liquidation case to be brought before a district court in which an insolvency case is pending with respect to the holding or parent company, as well as a district court that has jurisdiction over the place of the principal office.

Other revisions and prospects

Among the amendments to the Civil Rehabilitation Law effected in 2005, one big revision has been made concerning issues of new shares. Before the amendment, in cases where the debtor corporation had a stipulation in its articles of incorporation whereby the transfer of shares of the debtor corporation needed the approval of the board of directors, a special resolution by a general meeting of stockholders, in which two-thirds or more of the votes of shareholders present were needed, was required to issue new stock to companies or persons, other than shareholders, who provided finance to debtors for making and fulfilling rehabilitation plans (a so-called sponsor in Japanese insolvency practice) or who were creditors in the case of debt-equity swaps. However, after the revision, issues of new shares can be performed by conclusive approval of the rehabilitation plan without a special resolution by a general meeting of stockholders, if the court permits the debtor to submit a rehabilitation plan that includes the terms of issuing new stocks on the conditions that the liabilities of the debtor exceed assets and that issuing new stocks is indispensable for rehabilitation.

Corporate arrangement will be abolished with the implementation of the new Corporate Law. After the incorporation of civil rehabilitation, corporate arrangement was rarely used and seemed to lose its reasons for existence. When the new Corporate Law is implemented, Japan will have two types of reorganization proceeding, civil rehabilitation and corporate reorganization, and two types of legal liquidation process, bankruptcy and special liquidation.

In the meantime, during the insolvency law reform, the Guideline to Private Renegotiation has been drawn up and the Industrial Revitalization Corporation of Japan (the IRCJ) has been established jointly by the public and private sector. Now that insolvency law reform has been completed and the IRCJ finished taking new revitalization cases at the end of March 2005, the issue of business recovery is shifting to the margin between in-court proceedings and out-of court workout. Some measures making up for this margin will be published soon. Establishing a practice of early undertaking regarding business recovery remains an important issue to be addressed.

Author biography

Michihiro Mori Nishimura & Partners In 2005, Michihiro Mori joined Nishimura & Partners' team of legal counsel on Japan law specializing in insolvency, litigation, labour law, and civil law enforcement matters. With his extensive work history and experience, combined with the resources of one of Japan's largest law firms, he is able to serve clients adroitly, providing counselling and advocacy concerning all aspects of these areas of law. Before joining the firm, he served as a judge on the Tokyo District Court from 1995 to 1998, and on the Fukuoka District Court from 2003 to 2005. Mori was educated at the University of Tokyo (LLB, 1993), the Legal Training and Research Institute of the Supreme Court of Japan, and Harvard Law School (LLM, 1999). He also served as staff attorney in the Civil Affairs Bureau of the General Secretariat of the Supreme Court from 2000 to 2003.