Understanding Avoidance Powers (Hinin-ken) in Japanese Bankruptcy: Protecting Creditor Interests?

In any bankruptcy proceeding, a core objective is to ensure a fair and equitable distribution of the debtor's assets among its creditors. However, in the period leading up to a formal bankruptcy filing, a distressed debtor might engage in transactions that unfairly diminish the assets available for distribution or improperly favor certain creditors over others. To counteract such actions and restore value to the bankruptcy estate, Japanese bankruptcy law, like insolvency regimes in many other jurisdictions, grants the bankruptcy trustee powerful tools known as "avoidance powers" or hinin-ken (否認権). This article provides an in-depth exploration of these avoidance powers, detailing the types of transactions that can be challenged, the conditions under which avoidance is possible, the procedures for exercising these powers, and their ultimate effect on the involved parties and the bankruptcy estate.

The Rationale and General Principles of Avoidance Powers in Japan

The fundamental purpose of avoidance powers is to rectify pre-bankruptcy transactions that are detrimental to the general body of creditors. As a debtor slides towards insolvency, there is an increased risk of asset dissipation – whether through outright concealment, transfers for less than fair value, or payments made to preferred creditors. Hinin-ken allows the bankruptcy trustee to "undo" such transactions, thereby clawing back assets or their value into the bankruptcy estate for a more equitable distribution according to the priorities established by the Bankruptcy Act (破産法 - Hasan-hō).

Several general principles or requirements typically underpin the exercise of avoidance powers:

1. Harmfulness to Creditors (有害性 - Yūgai-sei): For a transaction to be avoidable, it must generally have caused harm to the collective interests of the creditors. This means that the avoidance of the transaction should result in an increase in the assets available for distribution to the general creditors, or otherwise improve their overall position. For instance, a payment to a fully secured creditor from the proceeds of their collateral, where the collateral's value equals or exceeds the debt, might not be considered harmful as it doesn't deplete assets that would have been available to unsecured creditors. Similarly, a truly contemporaneous exchange for equivalent value usually lacks this element of harm. A Supreme Court decision from January 25, 1993, addressed a nuanced scenario where funds borrowed by the debtor were specifically earmarked for repaying a particular existing debt, and these funds would not have otherwise been available to general creditors; the subsequent repayment using these specific funds was considered, in conjunction with the borrowing, as a single, neutral transaction lacking harm to other creditors.
2. Act Involving the Debtor's Assets (破産者の行為性 - Hasansha no Kōi-sei): Traditionally, avoidance powers target "acts" undertaken by the debtor concerning the property that would otherwise form part of the bankruptcy estate. However, the focus is increasingly on the detrimental effect of the transaction on the estate, rather than strictly on the debtor's direct involvement in every aspect. While purely creditor-initiated actions like a set-off (which is subject to its own set of restrictions) are generally not subject to hinin-ken, actions by third parties that are substantively equivalent to harmful acts by the debtor, or in which the debtor actively participated or colluded, can be caught. For example, payments received by a creditor through enforcement proceedings might be avoidable as preferences if the debtor participated in a way that facilitated this outcome, even if the debtor did not directly "intend" the preference in a subjective sense (Supreme Court, March 30, 1982). Similarly, the perfection of a security interest by a creditor during the suspect period, if it effectively creates a preference, might be challenged (Supreme Court, October 17, 1996, concerning a provisional registration based on a provisional disposition order).
3. Impropriety or Unfairness (行為の不当性 - Kōi no Futō-sei): While the underlying fairness of a transaction is a broad consideration, "impropriety" as a standalone, undefined general requirement for avoidance has largely been superseded by the specific categories and conditions set out in the Bankruptcy Act. The modern approach focuses on whether a transaction falls within one of the statutorily defined types of avoidable acts. If a transaction, while technically meeting the criteria for avoidance, was undertaken for overriding reasons of public policy or to meet essential needs (e.g., payments for basic living expenses by an individual debtor), its challenge might be constrained by general legal principles such as the doctrine of abuse of rights, rather than a specific "propriety" defense against avoidance. The Bankruptcy Act itself now provides specific rules for certain types of transactions, such as those made for fair value but with an intent to hinder creditors (discussed below).

Types of Avoidable Acts under Japanese Bankruptcy Law

The Japanese Bankruptcy Act categorizes avoidable transactions primarily into fraudulent acts and preferential acts.

A. Avoidance of Fraudulent Acts (詐害行為否認 - Sagai Kōi Hinin) (Bankruptcy Act, Art. 160)
This category targets transactions that are detrimental to creditors generally by reducing the debtor's overall assets.

1. Acts Done with Knowledge of Harm (Art. 160(1)(i)): Often referred to as "intentional avoidance" (koi hinin) under older terminology. The trustee can avoid acts undertaken by the debtor if the debtor knew at the time of the act that it would harm the creditors. Examples include selling valuable assets for a significantly undervalued price or making substantial gifts when the company is insolvent or approaching insolvency. This is conceptually similar to fraudulent conveyance actions aimed at actual fraud.
   • Beneficiary's Defense: The transaction cannot be avoided if the beneficiary (the person who received the property or benefit from the act) can prove that they did not know, at the time of the act, that it would be detrimental to the creditors (i.e., the beneficiary acted in good faith).
     It is worth noting that the avoidance power under the Bankruptcy Act is distinct from the general right of a creditor to seek cancellation of a fraudulent act under the Civil Code (Supreme Court, November 25, 1983).
2. Acts Done After Suspension of Payments or Bankruptcy Petition (Art. 160(1)(ii)): Often termed "crisis period avoidance" (kiki hinin). If the debtor performs an act that is harmful to creditors after it has suspended payments (支払停止 - shiharai teishi) or after a bankruptcy petition has been filed (by the debtor or a creditor), such an act is avoidable.
   • In this scenario, the trustee does not need to prove the debtor's subjective knowledge or intent to harm creditors. The fact that the harmful act occurred during this defined "critical period" is sufficient.
   • Beneficiary's Defense: The transaction cannot be avoided if the beneficiary can prove that they were unaware, at the time of the act, of the suspension of payments or the filing of the bankruptcy petition.
3. Avoidance of Gratuitous Acts or Their Equivalents (無償行為の否認 - Mushō Kōi no Hinin) (Bankruptcy Act, Art. 160(3)):
   • Gratuitous acts (e.g., gifts) or acts that are economically equivalent to gratuitous acts (e.g., selling a valuable asset for a nominal sum) made by the debtor are subject to a stricter avoidance rule.
   • Such acts are avoidable if they were made within six months before the suspension of payments or bankruptcy petition filing, or at any time after such events.
   • Critically, for these acts, neither the debtor's knowledge of harm nor the beneficiary's knowledge (good faith) is a defense. The focus is on the objective lack of consideration and the inherent detriment to creditors.
   • The debtor's solvency at the time of the gratuitous act is not a defense if the act falls within these prescribed timeframes (Supreme Court, November 16, 2017).
   • A significant practical application has been the avoidance of personal guarantees provided by business owners for their company's debts when the owner subsequently enters personal bankruptcy. If the owner provided the guarantee without receiving a direct, quantifiable fee from the company, it has been susceptible to being treated as a gratuitous act. The Supreme Court on July 3, 1987, ruled that such guarantees provided within the critical six-month period before the guarantor's financial crisis could be avoidable as gratuitous acts. This remains a debated area, as such guarantees are often indispensable for SME financing, and the guarantor (owner) often receives indirect benefits from the company's continued viability.
4. Avoidance of Disproportionate Substitution Payments (Art. 160(2)):
   • If a debtor settles an existing debt by transferring property (a payment in kind) instead of cash, and the fair value of the property transferred substantially exceeds the amount of the debt satisfied, the portion of the transfer representing this excess value can be avoided if the conditions for fraudulent act avoidance (under Art. 160(1)) are met. This targets situations where a guise of debt settlement is used to effect a partly gratuitous transfer.
5. Avoidance of Acts for Fair Value with Intent to Defraud (Art. 161 - 適正価格処分行為の否認, Tekisei Kakaku Shobun Kōi no Hinin):
   • This provision addresses a specific type of transaction that can be problematic: where the debtor disposes of property for what appears to be fair market value, but the transaction is part of a scheme to make the proceeds harder for creditors to reach (e.g., converting illiquid real estate into easily concealable cash, which is then intended to be hidden or dissipated).
   • Historically, Japanese case law was somewhat broad in allowing avoidance of such "asset conversion" transactions if they facilitated hiding assets. The current Bankruptcy Act (Art. 161) has introduced stricter conditions for avoiding such fair value transactions, aiming to protect legitimate business disposals unless clear fraudulent intent is established:
     1. The act (e.g., sale of real estate) must be of a nature that, by changing the form of the debtor's assets, creates a demonstrable risk that the debtor will conceal the proceeds, make gratuitous transfers, or otherwise dispose of the value in a manner harmful to creditors.
     2. The debtor, at the time of the act, must have had the intention to engage in such subsequent concealment or harmful disposition of the proceeds.
     3. The counterparty (the purchaser/beneficiary) must have known of the debtor's fraudulent intent regarding the proceeds.
   • The burden of proving all these elements lies with the trustee. However, if the counterparty is an "insider" (e.g., a director or relative), the burden of proving their lack of knowledge of the debtor's fraudulent intent (good faith) may shift to that insider (Art. 161(2)). This provision carefully balances the need to claw back assets in cases of clear fraud with the need to ensure that ordinary commercial transactions undertaken for fair value are not unduly chilled.

B. Avoidance of Preferential Acts (偏頗行為否認 - Henpa Kōi Hinin) (Bankruptcy Act, Art. 162)
This category targets transactions that, while not necessarily reducing the debtor's total net worth, result in one or more creditors receiving more than their fair share, thereby disrupting the principle of equal treatment among creditors of the same class.

1. Preferential Acts Made After Insolvency or Petition Filing (Art. 162(1)(i)):
   • The trustee can avoid acts that provide security for an existing debt or extinguish an existing debt (e.g., making a loan repayment) if these acts were done:
     • After the debtor became "unable to pay its debts" (支払不能 - shiharai funō, i.e., cash-flow insolvent) or after a bankruptcy petition was filed against the debtor; AND
     • The beneficiary (the preferred creditor) knew at the time of the act that the debtor was insolvent or that a petition had been filed, AND knew that the act would harm (i.e., be preferential towards them at the expense of) other creditors.
   • A suspension of payments by the debtor creates a rebuttable presumption that the debtor was unable to pay its debts (Art. 162(3)).
2. Non-Obligatory Preferential Acts within a "Danger Zone" (Art. 162(1)(ii)):
   • This rule applies to preferential acts that were "non-obligatory" (非義務行為 - hi-gimu kōi) in nature or timing. This means acts that the debtor was not legally bound to perform at that specific time or in that specific manner. Examples include:
     • Providing new security for an old, previously unsecured debt.
     • Making a loan repayment significantly before its due date.
     • Making a payment through an unusual method (e.g., transferring property when cash payment was the norm).
   • Such non-obligatory preferential acts are avoidable if they were made within 30 days before the debtor became unable to pay its debts (or at any time after becoming unable to pay but before suspension of payments or petition filing).
   • For these non-obligatory acts within the 30-day "danger zone," the trustee does not need to prove the beneficiary's knowledge of the debtor's insolvency. Instead, the act is avoidable unless the beneficiary can prove that they did not know, at the time of the act, that it would harm other creditors (i.e., that it was preferential). This effectively shifts the burden of proving good faith to the preferred creditor for these types of transactions.
3. Special Rules for Insider Beneficiaries (Art. 162(2)(i)):
   • If the creditor who received the preference is an "insider" of the debtor (such as a director, parent company, affiliate, or a close relative in the case of an individual debtor), the burden of proving their lack of knowledge that the preference was harmful to other creditors (i.e., their good faith) shifts to that insider beneficiary, even for obligatory acts made after insolvency.
4. Exception for Contemporaneous Exchanges (New Value):
   • Crucially, the preference avoidance rules target security or payments for pre-existing debts (Art. 162(1) refers to 既存の債務 - kizon no saimu, existing debts). Transactions where the debtor provides security or makes a payment in direct and substantially contemporaneous exchange for new value (e.g., granting a mortgage to secure a new loan, or paying cash for newly delivered goods) are generally not considered preferential and are not avoidable under these provisions. This is because such transactions do not diminish the net assets available to other pre-existing creditors; they are value-for-value exchanges. This protection is vital for legitimate ongoing business and for enabling "rescue financing" for distressed companies.

C. Other Specific Avoidance Rules

1. Avoidance of Late Perfection of Rights (対抗要件の否認 - Taikō Yōken no Hinin) (Bankruptcy Act, Art. 164):
   • Sometimes, the underlying transaction that creates a right (e.g., a sale contract for real estate, an agreement to assign a claim) might occur well before any financial distress, but the formal act of "perfecting" that right against third parties (e.g., registering the title transfer, formally notifying the underlying debtor of the claim assignment) is delayed.
   • If such perfection occurs after the debtor has suspended payments or a bankruptcy petition has been filed, and the party perfecting the right knew of these events at the time of perfection, the act of perfection itself can be avoided by the trustee.
   • Grace Period: The Act provides a 15-day grace period. If the act of perfection occurs within 15 days of the underlying act that created the right to demand perfection (e.g., within 15 days of the sale contract), then the perfection is generally not avoidable under this specific rule, even if it falls within the critical period (Supreme Court, August 20, 1970). This recognizes that some practical delays in completing formalities are normal.
   • This rule is particularly relevant for security interests, such as assignment-based security over a company's receivables, where perfection (e.g., through notice to account debtors or public registration) is key to prevailing over the bankruptcy trustee. Attempts to structure security agreements so that perfection occurs only upon the debtor's financial crisis have been viewed critically by courts, with some such arrangements being found avoidable on other grounds (e.g., Supreme Court, July 16, 2004, concerning a security assignment triggered by the debtor's crisis).
2. Avoidance of Acts Related to Enforcement Proceedings (執行行為の否認 - Shikkō Kōi no Hinin) (Bankruptcy Act, Art. 165):
   • This provision allows the trustee to challenge benefits obtained by a creditor through individual legal enforcement actions (e.g., seizure of assets, court-ordered sale) if the conditions for preference (or fraudulent act) avoidance are met.
   • Even if a creditor obtained payment based on an otherwise valid and enforceable court judgment or a notarized deed, the receipt of that payment via enforcement can be avoided as a preference if it occurred during the suspect period and with the requisite knowledge.
   • The underlying act that created the obligation (e.g., the contract leading to the judgment debt) can also be avoided if it was fraudulent, regardless of the existence of an enforceable title.
   • Furthermore, collusive acts that led to the creation of an enforceable title (e.g., a debtor improperly confessing judgment) might themselves be subject to avoidance.
   • However, the actual transfer of title to a bona fide third-party purchaser in a properly conducted judicial auction or enforcement sale is generally protected to maintain the stability and reliability of such execution procedures. The avoidance action would typically target the proceeds received by the prefered creditor, not the property itself from an innocent auction buyer.

Procedure for Exercising Avoidance Powers

The exercise of avoidance powers follows specific procedural pathways:

• Exclusive Right of the Trustee: Avoidance powers are exercised exclusively by the court-appointed bankruptcy trustee. Individual creditors cannot directly bring avoidance actions in a bankruptcy proceeding (though they can bring pre-bankruptcy fraudulent conveyance actions under the Civil Code, which are then typically superseded or taken over by the trustee).
• Methods of Exercise:
  • By Lawsuit (訴え - uttae) or as a Defense (抗弁 - kōben): The trustee can initiate a lawsuit against the beneficiary (or a subsequent transferee) seeking the return of the property or its monetary value. Alternatively, if the beneficiary sues the bankruptcy estate (e.g., to enforce a claim arising from an allegedly avoidable transaction), the trustee can raise the avoidability of the transaction as a defense (Bankruptcy Act, Art. 173).
  • By Summary Avoidance Claim (否認の請求 - Hinin no Seikyū): For potentially clearer cases, the Bankruptcy Act (Art. 174) allows the trustee to file a petition-like "avoidance claim" with the bankruptcy court. The court can decide this matter through a more expedited summary proceeding, issuing a court order (決定 - kettei). If the counterparty (beneficiary or transferee) is dissatisfied with the court's order upholding the avoidance, they can then file a formal "objection lawsuit" (異議の訴え - igi no uttae) within one month to have the matter fully litigated in a standard trial format (Bankruptcy Act, Art. 175). This two-step process aims to provide a quicker path for undisputed or straightforward avoidance matters while preserving the right to a full trial for contested ones.
• Avoidance Against Subsequent Transferees (転得者否認 - Tentokusha Hinin) (Bankruptcy Act, Art. 170):
  • If the property or benefit from an avoidable transaction has been further transferred from the initial beneficiary to a subsequent recipient (a tentokusha), the trustee may, under certain conditions, seek recovery from this subsequent transferee.
  • The general conditions, as clarified by amendments in 2017 (reflecting changes in the Civil Code's rules on fraudulent act cancellation), are:
    1. Grounds for avoidance must have existed against the initial beneficiary.
    2. The subsequent transferee must have known, at the time they acquired the property, that the prior transaction (between the debtor and the initial beneficiary) constituted grounds for avoidance against that initial beneficiary.
  • If the subsequent transferee is an "insider," their requisite knowledge might be presumed, or the burden of proving good faith may shift to them. If they acquired the property gratuitously (without giving value), their knowledge is generally not required for the trustee to avoid the transfer.
  • These rules aim to prevent the easy circumvention of avoidance powers through chains of transfers, while still providing some protection to innocent subsequent purchasers for value. The earlier legal standard, sometimes interpreted as requiring "double bad faith" (knowledge by the subsequent transferee of the initial beneficiary's own bad faith), made recovery from subsequent transferees exceedingly difficult.
• Time Limits for Exercising Avoidance Powers (Bankruptcy Act, Art. 176):
  • The trustee must exercise avoidance powers within two years from the date of the commencement of the bankruptcy proceedings.
  • Additionally, an absolute "long-stop" period exists: no avoidance power can be exercised if ten years have passed since the date of the original avoidable act itself. (This ten-year period was shortened from a previous twenty-year limit by amendments in 2017, aligning with similar changes for fraudulent act cancellation rights under the Civil Code).
  • These time limits are generally understood as "periods of exclusion" (joseki kikan) rather than statutes of limitation, meaning they are typically not subject to tolling or interruption.

Effects of Successful Avoidance (否認の効果 - Hinin no Kōka)

When a trustee successfully avoids a transaction, the primary legal consequence is the restoration of the bankruptcy estate to the financial position it would have occupied had the avoidable act not occurred (原状回復 - genjō kaifuku) (Bankruptcy Act, Art. 167(1)).

• Return of Property or Value:
  • If specific property was transferred, that property must be returned to the bankruptcy estate.
  • If money was paid preferentially, that amount must be repaid to the estate.
  • If the specific property can no longer be returned in its original form (e.g., it has been consumed, destroyed, or fundamentally altered), the beneficiary must pay its monetary value to the estate. This value is generally assessed as of the time the avoidance power is actually exercised, not the time of the original transaction (Supreme Court, April 3, 1986).
  • The avoidance typically nullifies the entire detrimental effect of the transaction. For example, if a fraudulent transfer caused the estate to be X amount smaller than it should have been, the full X amount is subject to recovery, not just a portion related to the debtor's degree of insolvency (Supreme Court, November 8, 2005).
• Rights of the Beneficiary/Counterparty Whose Transaction is Avoided:
  • Restitution of Consideration Paid (for fraudulent acts where consideration was given): If the avoided transaction was not entirely gratuitous (e.g., an undervalued sale where the beneficiary paid some amount), and the beneficiary is required to return the property, they are generally entitled to the return of the consideration they originally paid to the debtor.
    • If that specific consideration still exists in identifiable form within the bankruptcy estate (e.g., traceable cash), the beneficiary can claim its direct restitution.
    • If the consideration no longer exists in identifiable form within the estate, the beneficiary usually has an administrative expense claim (共益債権 - kyōeki saiken) against the estate for the value of the consideration they provided (Bankruptcy Act, Art. 168(1)). This gives them a high priority for repayment.
    • Exception for Collusion: However, if the debtor had a fraudulent intent regarding the consideration received (e.g., intended to conceal it), and the beneficiary knew of this fraudulent intent, then the beneficiary's claim for reimbursement of any non-extant consideration is relegated to the status of a general, unsecured bankruptcy claim, not an administrative expense (Art. 168(2)). This is because such a beneficiary knowingly participated in or was aware of the debtor's scheme to defraud other creditors.
    • The trustee also has the option, when exercising avoidance over property for which some consideration was paid, to simply demand payment of the difference between the property's actual value and the (lesser) consideration paid by the beneficiary, effectively allowing the beneficiary to keep the property by paying the shortfall (Art. 168(4)).
  • Revival of the Beneficiary's Original Claim (in preference cases): If a preferential payment or the granting of security is avoided, the underlying debt that was purportedly paid or secured is revived. The beneficiary (the formerly preferred creditor) can then file a proof of claim in the bankruptcy proceedings for this revived debt as a general unsecured creditor (Bankruptcy Act, Art. 169). Any security that was part of the preferential transaction is nullified. If the original debt was validly secured by other means (not part of the preference), that independent security may also be considered revived (Supreme Court, November 22, 1973).
• Rights of Subsequent Transferees (Post-2017 Amendments):
  • If an avoidance is successfully asserted against a subsequent transferee who had given value, that transferee may, in turn, be able to exercise any rights the initial (avoided) beneficiary would have had against the bankruptcy estate for the return of consideration that the initial beneficiary had paid to the debtor, up to the value of what the subsequent transferee themselves provided or lost due to the avoidance (Bankruptcy Act, Art. 170-2). This complex provision aims to adjust the equities in multi-party avoidance scenarios.
  • Similarly, if a preferential payment was made, and then the funds were passed to a subsequent transferee from whom the trustee recovers, the original preferred creditor (whose claim revives) is the one who files in the bankruptcy, not the subsequent transferee who had to return the funds (Art. 170-3, effectively applying Art. 169).

Conclusion

The avoidance powers, or hinin-ken, vested in the bankruptcy trustee are a formidable and indispensable component of the Japanese corporate bankruptcy system. They are designed to uphold the integrity of the bankruptcy process by enabling the trustee to recapture assets unfairly diverted from the estate and to reverse transactions that unjustly favored particular creditors at the expense of the broader creditor community. By allowing the trustee to "look back" and rectify certain pre-bankruptcy dealings, these powers are crucial for maximizing the assets available for distribution and for ensuring that this distribution occurs as equitably as possible according to the principles of bankruptcy law. For any party involved in or potentially affected by a Japanese corporate bankruptcy, a thorough understanding of the scope, conditions, and consequences of these avoidance powers is essential for assessing risks, understanding potential liabilities, and navigating the complexities of the proceedings.