Challenging Pre-Bankruptcy Transactions: What is the "Right of Avoidance" (Hinin-ken) in Japan?

When a company or individual in Japan enters bankruptcy proceedings (破産手続 - hasan tetsuzuki), the court-appointed bankruptcy trustee (破産管財人 - hasan kanzainin) is tasked not only with administering existing assets but also with investigating and potentially "clawing back" assets or value that were improperly transferred out of the debtor's estate before the bankruptcy filing. This powerful tool is known as the "Right of Avoidance" or Hinin-ken (否認権). Understanding this right is crucial for anyone who has engaged in transactions with a Japanese entity that subsequently becomes bankrupt.

The Purpose and General Principles of Hinin-ken

The primary purposes of the Hinin-ken are twofold:

1. Augmenting the Bankruptcy Estate (破産財団の増殖 - hasan zaidan no zōshoku): By nullifying certain pre-bankruptcy transactions and recovering assets or their monetary equivalent, the trustee aims to increase the pool of assets available for distribution to creditors.
2. Ensuring Fair and Equal Treatment of Creditors: The Hinin-ken helps to rectify situations where some creditors were unfairly preferred over others, or where assets were moved out of the reach of creditors in a way that undermines the principle of equitable distribution.

The right to exercise avoidance powers rests exclusively with the bankruptcy trustee (or a trustee in other insolvency proceedings like civil rehabilitation or corporate reorganization, where similar powers exist). The trustee acts on behalf of the entire body of creditors. The Japanese Bankruptcy Act (破産法 - Hasan Hō) provides the legal framework for these actions.

Key Categories of Avoidable Transactions

Japanese bankruptcy law specifies several types of pre-bankruptcy transactions that can be subject to the trustee's avoidance powers. These generally fall into categories aimed at addressing actions that were either intended to harm creditors or that had the effect of unfairly diminishing the estate or preferring certain creditors during a period of financial distress.

1. Avoidance of Fraudulent Acts (詐害行為否認 - Sagai Kōi Hinin)

This category, outlined in Article 160 of the Bankruptcy Act, targets transactions where the debtor acted in a way that was detrimental to creditors.

• Acts with Intent to Harm Creditors (故意の詐害行為 - koi no sagai kōi):
  • The trustee can avoid acts undertaken by the debtor with the knowledge that such acts would harm creditors. This includes actions like concealing assets, transferring them for no consideration, or selling them for a grossly inadequate price to keep them out of creditors' reach.
  • For this type of avoidance to succeed against the beneficiary of the transaction, the trustee generally needs to prove that the beneficiary also knew, at the time of the act, of the debtor's intent to harm creditors.
• Acts After Suspension of Payments or Bankruptcy Petition (支払停止後等の詐害行為 - shiharai teishi go tō no sagai kōi):
  • If the debtor engages in an act that harms creditors after they have suspended payments (支払停止 - shiharai teishi, a factual state indicating inability to pay debts) or after a bankruptcy petition has been filed, such an act can be avoided.
  • In this scenario, the burden shifts slightly: the act is avoidable unless the beneficiary can prove they did not know, at the time of the act, that the debtor had suspended payments or that a bankruptcy petition had been filed, nor did they know the act would harm creditors.
• Special Rule for Transactions with Ostensibly Adequate Consideration (Article 161):
  • Sometimes, a debtor might sell an asset for what appears to be fair market value, but with the underlying intention of converting a traceable asset (like real estate) into easily concealable cash, which they then plan to hide, spend dissipate, or give away gratuitously. Article 161 allows the trustee to avoid such a sale if:
    1. The act (e.g., selling property for cash) created a situation where the debtor could easily conceal, make a gratuitous transfer of, or otherwise dispose of the received consideration in a manner harmful to creditors;
    2. The debtor, at the time of the act, intended to engage in such concealment or harmful disposition of the consideration; AND
    3. The counterparty (beneficiary) knew, at the time of the transaction, of the debtor's aforementioned intent to conceal or improperly dispose of the proceeds.
  • The burden of proving these elements, including the counterparty's knowledge, generally lies with the trustee. However, if the counterparty is an "insider" (e.g., a director, relative), their knowledge of the debtor's harmful intent regarding the proceeds may be presumed, shifting the burden to the insider to prove they did not know.

2. Avoidance of Gratuitous Acts and Equivalent Acts (無償行為等の否認 - Mushō Kōi tō no Hinin)

Article 160, Paragraph 3 of the Bankruptcy Act provides a powerful tool for avoiding gratuitous acts or acts that are economically equivalent to gratuitous ones.

• Scope: This applies to:
  • Any act performed by the debtor without receiving any consideration (無償行為 - mushō kōi, e.g., gifts).
  • Any act performed for consideration that is grossly inadequate (これと同視すべき有償行為 - kore to dōshi subeki yūshō kōi).
• Timing: Such acts are avoidable if they were performed either:
  • After the debtor suspended payments or a bankruptcy petition was filed; OR
  • Within six months prior to the suspension of payments or the filing of a bankruptcy petition.
• No Need to Prove Intent or Beneficiary's Knowledge: Significantly, for this type of avoidance, the trustee does not need to prove that the debtor intended to harm creditors or that the beneficiary knew of the debtor's financial distress. The objective nature of the gratuitous act during a period of financial vulnerability is sufficient.
• Limited Defense for Beneficiary: A beneficiary who received property through such a gratuitous act (or its equivalent) can limit their liability to the extent they were enriched (現存利益 - genson rieki) if they can prove that, at the time of the act, they did not know that the debtor had suspended payments (or a petition was filed) or that the act would harm creditors (Article 167, Paragraph 2).

3. Avoidance of Preferential Transfers/Acts (偏頗行為否認 - Henpa Kōi Hinin)

This category, governed by Article 162, targets transactions that unfairly prefer one or more creditors over others when the debtor is insolvent.

• Acts After Debtor Becomes Unable to Pay (支払不能後の行為 - shiharai funō go no kōi) or After Suspension of Payments:
  • The trustee can avoid:
    1. The provision of security for an existing debt (e.g., granting a mortgage for an old loan).
    2. The extinguishment of an existing debt (e.g., making a loan repayment).
  • Conditions for Avoidance:
    • The act must not have been part of the debtor's legal obligations (非義務行為 - hi-gimu kōi, i.e., not legally required at that time or in that manner) OR, if it was an obligatory act, the creditor (beneficiary) must have known at the time of the act that the debtor was unable to pay its debts generally or had suspended payments, OR that the act would be detrimental to the equality of other creditors.
    • If the act was non-obligatory (e.g., early payment of a debt), the knowledge requirement for the creditor is that they knew the act would be detrimental to creditor equality.
• Non-Obligatory Preferential Acts Within 30 Days Before Debtor Becomes Unable to Pay:
  • Even if an act occurred shortly before the debtor became unable to pay, if it was a non-obligatory act (excluding acts non-obligatory only in their timing or method) that preferred a creditor, it can be avoided if the creditor knew at the time that it would be detrimental to creditor equality (Article 162, Paragraph 1, Item 2).
• Presumptions for Insiders: If the preferred creditor is an insider, their knowledge of the detrimental effect on other creditors is often presumed, making avoidance easier for the trustee.
• Exceptions:
  • Payments for new value provided contemporaneously are generally not considered preferential.
  • Payments of taxes and public dues are generally not subject to this type of avoidance (Article 162, Paragraph 3).
  • Certain payments related to bills of exchange necessary to avoid dishonor and preserve rights against other parties on the bill may also be exempt under specific conditions (Article 163).

4. Avoidance of Acts Denying Perfection or Establishment of Rights (対抗要件の否認 - Taikō Yōken no Hinin)

Article 164 addresses situations where a creditor or the debtor takes steps to perfect a legal right (e.g., register a transfer of title, record a mortgage, give notice of assignment of receivables to establish rights against third parties) too late in the process, specifically when bankruptcy is looming.

• The act of perfection (or any act required to establish a right against third parties) can be avoided if it was done after the debtor suspended payments or a bankruptcy petition was filed, provided the person undertaking the act of perfection knew of the suspension or petition at that time.
• Furthermore, even if the actor did not know, if the perfection occurs more than 15 days after the underlying legal act (e.g., the contract creating the security interest or transfer was made), and at the time of perfection the debtor had already suspended payments or a petition was filed, the perfection can be avoided if the actor knew of the suspension of payments or petition at the time of the underlying legal act.
• This provision aims to prevent a "race to the registry" where creditors, aware of the debtor's distress, try to secure their positions at the expense of the general creditor body.

5. Avoidance of Execution Acts (執行行為の否認 - Shikkō Kōi no Hinin)

Under Article 165, even if a creditor has obtained a judgment or other enforceable title and has levied execution (e.g., attached assets), the trustee can still avoid this execution act if the underlying conditions for avoiding a preferential act (under Article 162) are met. This ensures that the principles of preference avoidance are not circumvented merely because a creditor managed to secure an execution lien shortly before bankruptcy.

Typical Examples Encountered in Practice

The types of transactions that frequently come under scrutiny for avoidance include:

• Sales of valuable assets at significantly below market value (廉価売却 - renka baikyaku).
• Gifts or transfers for no consideration, especially to relatives or affiliated companies (贈与 - zōyo).
• Payments made to select creditors, particularly insiders or family members, while other creditors go unpaid (偏頗弁済 - henpa bensai).
• The sudden granting or late perfection of security interests on previously unsecured debts.
• Division of assets in a divorce settlement that disproportionately favors the non-bankrupt spouse (離婚に伴う財産分与 - rikon ni tomonau zaisan bun'yo).
• Repayment of loans from company directors or shareholders under suspicious circumstances.

Investigation and Burden of Proof

The bankruptcy trustee has a duty to investigate the debtor's pre-bankruptcy transactions to identify any potential avoidance actions. This involves reviewing financial records, interviewing the debtor and other relevant parties, and analyzing the nature and timing of transactions.

The burden of proof to establish the elements of an avoidable transaction generally rests with the trustee. This can be challenging, especially when it comes to proving the subjective elements like the debtor's intent or the beneficiary's knowledge. However, as noted, certain presumptions can assist the trustee, particularly when insiders are involved or when transactions occur very close to the bankruptcy filing or after a suspension of payments.

Effects of Successful Avoidance (否認権行使の効果)

If the trustee successfully avoids a transaction:

• Restoration to the Estate (原状回復 - genjō kaifuku): The primary effect is that the transferred property is returned to the bankruptcy estate. If the property itself cannot be returned (e.g., it has been consumed or sold to a bona fide purchaser for value), the trustee can recover its monetary value from the initial transferee (Bankruptcy Act, Article 167, Paragraph 1).
• Counterparty's Rights (相手方の地位 - aitekata no chii): The treatment of the counterparty who has to return the property or its value depends on the type of avoidance and their good faith:
  • Fraudulent Acts (Article 160, 161): If the counterparty had provided consideration, their claim for the return of that consideration is generally treated as an administrative expense claim (財団債権 - zaidan saiken) if the benefit they provided still exists within the estate, or a claim for its value as an administrative expense if it does not (Article 168, Paragraph 1). However, if the counterparty knew of the debtor's fraudulent intent regarding the disposition of the consideration received, their claim might be demoted to a general bankruptcy claim or even further subordinated (Article 168, Paragraph 2).
  • Gratuitous Acts (Article 160(3)): As mentioned, a good faith beneficiary may only need to return the "remaining enrichment" (Article 167, Paragraph 2).
  • Preferential Transfers (Article 162): If a preferential payment is recovered, the creditor's original debt is reinstated as a general bankruptcy claim, allowing them to participate in the bankruptcy distribution on an equal footing with other unsecured creditors (Article 169).

Time Limits for Exercising Avoidance Powers (否認権行使時期の限界)

The trustee's right to exercise avoidance powers is subject to statutory time limits (Bankruptcy Act, Article 176):

• The right of avoidance must be exercised within two years from the date of the commencement of the bankruptcy proceedings.
• An absolute time limit also exists: no avoidance action can be taken if twenty years have passed since the date of the act in question.
  These are periods of extinctive prescription (除斥期間 - joseki kikan), meaning the right is extinguished upon their expiry.

Conclusion

The Hinin-ken, or Right of Avoidance, is a formidable and essential instrument in the Japanese bankruptcy trustee's toolkit. It enables the trustee to look back at pre-bankruptcy dealings and reclaim assets or value that were improperly diverted from the estate, whether through fraudulent schemes, unfair preferences, or other detrimental transactions. By unwinding such actions, the trustee works to enlarge the bankruptcy estate and uphold the fundamental bankruptcy principles of maximizing assets available for creditors and ensuring their fair and equitable treatment. For businesses and individuals transacting with Japanese entities, particularly those in financial distress, an awareness of these avoidance powers is a critical aspect of risk assessment and legal diligence.