Mortgages under Civil Rehabilitation in Japan: How Does Japan's Civil Rehabilitation Act Affect Mortgage Enforcement When a Debtor Undergoes Rehabilitation?

When a borrower in Japan faces financial distress but seeks to continue operations rather than liquidate, they may utilize the Civil Rehabilitation Act (民事再生法 - Minji Saisei Hō). This legislation, applicable to both corporations and individuals, provides a debtor-in-possession (DIP) style restructuring framework aimed at rehabilitating the debtor's business or economic life. For lenders holding mortgages over the debtor's property, understanding how their security interests are treated within these proceedings is paramount. While certain fundamental rights are preserved, the Act introduces mechanisms that can significantly alter the timing and method of mortgage enforcement.

Overview of Civil Rehabilitation Proceedings

The primary goal of the Civil Rehabilitation Act is to facilitate the economic revival of a financially distressed debtor. This is typically achieved through the formulation and approval of a rehabilitation plan, which is a blueprint for restructuring debts and operations, agreed upon by a requisite majority of creditors and sanctioned by the court. Unlike bankruptcy, which focuses on liquidation, civil rehabilitation emphasizes the continuation of the debtor's enterprise or personal economic activity. The debtor usually remains in control of their assets and business as a debtor-in-possession, although a supervisor or, in certain cases, a trustee may be appointed by the court.

Mortgagee's Rights: The Right of Separation (別除権 - Betsujoken) Generally Continues

A cornerstone of a mortgagee's rights in Japanese insolvency law is the "right of separation" (別除権 - betsujoken). Similar to its application in bankruptcy proceedings, this right is generally preserved for mortgagees under the Civil Rehabilitation Act.

In principle, this means that a creditor holding a mortgage can enforce their security interest (e.g., by initiating or continuing a foreclosure auction) outside the collective framework of the main civil rehabilitation proceedings. Their claim, to the extent covered by the collateral's value, does not need to be treated merely as a general rehabilitation claim subject to the cramdown provisions of a rehabilitation plan.

Limitations on Mortgage Enforcement: Court-Ordered Stays and Prohibitions

Despite the general preservation of the right of separation, the Civil Rehabilitation Act grants the court significant powers to control and potentially delay the enforcement of security interests, including mortgages, if deemed necessary for the debtor's rehabilitation.

• Pre-Commencement Protective Measures (保全措置 - Hozen Sochi): Even before civil rehabilitation proceedings are formally commenced, if a petition has been filed, the court can issue various interim protective orders to preserve the debtor's assets. These can include prohibitions on the debtor disposing of assets or making preferential payments.
• Individual Stay Orders (個別中止命令 - Kobetsu Chūshi Meirei) (Article 26): Once a petition for civil rehabilitation is filed, the court has the authority to issue orders staying specific enforcement actions based on "rehabilitation claims" (claims that arose pre-petition). This can include halting ongoing litigation or provisional remedies like attachments.
• Comprehensive Prohibition Orders (包括的禁止命令 - Hōkatsuteki Kinshi Meirei) (Article 27): In situations where individual stay orders are deemed insufficient to achieve the objectives of rehabilitation (e.g., due to a multitude of creditors attempting piecemeal enforcement), the court can issue a comprehensive prohibition order. This order broadly forbids all rehabilitation creditors from initiating or continuing any enforcement actions, including execution against the debtor's assets. The issuance of such an order is typically contingent upon important assets of the debtor already being subject to a preservation order, or a supervisor or trustee having been appointed.
• Specific Stay of Security Interest Enforcement (一般的担保権の実行手続の中止命令 - Ippanteki Tanpoken no Jikkō Tetsuzuki no Chūshi Meirei) (Article 31): This provision is of direct importance to mortgagees. The court may order a stay of procedures to enforce a security interest (such as a mortgage foreclosure auction) if two conditions are met: Before issuing such a stay order concerning an ongoing auction, the court is required to hear the opinion of the auction petitioner (the mortgagee). The duration of the stay is generally for a "reasonable period," intended to give the debtor time to negotiate a workout with the secured creditor, pursue a security interest extinguishment claim (discussed below), or incorporate treatment of the secured claim into the rehabilitation plan. The underlying purpose of such a stay is to prevent the piecemeal liquidation of assets that are critical for the debtor's continued operation and successful rehabilitation.
  1. The stay is deemed to be in the general interest of the rehabilitation creditors (i.e., it aids the overall rehabilitation effort).
  2. The stay is unlikely to cause undue prejudice to the creditor seeking to enforce the security (the mortgagee).

Security Interest Extinguishment Claim (担保権消滅請求 - Tanpoken Shōmetsu Seikyū)

The Civil Rehabilitation Act (Article 148 et seq.) provides a mechanism known as a "security interest extinguishment claim," which allows the debtor (or a trustee, if one is appointed) to essentially "buy out" a mortgage or other security interest on property that is indispensable for the continuation of the debtor's business. This is a key difference from the similarly named provision in the Bankruptcy Act, where the primary aim is to facilitate the trustee's disposal of assets. In civil rehabilitation, the goal is to retain essential assets for the debtor's ongoing operations.

• Procedure: The debtor petitions the court for permission to pay a sum of money, equivalent to the market value of the encumbered property, into the court. If the court grants this permission and the debtor makes the required payment by the court-stipulated deadline, all security interests (including the mortgage) on that specific property are legally extinguished.
• Mortgagee's Rights in this Process:
  • The mortgagee can file an immediate appeal with a higher court if they object to the court's decision granting permission to extinguish the security interest.
  • If the mortgagee disputes the debtor's valuation of the property (which forms the basis of the payment amount), they can request the court to make a formal determination of the property's value.
• Outcome: Upon successful payment by the debtor, the mortgage is extinguished. The court registrar then commissions the Legal Affairs Bureau to cancel the mortgage registration from the property's title. The funds paid into court by the debtor are subsequently distributed to the (now former) secured creditors according to their entitlements, similar to a distribution in an execution proceeding. If the debtor fails to make the payment by the deadline, the court's permission to extinguish the security interest is revoked.

Special Provisions for Housing Loans (住宅資金貸付債権に関する特則)

Chapter 10 of the Civil Rehabilitation Act contains special provisions specifically concerning housing loans granted to individual debtors. The overarching aim of these rules is to enable individual debtors facing financial hardship to retain their homes while undergoing economic rehabilitation.

To qualify for these special provisions, the "housing" in question must generally be:

• Owned by the individual rehabilitation debtor.
• Used by the debtor as their personal residence.
• Have more than half of its floor area dedicated to the debtor's residential use.
• If the debtor owns multiple such properties, it must be their primary residence.

Key mechanisms under these special provisions include:

• Permission for Continued Payments (弁済の許可 - Bensai no Kyoka) (Article 197(3)): Normally, once civil rehabilitation proceedings commence, payments on pre-petition debts (including mortgage installments) are stayed. However, to prevent immediate default on a housing loan and the potential loss of the home, an individual debtor can obtain specific permission from the court to continue making their regular housing loan payments even after the proceedings have started.
• Special Housing Loan Clauses (住宅資金特別条項 - Jūtaku Shikin Tokubetsu Jōkō) in the Rehabilitation Plan (Article 198): A rehabilitation plan can include "special clauses" that modify the terms of the housing loan.
  • These clauses can be utilized even if a guarantee company has already paid off the original lender under a loan guarantee, provided the debtor files for civil rehabilitation within six months of such payment by the guarantor. This is often referred to as the "claw-back" or "rewind" (巻戻し - makimodoshi) effect, designed to reinstate the original loan terms for modification.
  • However, these special clauses are generally not available if the house is also encumbered by other mortgages unrelated to the housing loan, or if other properties are jointly mortgaged for the housing loan and those other properties have junior liens whose holders' rights could be prejudiced by subrogation issues.
  • Article 199 outlines several types of modifications that can be incorporated:
    1. Cure and Reinstatement (期限の利益回復型 - kigen no rieki kaifuku-gata): The debtor repays any arrears over the duration of the rehabilitation plan while resuming regular scheduled payments.
    2. Rescheduling (リスケジュール型 - risukejūru-gata): If cure and reinstatement is not feasible, the loan term can be extended (e.g., by up to 10 years, provided the debtor will not be older than 70 at the new maturity date).
    3. Principal Moratorium with Rescheduling (元本猶予の併用型 - ganpon yūyo no heiyō-gata): If even rescheduling is insufficient, a temporary moratorium on a portion of the principal payments can be combined with rescheduling.
    4. Consensual Modification (合意型 - gōi-gata): The parties can agree to any modification of terms with the creditor's consent.
    5. "As Is" Clause (そのまま条項 - sonomama jōkō): In practice, if the debtor is current on their housing loan, the plan may include a clause stating the loan will continue "as is," primarily to protect it from the general stay on debt payments.
• "Claw-back" (Makimodoshi) of Guarantee Company Payments (Article 204): If a rehabilitation plan containing special housing clauses is approved after a guarantee company has paid the original lender under a guarantee, the subrogated claim of the guarantee company is generally treated as if it never occurred. The original loan relationship with the primary lender is effectively reinstated, and the guarantee company's guarantee obligation is revived. This complex provision aims to ensure that the debtor deals with the original housing loan lender, who has the expertise in managing such loans, rather than the guarantee company, for the purpose of the special clauses.
• Specific Stay of Enforcement for Housing Loans (Article 197): The court can also issue a stay order specifically for the enforcement of a mortgage securing a housing loan if it finds there is a likelihood that a rehabilitation plan containing special housing clauses will be approved. The conditions for this specific stay differ slightly from the general stay order under Article 31; for example, the requirement that the stay be "in the general interest of creditors" is not applied here.

Comparison with Bankruptcy Treatment

While both bankruptcy and civil rehabilitation in Japan acknowledge the right of separation for mortgagees in principle, there are key differences in emphasis:

• Civil rehabilitation provides more tools for the court to delay or modify the enforcement of security interests (through stay orders and the security interest extinguishment claim for essential assets) with the aim of facilitating the debtor's survival and continued operation.
• In bankruptcy, the security interest extinguishment claim is primarily a tool for the trustee to efficiently dispose of assets, rather than to preserve them for the debtor's use.

Conclusion for Lenders

The Japanese Civil Rehabilitation Act significantly impacts mortgage enforcement. While a mortgagee's fundamental right of separation generally continues, it is qualified by the court's extensive powers to issue stay orders to protect the debtor's rehabilitative efforts. Furthermore, the security interest extinguishment claim mechanism provides a path for debtors to retain essential mortgaged assets by paying their value, thereby converting the mortgagee's secured claim on the asset into a monetary claim against the funds paid. The special, protective provisions for housing loans add another layer of complexity for mortgages securing residential properties of individual debtors.

For US businesses and other lenders with mortgage security in Japan, it is crucial to be aware of these provisions. Active participation in any civil rehabilitation proceedings, understanding the potential for stays or extinguishment claims, and asserting rights in a timely manner are essential to navigating this restructuring landscape and protecting their interests.