Q: What is a "Factory Mortgage" (Kojo Teito) in Japan and How Does It Differ from a Standard Real Estate Mortgage?

When businesses seek financing in Japan, particularly for industrial operations, the nature and scope of collateral can become complex. While standard real estate mortgages are common, Japan's legal framework offers a specialized system for securing assets integral to factory operations: the Factory Mortgage (Kojo Teito). This mechanism, governed by the Factory Mortgage Act (Act No. 54 of 1905), presents distinct features and advantages compared to mortgages under the Japanese Civil Code. Understanding these differences is crucial for anyone involved in lending to, investing in, or acquiring Japanese industrial enterprises.

The Standard Real Estate Mortgage in Japan: A Brief Overview

Under the Japanese Civil Code (Act No. 89 of 1896), a mortgage (teitoken) is a non-possessory security right that can be established over real property – primarily land and buildings – to secure an obligation, typically a loan. The mortgagee (creditor) does not take possession of the mortgaged property; the mortgagor (debtor or a third-party security provider) continues to use and profit from it. If the debtor defaults on the secured obligation, the mortgagee can foreclose on the mortgage, and the property will be sold at auction, with the proceeds applied to satisfy the debt.

A key aspect of the Civil Code mortgage, as stipulated in Article 370, is that its effect extends not only to the real property itself but also to anything "attached to and forming an integral part of such immovable" (fuka shite ittai to natteiru mono). This generally includes fixtures. Furthermore, the effect of the mortgage is also understood to extend to appurtenances (jūbutsu) of the principal mortgaged property (based on Article 87, Paragraph 2 of the Civil Code, which states that the disposition of a principal thing extends to its appurtenances).

However, when it comes to a factory, this standard framework presents limitations:

1. Machinery and Equipment: Much of a factory's value lies in its machinery, equipment, and other movable assets. Under a standard Civil Code mortgage, it can be ambiguous or difficult to definitively include these items within the scope of the mortgage unless they are unequivocally deemed permanent fixtures integrated into the land or building. Detached or less integrated machinery might be considered mere movables, falling outside the mortgage's scope.
2. Operational Value: A factory's true economic value often derives from its operation as an integrated whole, where land, buildings, machinery, and equipment function together. A standard real estate mortgage, focusing primarily on the immovable components, might not fully capture or secure this holistic operational value. Piecemeal collateralization could lead to a lower overall valuation and difficulties in realizing the factory's value as a going concern upon enforcement.
3. Cumbersome Procedures for Movables: While movables can be pledged (shichiken), this requires the transfer of possession to the creditor, which is impractical for operational factory machinery. Alternatively, creating security over numerous individual movables can be procedurally complex and may not offer robust protection.

These limitations highlighted the need for a more specialized approach to secure financing for industrial enterprises.

The Genesis and Purpose of the Factory Mortgage Act

The Factory Mortgage Act was established in 1905, a period of significant industrial development in Japan. The primary impetus behind this legislation was to facilitate corporate financing for factories by allowing them to offer more comprehensive and valuable collateral. Traditional Civil Code provisions were often insufficient to meet the evolving needs of industrial finance.

The Act serves as a special law (tokubetsuho) in relation to the Civil Code. This means that where the Factory Mortgage Act provides specific rules for factory mortgages, those rules take precedence over the general provisions of the Civil Code. For matters not covered by the Factory Mortgage Act, the Civil Code provisions on mortgages generally apply.

The core objectives of the Factory Mortgage Act, particularly concerning the "factory mortgage in the narrow sense" (which is distinct from a "factory foundation mortgage," another mechanism under the same Act), are:

• To expand the scope of the mortgage: Allowing the mortgage to cover not only the land and buildings but also the machinery, equipment, and other items essential for the factory's operation, even if they aren't strictly fixtures under Civil Code interpretations.
• To treat the factory as an organic unit: Recognizing that the value of a factory is maximized when its components are treated as an integrated operational unit, thereby enhancing its value as collateral.
• To simplify and strengthen security for lenders: Providing a clearer and more robust framework for securing loans against the entirety of a factory's productive assets.

Defining the "Factory Mortgage" (Kojo Teito – Narrow Sense)

The "factory mortgage in the narrow sense" (kyogi no kojo teito) under the Factory Mortgage Act is a mortgage created over the land and/or buildings that belong to a "factory" as defined by the Act. The Act broadly defines a factory as a place used for the manufacturing or processing of goods, or for printing or photography, for business purposes (Article 1, Paragraph 1). It also extends this definition to places used for the business of supplying electricity or gas, or providing telecommunications services (Article 1, Paragraph 2).

While it is established on specific immovables (land/buildings), its defining characteristic is its expanded reach over associated assets, aiming to secure the factory as a cohesive economic entity.

Key Differences: Factory Mortgage vs. Standard Real Estate Mortgage

The distinctions between a factory mortgage and a standard Civil Code mortgage are significant, primarily concerning the scope of the collateral and the legal mechanisms for defining that scope.

1. Scope of Collateral – The Defining Distinction

This is the most critical area of divergence.

• Standard Real Estate Mortgage (Civil Code):
  • Covers the land and/or building itself.
  • Extends to "fixtures" that are physically and functionally integrated with the immovable property (Civil Code, Article 370). The interpretation of what constitutes a fixture can sometimes be a grey area.
  • Also extends to "appurtenances" (jūbutsu) – separate items that serve the primary use of the main property, provided they belong to the same owner (Civil Code, Article 87). Examples might include detached sheds serving a main building. However, the application to factory machinery could be uncertain.
• Factory Mortgage (Factory Mortgage Act):The Factory Mortgage Act (Article 2) explicitly provides for this expanded scope. This means that even if a piece of machinery is not a "fixture" in the traditional sense (e.g., it could be moved without damaging the building), it can still be subject to the factory mortgage if it is installed on the premises and used for the factory's operations.The Article 3 Inventory (Dai-san-jō Mokuroku)A unique and vital feature of the factory mortgage system is the "Article 3 Inventory". When a factory mortgage is registered, an inventory of the specific machinery, tools, and other such items (which are not land or buildings themselves but are covered by the mortgage due to their use in the factory) must be submitted to the Legal Affairs Bureau (registry office).This contrasts sharply with standard real estate mortgages, where there is no equivalent formal inventory system for appurtenances or less-integrated fixtures. The efficacy of a standard mortgage over such items relies more on general legal principles and case-by-case interpretation.
  • Covers the mortgaged factory land and/or buildings.
  • Crucially, its effect extends beyond traditional fixtures and appurtenances to include:
    • Things added to and forming an integral part of the land or building (fuka shite之to ittai o nashitaru mono) – similar to Civil Code fixtures.
    • Machinery, instruments, and other things supplied for the use of the factory (sono tochi/tatemono ni sonaetsuketaru kikai, kigu sono ta kojo no yo ni kyosuru mono) that are installed on the land or in the building. This is a significant expansion. These items do not need to be so integrated as to lose their independent character, unlike strict fixtures. They are covered because they are dedicated to the factory's operational purpose. The PDF refers to these as "備え付けた機械、器具等" (installed machinery, equipment, etc.).
• Purpose: This inventory serves to clearly identify the movable assets that, by virtue of the Factory Mortgage Act, fall under the scope of the factory mortgage. It provides clarity and public notice regarding these specific assets.
• Legal Effect: The inventory is considered part of the mortgage registration. For the mortgage to be effective against third parties with respect to the machinery and equipment listed, these items generally must be recorded in this inventory. The Supreme Court ruling of July 14, 1994 (Minshu 48-5-1126), affirmed that for the mortgage's effect on such "supplied-for-use objects" (kyōyō bukken) to be asserted against third parties, their inclusion in the Article 3 Inventory is necessary. This highlights the inventory's role as a perfection requirement for these ancillary assets.
• Content: The inventory typically lists items by type, structure, quantity, manufacturer, manufacturing date/year, serial numbers, and other identifying information.

2. Valuation and Economic Unity

The Factory Mortgage Act aims to preserve the factory's value as a going concern or an organic economic unit.

• Standard Real Estate Mortgage: When foreclosed, the valuation might primarily focus on the liquidation value of the land and buildings separately, potentially undervaluing the synergistic value of the entire operation.
• Factory Mortgage: By encompassing essential machinery and equipment, the factory mortgage allows the entire operational setup to be treated more cohesively. This can lead to a higher overall collateral valuation because it reflects the earning capacity of the factory as an integrated entity, not just the sum of its parts. Upon enforcement, there's a better chance of selling the factory as a functional unit.

3. Prohibition on Separate Seizure of Listed Items

Article 7 of the Factory Mortgage Act stipulates that items covered by the factory mortgage (i.e., the land/building and the items listed in the Article 3 Inventory as being supplied for the factory's use) cannot be subject to separate attachment, provisional attachment, or provisional disposition if they are not taken together with the factory land or building to which they are attached or for whose use they are supplied. This provision protects the integrity of the factory as a single collateral unit and prevents the piecemeal dismantling of its operational capacity by other creditors, thereby safeguarding the factory mortgagee's security.

4. Pursuit Rights (Tsuikyūkō)

The Factory Mortgage Act (Article 5) grants the mortgagee the right to pursue mortgaged objects (including those listed in the Article 3 Inventory) even if they are separated from the factory premises and delivered to a third party, unless the third party acquired them in good faith and without negligence (akin to the principle of bona fide purchase of movables under Article 192 of the Civil Code). This provides a stronger right of pursuit for the ancillary items than might be available under a standard mortgage for items that are not clearly fixtures.

Why Was the Factory Mortgage System Deemed Necessary?

The limitations of the Civil Code's general provisions for securing industrial assets were a significant driver for the enactment of the Factory Mortgage Act.

• Impracticality of Pledge for Machinery: A pledge (shichiken) requires the creditor to take possession of the pledged asset. This is unworkable for essential factory machinery and equipment, as the factory would cease to function.
• Cumbersomeness and Incompleteness of Standard Mortgages:
  • Establishing separate security interests over numerous individual pieces of machinery would be extremely burdensome and costly.
  • A standard mortgage on only land and buildings often failed to reflect the true operational value of the factory, making it harder for businesses to obtain sufficient credit. The individual value of separated machinery might be significantly lower than its value as part of an operational factory.
• Promoting Industrial Finance: By creating a mechanism to secure a factory's assets as an integrated whole, the Act aimed to increase the creditworthiness of industrial enterprises, thereby facilitating investment and supporting Japan's industrial growth. The system allows for the "unitary collateralization of business equipment" (kigyo setsubi o tan'itsu tai toshite tanpoka suru).

The Factory Mortgage Act, therefore, provided a solution by allowing land, buildings, and essential operational assets to be bundled together under a single, more comprehensive security interest.

Considerations and Limitations of the Factory Mortgage

While advantageous, the factory mortgage system is not without its complexities:

• "Factory" Definition: The application of the Act is limited to entities that fall within the statutory definition of a "factory". Businesses that do not meet this definition cannot utilize this specific mortgage type.
• Article 3 Inventory Management: The accuracy and maintenance of the Article 3 Inventory are crucial. Changes to machinery and equipment (additions, disposals, replacements) necessitate updates to the inventory through formal registration amendment procedures to maintain the mortgage's effectiveness over those items against third parties. This can be an ongoing administrative task for the factory owner.
• Coexistence with Other Security: It's important to understand how a factory mortgage interacts with other potential security interests or ownership rights over specific assets within the factory. The PDF notes that, as a general rule, items already subject to the rights of others cannot be included in the scope of the factory mortgage in a way that prejudices those prior rights, or if included, the prior rights might take precedence depending on perfection.

Conclusion

The Japanese factory mortgage (Kojo Teito), as established by the Factory Mortgage Act, represents a significant departure from the standard real estate mortgage under the Civil Code. Its primary distinction lies in its expanded scope, designed to encompass not just the land and buildings of a factory but also the machinery, equipment, and other apparatus integral to its operations. This is largely achieved through the mechanism of the Article 3 Inventory, which formally lists these ancillary assets as part of the registered mortgage.

By treating the factory more as an organic, operational whole rather than a mere collection of separate assets, the factory mortgage system aims to enhance collateral value, facilitate more substantial financing for industrial enterprises, and provide lenders with a more comprehensive security interest. However, its specialized nature also brings procedural requirements, such as the diligent management of the Article 3 Inventory, that must be carefully observed to ensure the mortgage's full effectiveness. For foreign entities lending to or investing in Japanese industrial sectors, a clear understanding of this specialized collateral tool is indispensable for accurately assessing security packages and mitigating risks.