Q: For U.S. Companies: Key Legal Considerations When Dealing with Japanese Factory Mortgages or Foundations as a Creditor or Investor?

Japanese Attorney at Law - Bengoshi L.L.

• 6 min read

U.S. companies engaging in financing transactions or investments involving Japanese industrial operations will often encounter specialized security mechanisms unique to Japanese law. Among the most significant are the "narrow sense" factory mortgage (Kojo Teito) and the "factory foundation" (Kojo Zaidan), both governed by Japan's Factory Mortgage Act (Act No. 54 of 1905). These tools allow for the collateralization of factory assets, including machinery and equipment, in ways that differ substantially from U.S. UCC-style security interests. For U.S. creditors or investors, understanding the key legal considerations surrounding these Japanese instruments is paramount for effective risk assessment, due diligence, and enforcement.

The first crucial point for U.S. entities is recognizing that Japanese secured transactions law, particularly for specialized assets like factories, operates under a distinct statutory framework. It is not a Uniform Commercial Code (UCC) system.

  • Statutory Basis: Both the factory mortgage and the factory foundation are creatures of specific statutes that modify or supplement the general principles of the Japanese Civil Code. Their creation, scope, perfection, and enforcement are dictated by the Factory Mortgage Act and related regulations.
  • Registration is Paramount: Unlike the U.S. system where filing a financing statement perfects a security interest in a wide range of collateral, Japanese law places immense emphasis on specific acts of registration in designated public registers to create, perfect, and establish the priority of these security interests. The nature and location of these registrations are highly specific to the type of security and asset involved.

2. Rigorous Due Diligence on the "Factory" and Its Assets

Before entering into any transaction involving a Japanese factory mortgage or foundation, U.S. companies must conduct thorough due diligence:

  • Verifying "Factory" Status: The Factory Mortgage Act has a precise definition of what constitutes a "factory" (covering manufacturing, processing, printing, photography, and certain utility/telecom/broadcasting operations conducted at a specific "place"). It's essential to confirm that the target operation legally qualifies, as this is a prerequisite for using these specialized security devices.
  • Asset Ownership and Existing Encumbrances: Diligently verify the Japanese entity's ownership of all assets intended to be included as collateral—land, buildings, crucial machinery, and, for foundations, any industrial property rights or leaseholds. Critically, searches must be conducted for any pre-existing mortgages, pledges, statutory liens, attachments, or other encumbrances that could affect the priority of the new security interest or an asset's eligibility for inclusion (particularly for factory foundations, which require assets to be largely free of conflicting prior rights).
  • Scope of Includable Assets: Understand precisely what assets can (and cannot) be legitimately included:
    • For a "narrow sense" factory mortgage, this involves scrutinizing which machinery and equipment qualify as "supplied for the use of the factory" (kyōyō bukken) and are thus eligible for the Article 3 Inventory. Certain independently registrable movables like most ships and automobiles are typically excluded and require their own security registrations.
    • For a factory foundation, the list of potential constituent assets is broader (land, buildings, machinery, industrial property rights, specific leaseholds, etc. ), but each must meet strict eligibility criteria.

3. The Critical Role of Inventories and Registration for Perfection

Perfection (taikō yōken)—the process by which a security interest becomes enforceable against third parties—is achieved through meticulous registration.

  • Factory Mortgage (Article 3 Inventory - Dai-san-jō Mokuroku):
    • For the mortgage to effectively cover machinery and equipment against third-party claims, these assets must be accurately and specifically listed in the registered Article 3 Inventory. The Supreme Court of Japan confirmed this perfection requirement in its ruling of July 14, 1994. U.S. creditors should ensure this inventory is comprehensive and correctly filed.
  • Factory Foundation (Factory Foundation Inventory - Kojo Zaidan Mokuroku):
    • The Factory Foundation itself is created by a "registration of preservation of ownership" (shoyuken hozon toki), and its constituent assets are defined by the detailed Factory Foundation Inventory, which becomes part of the public register. This inventory's recording is both an establishment requirement for the assets to be part of the foundation and a perfection requirement for their status as such.
    • Furthermore, for registered assets (like land or patents) included in a foundation, notations are made in their individual primary registers stating that they "belong to Factory Foundation No. X" (Article 34, Factory Mortgage Act). This is crucial for perfecting the restrictions on their separate disposal.
  • Timely Amendments: Factories are dynamic. If secured machinery is replaced, new significant equipment added, or assets otherwise disposed of (where permissible), the relevant inventory (Article 3 or Factory Foundation) must be formally amended through a new registration to reflect these changes accurately. Failure to do so can result in new assets being unperfected or removed assets still appearing encumbered, leading to disputes.
  • The Six-Month Mortgage Rule (Factory Foundations): A Factory Foundation legally dissolves if a mortgage is not registered upon it within six months of its creation (Article 10, Factory Mortgage Act). This is a critical deadline for financiers relying on a newly established foundation as collateral. A similar rule applies if all mortgages are later extinguished without new ones being registered promptly.

4. Understanding Restrictions on the Borrower's Ability to Deal with Secured Assets

These Japanese security devices impose significant limitations on the borrower's (factory owner's) ability to deal with the encumbered assets, which generally benefits the creditor:

  • Factory Foundation (Article 13(2), FMA): Constituent assets of a registered Factory Foundation generally cannot be separately transferred, further encumbered, or attached by other creditors. The foundation is meant to be an indivisible whole for security purposes. This provides strong protection for the mortgagee's interest in the entire collateral package.
  • Factory Mortgage (Article 7, FMA): Machinery and equipment listed in the Article 3 Inventory generally cannot be attached separately from the mortgaged land or building. If such assets are removed without mortgagee consent, the mortgagee may have pursuit rights (Article 5, FMA).

U.S. creditors should understand these restrictions as they define the integrity of their collateral and can influence loan covenants regarding asset management.

The Factory Mortgage Act grants mortgagees specific consent rights over certain actions by the borrower, providing a measure of control or influence:

  • Separation of Assets from a Factory Foundation: Typically requires the consent of all mortgagees on the foundation (Article 15, FMA).
  • Leasing of the Entire Factory Foundation: Requires consent of the mortgagee(s) (Article 14, Paragraph 2, FMA).
  • Amendments to Inventories: Many amendments to the Article 3 Inventory or the Factory Foundation Inventory, particularly those involving the removal or substitution of assets, require mortgagee consent (Article 38, Paragraph 2, FMA, applied directly or mutatis mutandis).

These consent rights are important tools for creditors to protect the value and composition of their security.

6. The Enforcement Process: Unitary Sales and Court Involvement

Should enforcement become necessary:

  • The process is generally a court-supervised public auction under the Civil Execution Act, but with specific modifications from the Factory Mortgage Act.
  • Unitary/En-Bloc Sale Preference: Both systems strongly favor a unitary sale of the secured assets to preserve operational ("going-concern") value. For a factory mortgage, this means selling the land/building together with the inventoried machinery. For a factory foundation, the primary method is an en-bloc sale of the entire foundation as a single unit.
  • Court's Role in Post-Auction Registrations (Foundations): A distinctive feature for factory foundations is the extensive role of the Japanese court clerk in managing and commissioning the various title transfer registrations for all registered constituent assets (land, IP rights, etc.) in their respective primary registers after an en-bloc sale (Article 47, FMA). This helps ensure a cleaner transfer of title for the entire operational entity to the buyer.
  • Piecemeal Sale of Foundation Assets: While an en-bloc sale is preferred for foundations, Article 46 of the FMA allows a court, upon mortgagee petition, to order the individual sale of a foundation's components. This, however, leads to the foundation's legal dissolution.

7. Strategic Choice of Security Device

U.S. creditors or investors should understand the strategic reasons for choosing one device over the other:

  • A narrow factory mortgage is generally less complex and costly to establish and may be suitable when the primary collateral is a specific factory site and its key installed machinery.
  • A Factory Foundation is more appropriate for large, integrated operations where maximizing collateral value by bundling diverse assets (including immovables, many types of movables, and some intangibles) as a single going concern is paramount. It offers very strong control over the asset pool but comes with higher complexity and administrative burdens.

8. Overarching Practical Considerations for U.S. Entities

  • Engagement of Specialized Japanese Legal Counsel: Navigating these complex, statute-specific Japanese security systems is virtually impossible without experienced local legal counsel. Their expertise is vital for due diligence, documentation, registration, and enforcement.
  • Language and Documentation: All legal proceedings, official documents, and registrations will be in Japanese. Accurate translation and understanding of Japanese legal terminology are critical.
  • Costs and Timeframes: Establishing and maintaining these security interests, particularly a Factory Foundation, can involve significant time and expense (legal fees, registration taxes, appraisal costs). These should be factored into any transaction.
  • Cross-Border Enforcement: While the security is created under Japanese law, U.S. entities should also consider (with counsel) the implications for cross-border recognition or enforcement, though this aspect is beyond the direct scope of the provided PDF information.

Conclusion

Japanese factory mortgages and factory foundations offer powerful, albeit intricate, mechanisms for securing industrial assets. For U.S. companies operating as creditors or investors in Japan, a thorough understanding of these unique systems is indispensable. Key considerations include conducting comprehensive due diligence on the "factory" status and its assets, meticulously managing the critical registration and inventory requirements to ensure perfection against third parties, being aware of the statutory restrictions on asset disposal and the corresponding mortgagee consent rights, and understanding the specific enforcement procedures. Given the specialized nature of these Japanese collateral tools and their deviation from U.S. norms, engaging knowledgeable local legal counsel from an early stage is a fundamental prerequisite for protecting one's interests.