Q: Issues and Proposed Reforms for Japan's Factory Mortgage and Factory Foundation Laws: A Look at Current Debates?

Japan's Factory Mortgage Act (Act No. 54 of 1905) introduced two specialized security devices: the "narrow sense" factory mortgage (Kojo Teito) and the more comprehensive "factory foundation" (Kojo Zaidan). These systems were groundbreaking in their time, designed to facilitate industrial financing by allowing for more effective collateralization of factory assets than was possible under the general Civil Code. However, over a century later, in the face of evolving business practices and modern financing techniques like project finance, these systems have exhibited certain limitations, leading to discussions and proposals for reform. This article explores some of the identified issues with these longstanding laws and the nature of the reforms that have been considered.

A Quick Recap: Factory Mortgages and Factory Foundations

Before delving into their shortcomings, it's useful to briefly recall what these systems entail:

• "Narrow Sense" Factory Mortgage: A mortgage established on a factory's land and/or buildings, with its scope statutorily extended to cover specific operational machinery and equipment listed in a registered "Article 3 Inventory" (Dai-san-jō Mokuroku). This inventory is crucial for perfecting the mortgage over these ancillary assets against third parties.
• Factory Foundation: A more elaborate system where a collection of diverse factory assets (land, buildings, machinery, industrial property rights, leaseholds, etc.) is legally bundled through a specific registration process to create a new, single "immovable" property—the foundation. This entire foundation can then be mortgaged as one unit.

Identified Shortcomings of the Existing "Narrow Sense" Factory Mortgage

Despite its utility in extending security to operational equipment, the narrow factory mortgage system has faced several criticisms:

1. Limited Scope of Application: The most fundamental limitation is that its use is restricted to undertakings that meet the statutory definition of a "factory" under the Factory Mortgage Act. This excludes many other types of businesses that might also have significant operational assets they wish to collateralize.
2. Challenges with the Article 3 Inventory:
   • Administrative Burden: For factories with frequently changing machinery, the requirement to continually update the Article 3 Inventory through formal amendment registrations to maintain perfection is administratively burdensome and costly. This can lead to discrepancies between the registered inventory and the actual assets on site.
   • Legal Complexities and Priority Issues: The legal effect of the inventory, particularly when multiple factory mortgages with differing or inconsistently updated inventories exist on the same property, has been a subject of debate (e.g., perfection requirement theory vs. public notice theory). This can create uncertainty regarding the priority of security interests over specific pieces of equipment.
3. Questionable Overall Advantage: Some legal commentators have questioned whether the factory mortgage, with its attendant inventory complexities, offers a significant practical advantage over using a standard Civil Code real estate mortgage combined with more modern movable security mechanisms (like registered security assignments of movables), especially if the unique benefits of the inventory system are perceived as marginal or outweighed by the burdens. This has even led to suggestions that this specific narrow factory mortgage system might be redundant or could be abolished/significantly overhauled.

Identified Shortcomings of the Existing Factory Foundation System

The Factory Foundation, while more comprehensive, also has its limitations:

1. Limited to "Factories": Like the narrow factory mortgage, its application is confined to statutorily defined "factories".
2. Potentially Incomplete Collateralization (Arbitrary Selection): The Factory Mortgage Act allows the owner to select which eligible assets are included in the foundation (the "arbitrary selection principle" - nin'i sentaku shugi). There is no obligation to include all assets of the factory. This means a Factory Foundation may not always represent a truly comprehensive security interest over all valuable operational assets, as owners might strategically exclude certain items.
3. Exclusion of Certain Valuable Intangible Assets: While "industrial property rights" (patents, trademarks, etc.) can be included, other valuable intangible assets, such as copyrights or significant contractual rights not amounting to leaseholds or superficies, generally cannot be incorporated as distinct components of a Factory Foundation.
4. Dependency on Core Real Property and Consents: The establishment of a Factory Foundation typically requires a core real property element (land, buildings, or recognized rights thereto like superficies or certain leaseholds) to define the "place" of the factory. If such a real property anchor is absent, or if necessary consents (e.g., from lessors for the inclusion of crucial leasehold rights) cannot be obtained, forming a foundation may be impossible.
5. Cumbersome Inventory Management: Similar to the Article 3 Inventory, managing the detailed and comprehensive Factory Foundation Inventory for large, dynamic industrial facilities with frequently changing assets is a significant administrative burden and expense.
6. Perceived Weakening of Security over Separated Movables: A Supreme Court decision (September 15, 1964, Showa 39) which recognized the possibility of bona fide purchase of movable assets that had been separated from a Factory Foundation was seen by some as potentially weakening the absolute "asset-bundle" protection. It suggested that the practical effect of the foundation over such separated movables might, in certain third-party scenarios, resemble the pursuit rights under a narrow factory mortgage rather than an unbreakable tie to the foundation.

The Impetus for Reform: Meeting Modern Financial Needs

The call for reforming these century-old collateral systems has been driven by several factors:

• Evolving Financing Techniques: The rise of sophisticated financing methods like Project Finance (PF) requires flexible and truly comprehensive security over entire business undertakings or specific projects, often involving a mix of tangible and intangible assets, and future revenues. The existing factory-specific systems are often not well-suited for these broader needs.
• Broader Business Applicability: There is a recognized need to extend the benefits of holistic asset collateralization to a wider range of businesses beyond the traditional, narrowly defined "factories."
• Simplification and Modernization: A desire to simplify the often complex and administratively demanding procedures, particularly those related to the creation and maintenance of asset inventories, and to align registration processes with modern digital practices.

Key Reform Proposals: The METI Model and Beyond

In Japan, discussions around reform have often centered on proposals developed by study groups associated with the Ministry of Economy, Trade and Industry (METI). A significant report in January 2003 by METI's Corporate Law Study Group (Security Systems Study Group) outlined models for new security systems. These proposals, as discussed in legal commentaries around 2016, included concepts like:

A. The "Business Facility Mortgage" (Jigyō Setsubi Teitō)

This was envisioned as an evolution of the narrow sense factory mortgage.

• Broader Applicability: It would potentially apply to a wider category of "business facilities" (jigyō setsubi), not just traditional "factories," thus expanding its utility to more commercial sectors.
• Inventory System Revisions: Discussions included making the inventory system more flexible. This might involve considering a "public notice theory" for the inventory's effect (where its primary role is alerting third parties, rather than being a strict item-by-item perfection requirement for every detail) or exploring whether non-owned assets (e.g., leased machinery critical to operations) could be included under certain conditions.
• Achieving Comprehensiveness: For this mortgage to offer truly comprehensive security over operational equipment, some proposals suggested that the inclusion of all essential operational equipment in the inventory might need to be mandatory rather than selective.

B. The "Business Facility Foundation" (Jigyō Setsubi Zaidan)

This was conceived as an enhanced version of the current Factory Foundation.

• Wider Scope: Applicable to "business facilities," offering broader sectoral reach.
• More Inclusive Asset Pool: Designed to allow for the inclusion of a wider range of assets, potentially including copyrights and other intangible rights not currently covered by Factory Foundations.
• Greater Flexibility in Formation: Potentially allowing for the establishment of such a foundation even without a traditional core real estate component or long-term leasehold, if the business's value and operational integrity are centered on other types of assets (e.g., extensive cable networks, a collection of high-value intellectual property and related operational tools).
• Stronger Unitary Treatment: Aiming to strengthen the "going concern" aspect, possibly allowing for en-bloc sale even in voluntary dispositions by the owner, not just in foreclosure scenarios.
• Comprehensive Asset Inclusion: To ensure robust security, a shift from the "arbitrary selection" of assets (as in the current Factory Foundation) towards a more mandatory inclusion of all key assets constituting the business facility was considered crucial.

C. A New Form of Comprehensive, Floating-Type Security System

The METI study group also explored a second, more radical proposal for a new type of comprehensive security interest, particularly aimed at entities like Special Purpose Companies (SPCs) often used in project finance.

• Blanket Coverage: This system would be designed to cover all assets of the designated entity, both present and future, effectively creating a floating charge over the entire enterprise or project.
• Suitability: While seen as potentially ideal for ring-fenced SPCs in project finance where all assets are dedicated to a single project, it was noted that such an all-encompassing charge might not be suitable for general operating companies. If all assets are subject to a blanket first-ranking charge, it could overly encumber the company and hinder its ability to obtain other forms of specific financing (e.g., for short-term working capital secured by receivables or inventory).

Overarching Objectives of the Proposed Reforms

The various reform discussions and proposals have generally shared common objectives:

• Broader Applicability: To allow more types of businesses, beyond the traditional industrial "factory," to benefit from robust, holistic collateralization systems.
• More Truly Comprehensive Security: To enable a wider range of valuable business assets, including more intangibles and potentially future assets, to be effectively secured.
• Simplified and Modernized Procedures: To reduce the administrative burdens and costs associated with current inventory systems and registration processes.
• Enhanced Legal Certainty and Utility: To provide clearer, more predictable, and more effective security tools that align with contemporary financing practices, especially for complex projects and enterprise-level financing.

Challenges and Status of Reform Efforts (as of a 2016 Perspective)

Despite the recognized need and detailed proposals, comprehensive legislative reform in this area has proven challenging. Commentaries from around 2016 indicated that formal deliberations by the Ministry of Justice regarding the overhaul of enterprise and foundation security laws had largely stalled after an interim report was issued in 2006 (Heisei 18).

Implementing such wide-ranging reforms involves navigating complex legal issues, including:

• Balancing the desire for comprehensive "blanket" security with the need for businesses to retain flexibility and access various forms of financing.
• Addressing intricate priority rules that would arise with new forms of security, especially in relation to existing statutory liens and other security interests.
• The technical and administrative challenges of designing and implementing new or significantly revised registration systems.

Even in the absence of major legislative changes to the Factory Mortgage Act itself, there have been ongoing practical considerations, such as proposals for modernizing the registration processes for existing factory foundations, aiming to digitize records and align procedures more closely with the already modernized general real estate registration system in Japan.

Conclusion

The Japanese factory mortgage and factory foundation systems, while pioneering for their era, have faced scrutiny regarding their limitations in the context of modern business and complex financing demands. Various reform proposals have been put forth over the years, notably those stemming from METI-led study groups, which envisioned more flexible, comprehensive, and broadly applicable systems like a "Business Facility Mortgage" or "Business Facility Foundation," and even new forms of enterprise-wide floating charges for specific contexts.

These debates underscore a persistent effort within Japan to adapt its unique statutory collateral systems to better serve contemporary economic needs and sophisticated financial transactions. While comprehensive legislative reform has been a gradual and challenging endeavor, the identified issues and the nature of the proposed solutions provide valuable insight into the ongoing quest for more efficient and effective business security law in Japan.