Rescinding Fraudulent Acts in Japan (Sagai Kōi Torikeshi-ken): How Can Creditors Challenge a Debtor's Asset-Shielding Transactions?

When debtors face financial distress, they sometimes engage in transactions that diminish their assets, making it harder for their creditors to obtain satisfaction. Japanese law provides a powerful remedy for creditors in such situations: the "Right to Rescind Fraudulent Acts" (詐害行為取消権 - sagai kōi torikeshi-ken), governed by Articles 424 et seq. of the Civil Code. This right allows a creditor, through court action, to nullify certain acts undertaken by the debtor with the knowledge that such acts would prejudice (harm) the creditors, and to seek the return of the improperly transferred assets or their value. The revised Civil Code (effective April 2020) has further refined and detailed the rules surrounding this critical tool for creditor protection.

Purpose and Legal Nature of the Fraudulent Act Rescission Right

1. Primary Objective: Preservation of the Debtor's "Liability Property"
   The fundamental purpose of the sagai kōi torikeshi-ken is to preserve the debtor's "liability property" (責任財産 - sekinin zaisan)—the general pool of assets available to satisfy the claims of all creditors. When a debtor undertakes an act that improperly reduces these assets, this right allows a creditor to step in, effectively undo the prejudicial transaction, and restore the dissipated assets or their value to a state where they can be reached by creditors, typically in preparation for future enforcement proceedings (e.g., execution of a judgment).
2. Supporting Creditor Equality
   While the rescission right is exercised by an individual creditor, its ultimate aim is to benefit the collective body of creditors by restoring assets to the debtor's estate. The revised Article 425 of the Civil Code clarifies that a final and binding judgment upholding the rescission is effective not only against the defendant (beneficiary or transferee) but also against the debtor and all other creditors of the debtor. This underscores its function in safeguarding the common security for all creditors, thereby supporting the principle of creditor equality in subsequent enforcement or bankruptcy distributions. It does not, however, grant the revoking creditor an automatic priority in the recovered assets over other creditors beyond what general enforcement or bankruptcy law might allow (though direct recovery to the creditor can create factual advantages, as discussed later).
3. Legal Nature under the Revised Civil Code
   Under the current Civil Code, the exercise of this right involves a court rescinding (cancelling) the debtor's prejudicial act. The typical consequence is that the property or its value is ordered to be returned to the debtor, or in certain cases, directly to the revoking creditor who then notionally holds it for the benefit of the debtor's estate (subject to potential set-off). This differs from some alternative theories debated under the old law, such as the "Responsibility Theory" (sekinin setsu), which posited that the property would remain with the beneficiary/transferee but become subject to execution as if it were still the debtor's. The new law has opted for a clearer "rescission and return" model.

Core Requirements for Exercising the Right Against a Beneficiary (Article 424)

For a creditor to successfully exercise the sagai kōi torikeshi-ken against the direct beneficiary of the debtor's act, several conditions must be met:

1. Existence of the Creditor's Claim (被保全債権 - hihozen saiken):
   The creditor must have a valid, existing claim against the debtor. This "preserved claim" is usually monetary or at least capable of being valued in monetary terms (e.g., a claim for specific performance that, if breached, would turn into a damage claim).
   • Timing of the Claim's Origin (Article 424, Paragraph 3): Crucially, the cause of the creditor's claim must have arisen before the debtor committed the alleged fraudulent act. The claim itself might have become fully due or quantified after the fraudulent act, but its underlying legal basis must predate it. For example, if a guarantee agreement was signed before the fraudulent act, a claim for reimbursement under that guarantee arising after the act can still be a preserved claim. This rule aims to protect creditors who relied on the debtor's asset condition as it existed before the prejudicial transaction.
   • Nature of the Claim: The claim does not need to be due at the time of the fraudulent act or when the rescission right is exercised. Conditional or future claims can also qualify if their cause predated the act. However, claims that are not legally enforceable (e.g., natural obligations, or claims fully discharged in bankruptcy without revival – see Supreme Court, February 25, 1997) cannot form the basis for this right (Article 424, Paragraph 4). Claims that are not yet concretely defined in scope or content (e.g., a right to property division upon divorce before any agreement or court determination – see Supreme Court, July 11, 1980) have also been held insufficient.
2. Debtor's Act Concerning a Property Right:
   The debtor's act targeted for rescission must be one that disposes of a property right or creates an obligation that diminishes the debtor's net assets available to creditors. This typically involves acts like:
   • Selling or gifting assets.
   • Creating security interests (mortgages, pledges) over assets.
   • Forgiving a debt owed to the debtor.
   • Undertaking new, substantial obligations.
     Acts that do not concern property rights in this sense (e.g., purely personal family law acts like marriage or adoption, or, according to a Supreme Court judgment of September 20, 1974, the renunciation of an inheritance) are generally not subject to rescission, even if they indirectly affect the debtor's financial capacity. However, an agreement on the division of an estate among heirs can be a target if it results in a prejudicial distribution (Supreme Court, June 11, 1999).
3. The Act Must Be Prejudicial to Creditors (詐害行為 - sagai kōi):
   This is the objective element of harm. The debtor's act must have resulted in their assets becoming insufficient to satisfy all their existing creditors (i.e., the act caused or worsened the debtor's state of insolvency - mushiryoku - 無資力).
   • Insolvency Assessment: Insolvency is generally assessed by comparing the debtor's total liabilities with their total realizable assets (excluding assets already validly encumbered by specific security interests to the extent of that security). The debtor must typically be insolvent at the time of the prejudicial act and this state of insufficient assets must generally continue up to the time the rescission right is exercised (specifically, the conclusion of oral arguments in the rescission lawsuit). If the debtor subsequently becomes solvent, the "necessity for preservation" may cease, and the right to rescind might be lost (this is a defense for the beneficiary/transferee).
4. Debtor's Knowledge of Prejudice (詐害の意思 - sagai no ishi):
   The debtor must have known, at the time of committing the act, that it would prejudice (harm) their creditors. This means the debtor was aware that the act would reduce their ability to meet their obligations to their general creditors. It is not necessary that the debtor intended to harm a specific creditor; knowledge that the act would be generally detrimental to the body of creditors is sufficient.
5. Beneficiary's Lack of Good Faith (Defense by Beneficiary - Article 424, Paragraph 1 Proviso):
   Even if all the above conditions are met, the rescission right can only be exercised against a beneficiary if the beneficiary, at the time of the act, knew that the act was prejudicial to the debtor's other creditors. The burden of proving good faith (i.e., that they did not know of the prejudicial nature of the act to other creditors) rests with the beneficiary. If the beneficiary successfully proves their good faith, the creditor cannot rescind the act against them.

Special Rules for Specific Types of Prejudicial Acts

The revised Civil Code introduced more detailed provisions for certain common types of transactions that might be prejudicial, largely aiming for consistency with principles found in Japanese bankruptcy law's denial powers:

1. Dispositions for Reasonable Value (Article 424-2):
   If the debtor disposed of property but received reasonable value in return (e.g., a sale at fair market price), this act is generally not considered prejudicial and cannot be rescinded.
   • Exception: It can be rescinded if (a) the act was part of a scheme to convert assets into a form that is easier to hide, dissipate, or grant away without consideration (e.g., selling real estate to get easily concealable cash); (b) the debtor had the specific intent to engage in such concealment or dissipation with the proceeds; AND (c) the beneficiary knew of the debtor's specific intent to conceal/dissipate.
2. Provision of Security or Extinguishment of Debt for an Existing Obligation (e.g., Preferential Payments - Article 424-3):
   Paying off an existing debt or providing security for an existing debt is generally not prejudicial if it was an act the debtor was obligated to do (e.g., payment of a due debt) and was done at an appropriate time.
   • However, such acts ARE prejudicial and can be rescinded if both of the following conditions are met:
     • The act was done when the debtor was already insolvent (unable to pay debts generally as they become due - 支払不能 shiharai funō) or had suspended payments (支払の停止 - shiharai no teishi).
     • The act was done with the debtor and the benefiting creditor colluding (通謀 - tsūbō) to harm other creditors.
   • Stricter Rules for "Non-Obligatory" Preferential Acts: If the act was "non-obligatory" (e.g., providing security that was not originally promised, or making a payment before it was due) and was done within 30 days before the debtor became insolvent (or after insolvency but before suspension of payments), it can be rescinded if there was collusion to harm other creditors.
3. Excessive Value in Kind for Debt or Excessive Security (Article 424-4):
   If a debtor makes a payment in kind (e.g., transfers property instead of cash) or provides security where the value of the property transferred or the security provided is grossly excessive compared to the amount of the debt it is intended to satisfy or secure, the creditor can seek rescission of the excessive portion of the transaction, provided the debtor knew the act would prejudice other creditors.

Exercising the Right Against Subsequent Transferees (Tentokusha) (Article 424-5)

If the property or benefit from the debtor's fraudulent act has been further transferred from the initial beneficiary to a subsequent transferee (tentokusha - 転得者), or even further down a chain of transferees, the creditor may still be able to exercise the rescission right against the current holder. However, the requirements are stricter:

1. Conditions Against Initial Beneficiary Met: All the conditions for rescinding the act against the initial beneficiary (including their bad faith) must be satisfied.
2. Chain of Bad Faith: All intervening transferees in the chain between the initial beneficiary and the current defendant transferee must also have been in bad faith (i.e., knew that the original debtor's act was prejudicial to the debtor's creditors) at the time they each acquired the property.
3. Current Transferee's Bad Faith: The current transferee (the defendant in the rescission suit) must also have been in bad faith at the time they acquired the property.

The burden of proving the bad faith of the subsequent transferees lies with the revoking creditor. This "chain of bad faith" requirement provides significant protection to innocent subsequent purchasers for value. If any party in the chain (from the initial beneficiary onwards to the person immediately before the current holder) was in good faith, the chain is broken, and the rescission right cannot typically be exercised against a subsequent bad-faith transferee.

Method of Exercise and Effects of Rescission

• Lawsuit Required (Article 424, Paragraph 1): The right must be exercised by filing a lawsuit in court. It cannot be asserted merely as an out-of-court demand or as a defense in other proceedings.
• Proper Defendants (Article 424-7, Paragraph 1): The defendant in the lawsuit is the beneficiary who received the property/benefit directly from the debtor, or the subsequent transferee who currently holds it. The debtor is not made a defendant in the rescission lawsuit itself.
• Notice to Debtor (Article 424-7, Paragraph 2): However, the creditor who files the rescission suit must, without delay, give notice of the lawsuit to the debtor. This allows the debtor to be aware of the proceedings and potentially intervene if their interests are affected.
• Return of Property or Its Value (Article 424-6):
  • The primary remedy is the rescission of the prejudicial act and an order for the return of the actual property (if it still exists and can be returned) to the debtor.
  • If the return of the actual property is difficult or impossible, its monetary value must be returned.
• Direct Delivery to Creditor (Article 424-9): The revoking creditor can request the court to order that any money or movable property to be returned be delivered directly to the creditor themselves. If the creditor receives such direct delivery, they are then obliged to account for it to the debtor (or the debtor's estate). This provision, particularly for money, can lead to a factual priority for the revoking creditor if they are able to set off their own claim against the debtor against their obligation to remit the recovered sum.
• Scope of Rescission (Article 424-8): If the subject matter of the fraudulent act is divisible (e.g., a sum of money), the creditor can only request rescission up to the amount of their own preserved claim against the debtor. They cannot seek to recover more than is necessary to secure their own debt.
• Effect of Judgment (Article 425): A final and binding court judgment upholding the rescission is effective not only between the revoking creditor and the defendant (beneficiary/transferee) but also against the debtor and all other creditors of the debtor. This means the recovered asset or value is considered part of the debtor's general assets available for satisfying all creditors.
• Rights of Beneficiary/Transferee After Making Restitution (Articles 425-2 to 425-4): If a beneficiary or transferee is forced to return property or its value, they may, in turn, have rights to recover any counter-performance they had given to the debtor (Article 425-2). If the fraudulent act involved the extinguishment of a debt owed by the debtor to the beneficiary (e.g., a preferential payment), the beneficiary's claim against the debtor may revive upon making restitution (Article 425-3). Specific rules also govern the rights of a subsequent transferee who made restitution against their own transferor or against the original debtor (Article 425-4).

Time Limits for Exercising the Right (Article 426)

The right to file a lawsuit for rescission of a fraudulent act is subject to strict time limits:

1. Within two years from the time the creditor became aware of (a) the fraudulent act itself AND (b) the fact that it was prejudicial to creditors.
2. In any event, within ten years from the time of the fraudulent act itself (even if the creditor was unaware). (This was shortened from 20 years under the old law).

These periods are considered periods for filing suit (shusso kikan - 出訴期間) and are generally not subject to the ordinary rules of interruption or renewal applicable to statutes of limitations (prescription periods). Missing these deadlines results in the loss of the right to seek rescission.

Conclusion

The Creditor's Right to Rescind Fraudulent Acts is a vital, albeit complex, component of Japanese creditor protection law. It allows creditors to challenge transactions designed to improperly shield a debtor's assets, thereby preserving those assets for eventual satisfaction of debts. The revised Civil Code has introduced greater detail and systematization to this right, particularly by delineating rules for specific types of prejudicial acts and clarifying the positions of subsequent transferees, largely seeking to harmonize its principles with those found in modern Japanese bankruptcy law concerning denial powers. Successful exercise of this right requires a thorough understanding of its intricate requirements regarding the debtor's conduct and knowledge, the nature of the act itself, the knowledge of beneficiaries and transferees, and strict adherence to the prescribed time limits for legal action.