This content is from: Local Insights

Subordination in Japanese insolvency proceedings

Tomohiro Okawa
There are the three main types of insolvency proceedings in Japan. The first is bankruptcy proceedings under the Bankruptcy Act: liquidation-type insolvency proceedings. The second is civil rehabilitation proceedings under the Civil Rehabilitation Act: debtor-in-possession-type insolvency proceedings, which aims to enable a debtor-in-possession to recover by restructuring creditors' claims based on a rehabilitation plan. The third is corporate reorganisation proceedings under the Corporate Reorganisation Act: trustee-type insolvency proceedings, in which a court-appointed trustee manages a stock corporation to recover by restructuring creditors' claims based on a reorganisation plan.

As a general matter, the Bankruptcy Act is silent on the issue of subordination and the judicial position on this issue remains unsettled. There are two opposing court precedents on this issue; a ruling of the Tokyo District Court on December 16 1991 in which the court denied the subordination of the claim submitted by the parent company of the insolvent party, reasoning that there are no statutory grounds under the Bankruptcy Act, and a ruling of the Hiroshima District Court on March 6 1998 in which the court permitted the subordination of the claim submitted by the controlling creditor of the insolvent party based on the principle of good faith.

In contrast, both the Civil Rehabilitation Act (Article 155, Paragraph 1) and the Corporate Reorganisation Act (Article 168, Paragraph 1) contain provisions that any modification of rights based on a rehabilitation plan or a reorganisation plan must be equal between creditors. This does not apply, however, where equity will not be undermined even if such plan prescribes any difference in treatment of creditors. In other words, the legislation permits the submission of a rehabilitation plan or a reorganisation plan that contemplates the subordination of the claims of related parties if equity is not undermined. For example, a ruling of the Tokyo High Court on February 11 1965 upheld a reorganisation plan that would subordinate the claim of the insolvent party's representative director, reasoning that the insolvency was primarily attributed to his mismanagement. Also, the Fukuoka High Court on December 21 1981 upheld a reorganisation plan that would subordinate the claim submitted by the insolvent party's controlling shareholder, based on the finding that the shareholder in question effectively controlled the insolvent party's operations (for example, human resources, business development, product pricing and financial matters) and that the insolvent party was forced to file for the corporate reorganisation proceedings due to such shareholder's business failure.

Court rulings regarding Lehman Brothers

It is important to note, however, that neither the Civil Rehabilitation Act nor the Corporate Reorganisation Act contain provisions that require specific claims be subordinated if certain conditions are met. This issue was highlighted in certain of the court decisions arising out of the Lehman Brothers' insolvency; in particular, whether or not the debtor-in-possession is required to subordinate the claims of affiliated entities to those of third-party claimants.

In the civil rehabilitation proceedings of the Lehman Brothers Group Japanese affiliates, the debtors-in-possession submitted rehabilitation plans that treated the claims of affiliates equally with those of third parties. While the court approved such plans, two banks individually challenged them, arguing that they violated the debtor-in-possession's obligation to subordinate the affiliate claims to third-party claims based on the principle of good faith or, in the alternative, equity.

In Aozora Bank v Lehman Brothers Holding Corporation, the 9th Division of the Tokyo High Court on June 30 2010 held that the loans to the insolvent party from its affiliates were not able to be evaluated as substantially equivalent to equity investments because it is not beyond the ordinary course of Lehman Brothers Group business to borrow funds from affiliates and to lend funds to other affiliates. The appeal of Aozora Bank was dismissed.

In Shinsei Bank v Sunrise Finance Corporation (the latter being a Japanese affiliate of the Lehman Brothers Group), the 1st Division of the Tokyo High Court on July 4 2011 ruled that even if there exist certain cases which require specific creditor's claims be subordinated in a rehabilitation plan, those would be limited to exceptional cases where not doing so would clearly be deemed contrary to justice. The court went on to explain that the court is required to disapprove a rehabilitation plan with no subordination which has already been resolved by the creditors' meeting only in extremely limited cases where such plan must be corrected from the viewpoint of justice. The court then held that it could not find any reason to justify the subordination of the affiliate entities' claims, given that the creditors outside the group obviously expected the property and fund-raising capability of the entire group (rather than that of the debtor-in-possession) under the credit status of Lehman Brothers Holding (a holding company of the Lehman Brothers Group) and that the transfer of funds within the group had not deviated from the Lehman Brothers Group business model. The court dismissed the appeal from Shinsei Bank.

As such, based on the foregoing legislation and court precedents, rehabilitation plans and reorganisation plans may subordinate the claims of a specific creditor, provided it will not lead to an unjust result, but will in only very limited circumstances be required to subordinate the claims of a particular creditor.

Tomohiro Okawa

© 2021 Euromoney Institutional Investor PLC. For help please see our FAQs.

Instant access to all of our content. Membership Options | 30 Day Trial