Allocation of Risk in Japanese Contracts: If a Subject Matter is Lost or Damaged After Contract Formation, Who Bears the Loss?

Contracts are formed with the expectation that both parties will fulfill their obligations. However, events can occur after a contract is made but before performance is completed that render one party's performance impossible—for example, the specific goods to be sold are destroyed in a fire, or a unique service can no longer be provided. When such impossibility arises, particularly due to causes not directly attributable to the fault of the debtor (the party whose performance becomes impossible), a critical question emerges: who bears the risk of this loss? Specifically, must the other party (the creditor, who was to receive the now-impossible performance) still render their own counter-performance, such as paying the agreed price? This area of law, known in Japanese as kiken futan (危険負担 - "bearing of risk"), underwent significant conceptual changes in the 2020 revisions to the Japanese Civil Code.

The Traditional Approach (Pre-2020 Civil Code Revision): Extinction of Counter-Obligation

Before the 2020 revisions, the Japanese Civil Code's approach to risk allocation was primarily framed around the concept of whether the creditor's counter-obligation was automatically extinguished by law if the debtor's primary obligation became impossible due to grounds not attributable to the debtor.

• General Rule (Debtor Bears Risk): If a debtor's performance became impossible due to reasons for which they were not at fault (e.g., force majeure), the creditor's corresponding counter-obligation (e.g., payment of the price) was generally extinguished (former Article 536, Paragraph 1). The debtor, unable to perform, could not demand counter-performance.
• Exception (Creditor Bears Risk): If, however, the impossibility of the debtor's performance was due to reasons attributable to the creditor, then the creditor's counter-obligation remained, meaning they still had to perform (e.g., pay the price) despite not receiving the debtor's performance (former Article 536, Paragraph 2).
• Specific Rule for Sales of Specific Things (Old Article 534): A notable and often criticized rule was former Article 534, which stipulated that in contracts for the sale of specific, identified things, the risk of accidental loss or damage to the thing generally passed to the buyer from the moment the contract was concluded, even before delivery, unless otherwise agreed. This meant the buyer often had to pay the price even if the specific item was destroyed before they received it, provided the seller was not at fault.

This system, particularly old Article 534, was seen as complex and sometimes leading to outcomes that were not aligned with modern commercial expectations or international standards.

The New Paradigm in the Revised Civil Code (Article 536): A Shift to the "Right to Refuse Counter-Performance"

The 2020 revisions to the Civil Code fundamentally changed the conceptual basis of risk allocation for impossibility not attributable to the debtor. Instead of the counter-obligation being automatically extinguished, the new framework focuses on the creditor's right to refuse to perform their counter-obligation.

1. General Rule - Debtor Bears the Risk (Article 536, Paragraph 1):
The revised Article 536, Paragraph 1 states: "If the performance of an obligation has become impossible in whole or in part due to grounds not attributable to either the obligor or the obligee, the obligee may refuse to perform their own corresponding counter-obligation." (Note: While the text mentions "not attributable to either party," for the obligee's right to refuse, the crucial element is that the impossibility is not attributable to the obligee themselves).

• Meaning: If the debtor's promised performance becomes impossible due to, for example, a natural disaster for which neither party is to blame, the creditor (who was to receive that performance) can now actively refuse to render their counter-performance (e.g., refuse to pay the price).
• Counter-Obligation is Not Automatically Extinguished: This is a key shift. The counter-obligation (e.g., the duty to pay the price) does not vanish by operation of law under Article 536(1) alone. The creditor gains a defense – the right to refuse.
• Need for Termination to Extinguish Obligations Definitively: If the creditor wishes to definitively end all obligations under the contract (including their own counter-obligation), they would typically need to terminate the contract. Impossibility of performance is a ground for immediate termination by the creditor without prior demand (Article 542, Paragraph 1, Item 1 of the Civil Code), generally irrespective of the debtor's fault.
• Creditor Must Assert the Right: The refusal is a right that the creditor must exercise or assert, typically when the debtor demands counter-performance.

2. Exception - Creditor Bears the Risk (Article 536, Paragraph 2):
The revised Article 536, Paragraph 2 addresses the scenario where the creditor effectively bears the risk: "If the performance of an obligation has become impossible in whole or in part due to grounds attributable to the obligee, the obligee may not refuse to perform their own corresponding counter-obligation."

• Meaning: If the debtor's inability to perform is caused by reasons for which the creditor is responsible, the creditor cannot use that impossibility to excuse their own counter-performance. They must still pay the price or render their agreed-upon performance, even though they will not receive what they bargained for from the debtor.
• Example: A buyer provides faulty specifications for custom-made goods, making it impossible for the seller to manufacture them according to the contract. The buyer would likely still be obligated to pay the agreed price.
• Debtor's Duty to Return Incidental Benefits: The second sentence of Article 536, Paragraph 2 adds: "In this case, if the obligor [the party whose performance became impossible due to the obligee's fault] has received any benefit by being released from their own obligation, they must return that benefit to the obligee." For example, if the seller in the custom goods example saved material costs because production was halted due to the buyer's faulty specifications, those savings should be returned to (or offset against the payment due from) the buyer.
• Link to Termination (Article 543): Importantly, if the non-performance (including impossibility) is due to grounds attributable to the creditor, Article 543 of the Civil Code also prevents the creditor from terminating the contract.

What if the Creditor Has Already Rendered Their Counter-Performance?

Article 536, Paragraph 1 primarily addresses the scenario where the creditor refuses a future counter-performance. But what if the creditor has already paid the price, and then the seller's obligation to deliver specific goods becomes impossible without the seller's fault (and the risk has not yet passed to the buyer under specific sales rules)?

In such cases, while Article 536(1) doesn't explicitly grant a right to reclaim, the underlying principle of mutuality in bilateral contracts and the logic of the revised system suggest the creditor should be able to recover their payment. This is because they are not receiving the bargained-for exchange. The most straightforward way to achieve this would be for the creditor to terminate the contract based on impossibility (Article 542, Paragraph 1, Item 1). Termination triggers a duty of restitution under Article 545, allowing the buyer to reclaim the price paid. Alternatively, arguments based on unjust enrichment or the non-existence of debt for the counter-performance (given the failure of the basis of the exchange) might also be invoked.

Crucial Specific Rules for Sales of Identified Goods (Article 567)

While Article 536 provides the general framework for risk allocation, Article 567 of the Civil Code introduces very important specific rules for contracts involving the sale of identified goods (特定物 - tokuteibutsu). This article effectively replaces the old, much-criticized Article 534.

• Art. 567, Paragraph 1 (Risk Can Transfer to Buyer Post-Contract, Pre-Delivery in Certain Cases):
  "If identified goods that are the subject-matter of a sale are lost or damaged due to grounds not attributable to the seller, this occurring after the time when delivery should have been made (or, if a time for delivery was not specified, after the seller has notified the buyer that they are ready to deliver and has requested the buyer to accept delivery, or after the buyer has delayed in accepting delivery without justifiable reason), the buyer may not refuse to pay the purchase price."
  This is a significant provision. It means that even if the goods are still with the seller, if the agreed (or reasonable) time for delivery has arrived (and the seller was ready to deliver), or if the buyer is in delay of acceptance, and the goods are then accidentally lost or damaged (without seller's fault), the buyer bears the risk and must pay the price. This is a major deviation from the general principle of Art. 536(1) where the debtor (seller) would normally bear the risk until actual delivery or a more definitive transfer of control.
• Art. 567, Paragraph 2 (Risk with Seller for Pre-Delivery Accidental Loss – Aligning with Art. 536):
  "If identified goods that are the subject-matter of a sale are lost or damaged due to grounds not attributable to either the seller or the buyer, and this occurs before the time for delivery (or before the conditions in Paragraph 1 that shift risk to the buyer are met), the buyer may refuse to pay the purchase price."
  This paragraph aligns with the general risk allocation principle of Article 536, Paragraph 1, confirming that for accidental loss before the risk has shifted under Paragraph 1, the seller (debtor of the goods) effectively bears the risk, and the buyer can refuse payment.

Therefore, in sales of identified goods, the precise timing of the accidental loss or damage relative to the contractual delivery obligations and the parties' conduct (e.g., buyer's delay in acceptance) is critical in determining who bears the risk.

Interplay Between Risk Allocation (Refusal Right) and Termination for Impossibility

When a debtor's performance becomes impossible (and this is not due to the creditor's fault), the creditor generally has two related but distinct legal avenues:

1. Termination of the Contract (Article 542, Paragraph 1, Item 1): The creditor can immediately terminate the contract. This definitively dissolves all primary future obligations for both parties and triggers the duty of restitution for any performances already made (e.g., return of prepayment).
2. Refusal of Counter-Performance (Article 536, Paragraph 1): If the debtor (whose performance is now impossible) demands counter-performance (e.g., payment), the creditor can simply refuse to render it, citing the impossibility of the debtor's reciprocal obligation.

Why Choose One Over the Other?

• Termination provides finality and a clear path to unwinding the entire transaction through restitution. It's often the preferred route when the creditor wants to be completely free of the contract.
• Relying solely on the right to refuse counter-performance under Article 536(1) might be a less common standalone strategy if the contract is truly dead due to impossibility. If the creditor simply refuses payment but doesn't terminate, the contract technically remains in existence, albeit with the counter-obligation suspended. This might be relevant in very specific scenarios, perhaps if there's a faint hope performance could somehow become possible again (though true "impossibility" usually negates this), or for other strategic reasons in a complex dispute. In most cases of clear impossibility, termination will be the more comprehensive remedy.

The key is that the revised Civil Code offers the creditor the option to terminate due to impossibility (generally without needing to prove debtor's fault) and, separately, the right to refuse their own counter-performance when faced with the debtor's impossible performance (provided the creditor is not at fault for the impossibility).

Conclusion

The Japanese Civil Code's revised approach to kiken futan (allocation of risk) marks a significant conceptual shift. It moves away from the idea of automatic extinction of counter-obligations in cases of impossibility not attributable to the debtor, towards a system where the creditor gains a right to refuse their counter-performance. The general rule under Article 536 is that the debtor (whose performance has become impossible) bears the risk, meaning the creditor can refuse to pay or otherwise perform their side of the bargain.

However, this general rule is subject to crucial exceptions, most notably when the impossibility is due to grounds attributable to the creditor (in which case the creditor bears the risk and must still perform). Furthermore, for the sale of identified goods, Article 567 provides specific rules that can transfer the risk of accidental loss or damage to the buyer even before delivery, particularly if the agreed delivery time has passed or the buyer is in delay of acceptance, and the seller is not at fault. This interplay between general risk allocation principles and specific rules for sales contracts, alongside the overarching right to terminate a contract for impossibility, creates a nuanced framework that parties to Japanese contracts must navigate carefully when performance becomes unexpectedly impossible.