Voluntary Sale of Mortgaged Real Estate in Japan: How Does It Work and When Is It Preferable to Foreclosure?

When a borrower defaults on a mortgage, the traditional path to recovery for the lender is often a court-supervised foreclosure auction. However, foreclosure can be a lengthy, costly, and sometimes value-diminishing process. In Japan, as in many other jurisdictions, a "voluntary sale" (任意売却 - nin'i baikyaku) of the mortgaged real estate by the owner, with the cooperation of the mortgagee, often presents a more attractive alternative. This article explores the legal framework surrounding voluntary sales of mortgaged property in Japan, including mechanisms for discharging the mortgage, and how these sales are treated, particularly when the property owner faces formal insolvency proceedings.

The Mortgagor's Right to Sell and Basic Contractual Scenarios

Under Japanese law, a property owner (mortgagor) generally retains the right to sell their mortgaged property. The mortgage, being a right in rem, typically follows the property into the hands of the new owner, meaning the mortgagee can still enforce their security against the property even after the sale.

The rationale for allowing the owner to sell is partly rooted in economic efficiency. If the property's market value exceeds the mortgage debt (i.e., it's not "underwater"), the owner, as the residual claimant to any equity, has the strongest incentive to achieve the highest possible sale price.

While a sale "subject to" the existing mortgage is legally possible, most purchasers will require the mortgage to be discharged at or before closing to obtain clear title. This usually necessitates the mortgagee's involvement. The structure of such voluntary sales often depends on how the mortgage debt is handled in relation to the sale price:

1. Sale Price Covers Mortgage Debt (Property Not Underwater):
   • Seller Discharges Mortgage: The sale contract may stipulate that the seller uses the purchase proceeds to pay off the mortgage debt, and the mortgagee releases the mortgage. This is akin to selling an unencumbered property.
   • Purchaser Assumes or Pays Off Debt:
     • Exemptive Debt Assumption (免責的債務引受 - mensekiteki saimu hikiuke): With the mortgagee's consent, the purchaser assumes the mortgage debt, and the original debtor is released. This is a common practice in bank-involved transactions where the purchaser's creditworthiness is acceptable.
     • Cumulative Debt Assumption (重畳的債務引受 - chōjōteki saimu hikiuke): Both the original debtor and the purchaser become liable for the mortgage debt.
     • Assumption of Performance (履行引受 - rikō hikiuke): The purchaser agrees with the seller (but not directly with the mortgagee) to make payments on the mortgage debt. The seller remains primarily liable to the mortgagee.
   • If the seller fails to discharge the mortgage as agreed, the purchaser has remedies, including the right to refuse payment of the purchase price until the mortgage is cleared (Civil Code Art. 577) or claims under warranty against encumbrances (Civil Code Art. 567).
2. Sale Involving Complex Mortgage Situations (e.g., Multiple Mortgages, Potential Shortfall):
   Here, statutory mechanisms for clearing mortgages become more critical.

Statutory Tools for Voluntary Sale and Mortgage Discharge (Outside Insolvency)

Japanese Civil Code provides mechanisms to facilitate voluntary sales by allowing for the discharge of mortgages under certain conditions, even without a full foreclosure process:

1. Payment of Value and Discharge (代価弁済 - Daika Bensai) - Civil Code Art. 378:
   This provision allows a person who has acquired ownership or a leasehold over mortgaged property to extinguish the mortgage by paying or depositing a sum of money agreed upon with, or demanded by, the mortgagee.
   • Mechanism: The acquirer, with the mortgagee’s consent, pays an agreed value directly to the mortgagee(s) in exchange for the discharge of the mortgage.
   • Limitations: A significant practical limitation arises when there are multiple mortgagees. Article 378 historically required the consent of all mortgagees for the distribution of the paid amount. This could lead to "hold-out" problems, where a junior mortgagee with no realistic chance of recovery from the property's value might refuse consent to extract a nuisance payment.
2. Request for Extinguishment of Mortgage by Acquirer (抵当権消滅請求制度 - Teitōken Shōmetsu Seikyū Seido) - Civil Code Arts. 379 ff.:
   This system, reformed in 2003 (it was formerly known as "滌除" - tekiyo), provides a more structured way for a third-party acquirer of mortgaged property to clear existing mortgages.
   • Mechanism: The third-party acquirer (who has purchased the property from the mortgagor) can make a formal offer to the mortgagees to pay a specific sum (which should reflect the property's value) in exchange for the extinguishment of their mortgages.
   • Mortgagee's Options: Upon receiving such a request, a mortgagee can either:
     • Consent to the extinguishment for the offered price.
     • Demand a foreclosure auction of the property if they believe a higher price can be obtained (Civil Code Art. 383). If the auction does not yield a price exceeding the acquirer's offer by a certain margin, the mortgagee may face consequences. (The 2003 reforms simplified this counter-measure, removing some of the more burdensome aspects of the older tekiyo system for the objecting mortgagee, such as the obligation to guarantee a higher bid).
   • Purpose: This system aims to promote the alienability of encumbered property by providing a pathway for purchasers to obtain clear title, particularly when direct agreement with all mortgagees is challenging. However, it has been criticized, especially concerning properties significantly underwater, as it can allow an acquirer with little actual stake to dictate the timing of the mortgagees' realization, potentially to their detriment.

The Push for Voluntary Sales: Market Realities and Legal Debates

Particularly after periods of real estate market downturn in Japan, such as the collapse of the "bubble economy," the inefficiencies and potential value destruction associated with formal foreclosure auctions became more apparent. This led to increased interest in promoting voluntary sales as a more market-oriented and potentially value-maximizing approach.

During the legal reforms of the early 2000s, there were debates about further facilitating voluntary sales:

• Retention and Reform of the Mortgage Extinguishment Request System: Despite some calls for its abolition, the tekiyo system was reformed and retained as the teitōken shōmetsu seikyū seido, with the view that it could still aid in promoting voluntary transactions.
• Mortgagee's Right of Voluntary Sale?: Proposals were made to grant mortgagees a direct statutory right to conduct a voluntary sale of the mortgaged property upon default, outside of a court-supervised auction. However, this was generally not adopted in the main Civil Code framework. Granting such a right to a mortgagee (who is not the residual claimant to the property's equity if it's not underwater) could lead to sales that don't maximize overall value. To be fair, such a right would need significant safeguards for the owner and junior lienholders, potentially making it as cumbersome as a judicial sale.

The prevailing view remains that the property owner is usually best positioned to conduct a voluntary sale to achieve the highest market price, with mortgagees' interests protected by their lien and the statutory discharge mechanisms.

Voluntary Sale in the Shadow of Insolvency – When the Owner Is Financially Distressed

When the mortgagor (property owner) faces formal insolvency proceedings (bankruptcy, civil rehabilitation, or corporate reorganization), the ability to conduct a voluntary sale of mortgaged property, and the rights of the mortgagee, are significantly affected by the specific insolvency regime.

General Position of Secured Creditors in Insolvency:

• Bankruptcy (Hasan) and Civil Rehabilitation (Minji Saisei): Mortgagees generally hold a "right of separation" (betsujo-ken - 別除権). This means they can, in principle, enforce their mortgage (e.g., through foreclosure or by consenting to a voluntary sale and receiving proceeds) outside the main collective proceedings, although the insolvency trustee/supervisor has certain oversight and intervention powers.
• Corporate Reorganization (Kaisha Kōsei): Mortgagees are treated as "reorganization secured creditors" (kōsei tanpokenja - 更生担保権者). Enforcement of the mortgage is generally stayed, and the mortgagee’s claim is dealt with under the terms of the reorganization plan.

Powers of the Insolvency Trustee / Debtor-in-Possession (DIP) Regarding Mortgaged Property:

Insolvency administrators (trustees in bankruptcy, DIPs in civil rehabilitation, or trustees in corporate reorganization) have various powers that interact with voluntary sales:

1. Redemption (Ukemodoshi - 受戻し): In bankruptcy, the trustee can pay off the secured mortgage debt in full to free the property from the mortgage and bring it into the bankruptcy estate for the benefit of all creditors (Bankruptcy Act, Article 78(2)(xiv)). This is typically done if there is equity in the property for unsecured creditors. This option is generally not available in corporate reorganization due to the stay on paying pre-petition secured claims outside the plan.
2. Abandonment from the Estate (Zaidan Kara no Hōki - 財団からの放棄): If the mortgaged property is heavily underwater (debt exceeds value) and burdensome to the estate, the bankruptcy trustee can, with court permission, abandon it from the bankruptcy estate (Bankruptcy Act, Article 78(2)(xii)). The property then typically reverts to the debtor (if an individual) or is left for the mortgagees to realize their security against.
3. Trustee's Power to Sell (Voluntarily or via Auction):
   • Voluntary Sale by Trustee: Trustees in all types of insolvency proceedings generally have the power, with court approval, to sell estate assets, including mortgaged property (e.g., Bankruptcy Act, Art. 78(2)(i); Corporate Reorganization Act, Art. 72(2)(i)). If the property is sold voluntarily by the trustee, arrangements must be made with the mortgagee for the release of the mortgage, typically by paying them the proceeds up to their secured claim amount.
   • Sale via Execution Procedures by Trustee: Bankruptcy trustees also have the power to utilize official auction procedures to sell mortgaged property (Bankruptcy Act, Art. 184(2)). Notably, the "no-surplus, no-sale" rule (which can sometimes hinder foreclosure if the expected auction price doesn't cover senior liens and costs) was made inapplicable to trustee-initiated sales in the 2004 Bankruptcy Act reforms, facilitating sales even of underwater properties through this route.
   • If property is sold by the trustee subject to an existing mortgage (less common for voluntary sales aiming to maximize price), Bankruptcy Act Art. 65(2) clarifies that the mortgagee can still pursue any deficiency as an unsecured claim in the bankruptcy.

The Statutory Right to Request Extinguishment of Security Interests in Insolvency (Tanpoken Shōmetsu Seikyū Seido)

This is a particularly important set of provisions across all three major insolvency statutes in Japan. It allows the insolvency administrator (or DIP) to petition the court to extinguish mortgages and other security interests on property of the estate by paying the secured creditor an amount determined by the court to be the value of their security interest. This facilitates the sale of assets "free and clear" of liens, which can significantly enhance sale prices and aid restructuring or liquidation.

• Civil Rehabilitation Act (Art. 148 ff.): This was the first modern insolvency statute in Japan to introduce such a system. It allows the DIP to request extinguishment of security interests on assets deemed essential for the continuation of the debtor's business, upon payment of the value of the collateral. Mortgagees have the right to object to the proposed value and request a formal court valuation. This tool is primarily aimed at retaining critical assets needed for the business's turnaround.
• Corporate Reorganization Act (Art. 104 ff.): A similar system exists, but its application is broader. It can be used for property where its disposition is deemed necessary for the rehabilitation of the business. This can include the sale of non-core assets to generate funds or the sale of business units as part of a restructuring. Again, secured creditors can demand a court valuation. The valuation standard aims for a fair sale price, not necessarily a discounted auction price.
• Bankruptcy Act (Art. 186 ff.): The bankruptcy trustee can request the extinguishment of security interests if a voluntary sale of the collateral is deemed to be in the general interest of the creditors. A unique feature here is the potential for a "carve-out" (kumirekin - 組入金), where a portion of the proceeds from the sale of even fully mortgaged property may be allocated to the bankruptcy estate to cover administrative expenses or provide a small distribution to unsecured creditors. Mortgagees have counter-rights, including the right to demand a formal foreclosure auction (Art. 187) or to make a counter-offer to purchase the property themselves at a price slightly higher than what the trustee proposes to pay them from the voluntary sale (Art. 188). This system attempts to balance the efficiency of voluntary sales by the trustee with the protection of the mortgagee's interest in the collateral's value.

These statutory extinguishment rights effectively override the mortgagee's traditional right to the "indivisibility of the mortgage" (meaning the entire debt must be paid to release the mortgage on any part of it), at least within the context of insolvency proceedings, by substituting the value of the collateral.

Comparing Voluntary Sale and Foreclosure – Pros and Cons

Choosing between a voluntary sale and a formal foreclosure auction involves weighing several factors:

• Voluntary Sale:
  • Pros: Often results in a higher sale price (closer to true market value), can be faster, involves lower transaction costs (e.g., court fees, auction fees), allows for more control by the seller/debtor over the sale process, and carries less social stigma than a forced sale.
  • Cons: Requires the cooperation of the mortgagee(s), which may not always be forthcoming, especially if there are multiple lienholders with conflicting interests. Negotiations can be complex.
• Foreclosure Auction:
  • Pros: Provides a definitive, court-enforced sale process, can clear junior liens (if proceeds are sufficient), offers a structured framework when cooperation is lacking.
  • Cons: Can be a slow and protracted process, auction prices are often discounted from market value (a "foreclosure discount" - 競売減価 keibai genka), offers less control to the debtor, and is a public process that can damage reputation.

Conclusion

Voluntary sale of mortgaged real estate is a significant and often preferable alternative to contentious foreclosure proceedings in Japan. It allows for a market-driven approach to realizing asset value, potentially benefiting both the debtor (by maximizing any remaining equity or minimizing deficiency) and the mortgagee (by achieving a quicker and higher recovery). The Japanese legal system provides various contractual frameworks and statutory tools, both outside and within insolvency proceedings, to facilitate such sales while attempting to balance the complex web of interests among the property owner, purchasers, and one or more mortgagees. For creditors, understanding these mechanisms, including the powerful statutory rights to extinguish mortgages in insolvency to enable free-and-clear sales by an administrator, is crucial for developing effective strategies for recovering debt secured by real property in Japan.