Explanation of Insolvency Procedures under Japanese Corporate Law

Corporate management can sometimes face serious financial difficulties. The Japanese legal system provides a sophisticated legal framework designed not to simply end with the failure of a business, but to aim for an orderly resolution in such crisis situations. This framework is divided into two strategic directions. One is the ‘liquidation-type’ procedure, which aims to organize the company’s assets and distribute them fairly among creditors. The other is the ‘rehabilitation-type’ procedure, which assumes the continuation of the business and aims for revival by restructuring the financial content and organization. These legal procedures can be described as strategic toolkits to be chosen according to the company’s situation. For shareholders and managers, deeply understanding these options is essential in protecting the value of the company in crisis situations, fulfilling fiduciary responsibilities, and making informed and accurate decisions. This article provides a professional perspective on the overall picture of the four main legal procedures under Japanese insolvency law—bankruptcy, special liquidation, civil rehabilitation, and corporate reorganization—by comparing and analyzing their personalityistics, differences, and the handling of secured claims, incorporating recent court cases as well.

Overview of Insolvency Procedures in Japan

Japanese law establishes four main types of insolvency procedures conducted under the supervision of the courts. These procedures are broadly divided into two categories based on their purpose. The first is “liquidation-type procedures,” aimed at halting a company’s business activities and dissolving its corporate entity, which include bankruptcy proceedings and special liquidation proceedings. The second is “rehabilitation-type procedures,” which aim to rebuild the company while continuing its business, and civil rehabilitation proceedings and corporate reorganization proceedings fall under this category.

Furthermore, these procedures can also be classified based on who leads the process. One type is known as “trustee-type procedures,” where a neutral expert (trustee) appointed by the court takes control of the company’s management rights and property disposition rights to advance the proceedings. Bankruptcy proceedings and corporate reorganization proceedings belong to this category. The other type is called “DIP (Debtor in Possession) procedures,” where, in principle, the existing management retains control of the company and carries out the reconstruction or liquidation proceedings themselves. Special liquidation proceedings and civil rehabilitation proceedings correspond to this type.

This dual classification, namely the choice between “liquidation-type or rehabilitation-type” and “trustee-type or DIP-type,” clearly illustrates the strategic dilemma faced by companies on the brink of a management crisis. Choosing a procedure involves not only selecting a legal form but also making a critical decision about the business’s viability and whether to maintain management control. For example, if aiming for reconstruction, the management may opt for civil rehabilitation to retain control, but if creditors or the court deems the existing management responsible for the failure, corporate reorganization with an external trustee may be chosen. Therefore, management must objectively assess not only the financial viability of their company but also the degree of trust from stakeholders.

Liquidation Bankruptcy Procedures: Liquidating a Company’s Assets in Japan

Liquidation procedures aim to legally conclude a company’s operations in Japan when business continuity becomes unfeasible by converting its assets into cash and ensuring a fair distribution to creditors.

Bankruptcy Proceedings Under Japanese Law

Bankruptcy proceedings are the most fundamental and powerful liquidation procedures based on the Japanese Bankruptcy Law. For corporations, these proceedings are initiated by a court decision when the state of ‘inability to pay’ as defined by Article 15 of the Japanese Bankruptcy Law (an objective state where the debtor lacks the ability to generally and continuously pay its debts as they become due) or ‘excess of liabilities over assets’ as defined by Article 16 (a state where the debtor’s property is insufficient to cover its debts) is recognized.

Once the proceedings commence, the court appoints a ‘bankruptcy trustee’ from among neutral attorneys. According to Article 2, Paragraph 12 of the Japanese Bankruptcy Law, the bankruptcy trustee exclusively has the right to manage and dispose of the company’s assets. As a result, the existing management loses all rights to manage and dispose of property, and the bankruptcy trustee carries out a series of liquidation tasks such as investigating, securing, liquidating the company’s assets, and distributing them to creditors according to legal priority.

A significant feature of these proceedings is that they do not require the consent of creditors to begin. If the court recognizes an objective state of insolvency, the proceedings proceed compulsorily. This is a system designed to restore order and protect the interests of all creditors fairly by the intervention of a neutral third party in situations where there is intense conflict among creditors or when trust in the management has been lost. The bankruptcy trustee is endowed with a powerful authority called the ‘right of rejection,’ which can invalidate unfair payments made before the commencement of bankruptcy proceedings, thus playing a role in substantively ensuring the principle of equality among creditors. Therefore, bankruptcy proceedings are positioned as the final option when other collaborative solutions are impossible.

Special Liquidation Procedures Under Japanese Corporate Law

Special liquidation procedures, as stipulated under Article 510 and subsequent articles of the Japanese Companies Act, are simplified liquidation procedures available exclusively to stock companies. These procedures commence after a company dissolves through a special resolution at a shareholders’ meeting and enters the normal liquidation process, particularly when there is suspicion of insolvency or other significant impediments to the liquidation process.

Unlike bankruptcy proceedings, the process is not led by an external trustee appointed by the court but by a ‘liquidator’ from the company. Often, former directors take on the role of liquidator, allowing the management to maintain a certain level of control in a Debtor in Possession (DIP) type of procedure.

The crux of this procedure lies in forming agreements with creditors. Specifically, the liquidation progresses by either passing a repayment plan called an ‘agreement’ at a creditors’ meeting or establishing a ‘settlement’ with individual creditors. The passage of an agreement requires the consent of more than half of the voting rights holders present and at least two-thirds of the total amount of voting rights. As this requirement suggests, special liquidation assumes a cooperative situation where there is a pre-existing agreement on the liquidation plan with major creditors. If consent from creditors is not obtained, the procedure fails and, in many cases, transitions to bankruptcy proceedings.

Given its nature of presupposing consensus-building, special liquidation offers the advantage of being completed more swiftly and at a lower cost compared to bankruptcy proceedings. It is particularly frequently utilized in cases where the number of creditors is limited and cooperative, such as when a parent company liquidates a subsidiary.

Comparison Between Bankruptcy and Special Liquidation Under Japanese Law

The table below summarizes the main differences between bankruptcy proceedings and special liquidation proceedings in Japan.

Reorganization Bankruptcy Proceedings: Aiming for Business Revitalization Under Japanese Law

Reorganization proceedings are designed for situations where, despite financial difficulties, the business itself holds value and has the potential for continuation, with the goal of facilitating its revival.

Civil Rehabilitation Proceedings Under Japanese Law

Civil rehabilitation proceedings are based on the Japanese Civil Rehabilitation Act and aim to rehabilitate the business or economic life of a debtor. The greatest advantage of these proceedings lies in their flexibility, allowing all types of business entities, including stock companies, limited liability companies, and sole proprietors, to utilize them.

As a principle, the proceedings are carried out in a Debtor in Possession (DIP) manner, where the existing management retains control of the business and continues operations while formulating and executing a rehabilitation plan themselves. Article 38, Paragraph 1 of the Japanese Civil Rehabilitation Act stipulates that after the commencement of rehabilitation proceedings, the debtor retains the right to conduct business and manage and dispose of property. Shareholders’ rights are also generally unchanged.

However, there are significant constraints within these proceedings, particularly concerning the treatment of creditors with security interests (primarily financial institutions). In civil rehabilitation proceedings, secured creditors possess a “separate satisfaction right,” which allows them, in principle, to seize and sell the secured assets (such as factories or machinery) independently of the rehabilitation proceedings and recover their claims. This poses a risk of losing assets essential for the continuation of the business.

Therefore, to ensure the success of civil rehabilitation proceedings, it is virtually essential to negotiate with major secured creditors before filing and establish a cooperative relationship, such as obtaining their agreement to wait before exercising their security rights. The procedure solidifies the path to reconstruction by obtaining the approval of a rehabilitation plan with the consent of a majority of the voting rights holders and a majority of the total amount of voting rights at the creditors’ meeting.

Corporate Reorganization Proceedings Under Japanese Law

Corporate reorganization proceedings are the most powerful type of restructuring proceedings based on the Japanese Corporate Reorganization Act. Due to their powerful nature, they are limited to joint-stock companies (kabushiki kaisha) and are primarily used for the reorganization of large-scale enterprises.

The proceedings are trustee-based, and upon commencement, the court immediately appoints a ‘reorganization trustee,’ resulting in the dismissal of all existing management. The reorganization trustee assumes complete control over the company’s management and the disposition of its assets.

The most significant feature of corporate reorganization proceedings is the ability to halt the exercise of rights by secured creditors, which cannot be restricted in civil rehabilitation proceedings. Secured creditors do not retain their right of separate satisfaction, and their claims are treated as ‘reorganization secured claims’ within the proceedings. They are subject to modifications such as reductions or payment deferrals according to the reorganization plan. Furthermore, the rights of shareholders can also be significantly altered, and in many cases, a 100% reduction in capital (eliminating all existing shareholders’ rights) is implemented.

Thus, corporate reorganization proceedings fundamentally adjust the rights of all stakeholders, including secured creditors and shareholders, aiming for a complete reconstruction of the enterprise under the leadership of an external expert, the trustee. Due to their powerful nature, the proceedings are complex, costly, and time-consuming. For the management, choosing this path means sacrificing their positions for the salvation of the business, representing a significant decision to save the company at the expense of their own status.

Comparison Between Civil Rehabilitation and Corporate Reorganization in Japan

The table below summarizes the main differences between civil rehabilitation proceedings and corporate reorganization proceedings under Japanese law.

Handling of Security Interests in Bankruptcy Proceedings Under Japanese Law

In bankruptcy proceedings, how security interests are handled is an extremely important issue that can determine the success or failure of the process.

Separate Satisfaction Rights

Separate satisfaction rights allow creditors with security interests over specific properties to exercise their rights outside of the bankruptcy proceedings and receive payment with priority over other creditors. The legal basis for this is found in Article 65 of the Japanese Bankruptcy Law and Article 53 of the Japanese Civil Rehabilitation Law.

The existence of these rights significantly impacts the proceedings. For example, if a company aiming for civil rehabilitation has a bank’s mortgage on a factory that is central to its business, and the bank exercises its separate satisfaction rights to auction off the factory, business continuity becomes impossible. In other words, even if legal civil rehabilitation proceedings are initiated, without the cooperation of the secured creditors, reconstruction is effectively doomed.

Therefore, the presence of separate satisfaction rights divides bankruptcy proceedings into two aspects. One is the official procedure aimed at the fair distribution among unsecured creditors, which is managed by the court. The other is the extremely important negotiation with secured creditors that takes place behind the scenes. For management choosing civil rehabilitation, securing a “standstill agreement” (an agreement to temporarily suspend the exercise of security rights) with major financial institutions before filing is an absolute prerequisite for success.

Rehabilitation Security Rights

In corporate reorganization proceedings, separate satisfaction rights are not recognized. Once the proceedings commence, the execution of all security interests is automatically prohibited. The rights of secured creditors are transformed into a status known as “rehabilitation security rights,” which become subject to modification along with other claims within the reorganization plan. The legal basis for this is found in the Japanese Corporate Reorganization Law, where, for example, Article 2, Paragraph 10 defines rehabilitation security rights, and Article 47 prohibits their exercise.

This mechanism is what gives corporate reorganization proceedings their powerful reconstructive capability. By temporarily halting the exercise of individual creditors’ rights and bringing all stakeholders (secured creditors, unsecured creditors, shareholders) to the same table, the reorganization trustee can devise a comprehensive plan to redesign the company’s entire capital structure. The underlying philosophy prioritizes the public interest of corporate recovery over individual rights. It is because of this strong intervention in individual property rights that strict procedural requirements are imposed, such as the appointment of a neutral trustee and rigorous court supervision, to prevent abuse.

Comparison of the Handling of Security Interests in Each Procedure

Introduction to Recent Judicial Precedents in Japan

In the field of insolvency practice, new challenges constantly arise around the interpretation of legal provisions. Here, we introduce a significant decision by the Supreme Court of Japan.

The Supreme Court decision on December 22, 2021 (Reiwa 3), addressed the interpretation of Article 174, Paragraph 2, Item 3 of the Japanese Civil Rehabilitation Law. This provision states that if the resolution of a rehabilitation plan is established by “fraudulent means,” the court must not approve the plan.

The case in question involved a trustee of a company undergoing civil rehabilitation proceedings who entered into a settlement agreement with a major creditor holding a substantial claim, resolving a dispute over the validity of the claim. The settlement agreement included a clause that the creditor would vote in favor of the rehabilitation plan. Other creditors argued that this was a so-called “vote buying” and constituted “fraudulent means,” seeking disapproval of the plan.

In response, the Supreme Court ruled that a settlement agreement that includes consent to a rehabilitation plan does not immediately constitute “fraudulent means.” The Court stated that it is necessary to comprehensively consider the intent and circumstances under which the settlement agreement was concluded, and whether the content of the settlement is overall reasonable for the debtor company. In this case, the settlement resolved a complex dispute and contained rational content that contributed to the company’s reconstruction, and it was not concluded solely for the purpose of influencing the exercise of voting rights. Therefore, it did not fall under “fraudulent means.”

This precedent is significant as it acknowledges the reality of negotiations in insolvency proceedings by the judiciary. It is essential for trustees and management to negotiate with individual creditors to form a majority necessary for the approval of a rehabilitation plan. This decision indicates that such negotiations should not be prohibited merely because they condition consent to the plan, but should be judged on substantive criteria, such as whether the agreement content is commercially reasonable for the company as a whole and does not unfairly harm the interests of other creditors. This allows practitioners to conduct more flexible negotiations, but at the same time, they bear the responsibility to construct deals that are justifiable and fair to all creditors.

Summary

The Japanese insolvency legal framework offers companies in financial distress two fundamental directions: “liquidation” and “rehabilitation,” each with multiple procedures. Bankruptcy and special liquidation are liquidation-type procedures that organize and conclude a company’s assets, while civil rehabilitation and corporate reorganization aim for the continuation and revival of the business. These choices are closely linked to core management decisions, such as whether to maintain management rights (Debtor in Possession, or DIP) or entrust them to external professionals (trustee system). In particular, the handling of secured claims (existence of separate satisfaction rights) is a decisive factor that significantly influences the strategic value of each procedure. Navigating this complex legal framework and finding the optimal path requires not only a deep knowledge of the law but also advanced strategic thinking and negotiation skills.

Monolith Law Office has a proven track record of providing a wealth of legal services to domestic and international clients, particularly in the area of corporate insolvency proceedings under Japanese Corporate Law. Our firm is staffed with experts who are not only qualified as Japanese attorneys but also hold foreign legal qualifications and are English speakers, enabling us to provide strategic advice to maximize the rights and interests of management and shareholders in complex insolvency situations. From liquidation-type to rehabilitation-type procedures, we are committed to supporting our clients in all circumstances and leading them to the best resolution. For consultations on legal crisis management, please do not hesitate to contact our office.