Backing Out of a Japanese Real Estate Deal? Understanding 'Tetsuke Kaijo' (Earnest Money Forfeiture/Doubling) and Its Limits

Japanese Attorney at Law - Bengoshi L.L.

• 7 min read

Real estate transactions are significant undertakings, and occasionally, circumstances arise that necessitate a party to withdraw from a deal. In Japan, the concept of tetsuke, commonly translated as earnest money or deposit, plays a unique and pivotal role in such situations, particularly concerning the right to rescind a contract. This right, known as tetsuke kaijo, allows either the buyer or the seller to terminate a real estate sales contract under specific conditions, typically by forfeiting or doubling the tetsuke amount.

Understanding the intricacies of tetsuke kaijo, especially its crucial limitation based on "commencement of performance" (rikō no chakushu), is essential for anyone involved in Japanese real estate. This article delves into the mechanics of tetsuke, the exercise of tetsuke kaijo, and the boundaries that define this right.

Understanding "Tetsuke" (Earnest Money) in Japanese Real Estate

When a contract for the sale of real property is concluded in Japan, it is customary for the buyer to pay a sum of money to the seller known as tetsuke. While similar to earnest money deposits in other jurisdictions, tetsuke in Japan has distinct legal characteristics and functions defined by practice and the Civil Code.

There are generally three types of tetsuke recognized:

  1. Evidentiary Earnest Money (Shōyaku Tetsuke): This serves as proof that a contract has been formed. All tetsuke inherently has this characteristic.
  2. Rescission Earnest Money (Kaiyaku Tetsuke): This is the most significant type in the context of contract termination. It grants both the buyer and the seller the right to rescind the contract under certain conditions, as stipulated in Article 557(1) of the Japanese Civil Code. Unless the contract specifies otherwise, tetsuke is presumed to be of this nature.
  3. Penalty Earnest Money / Liquidated Damages (Iyaku Tetsuke): This type stipulates that if one party breaches the contract, the tetsuke amount will be forfeited as a penalty or as pre-determined liquidated damages. If the tetsuke is designated as iyaku tetsuke, the rules for kaiyaku tetsuke under Article 557 might not apply in the same way, and the remedies for breach would follow the specific contractual terms or general rules on default.

The amount of tetsuke can vary but typically ranges from 5% to 20% of the total purchase price in residential transactions, and can be a significant sum in commercial deals. The legal presumption that tetsuke functions as kaiyaku tetsuke is a cornerstone of Japanese real estate practice, providing a degree of flexibility to both parties before the transaction progresses too far.

The Mechanism of "Tetsuke Kaijo": Rescission Rights under Civil Code Article 557(1)

Article 557(1) of the Japanese Civil Code outlines the right of tetsuke kaijo:

"When the buyer has paid earnest money (tetsuke) to the seller, the buyer may rescind the contract by forfeiting such earnest money, and the seller may rescind the contract by actually tendering double the amount of such earnest money, until either party commences performance of the contract."

This provision establishes a reciprocal right of rescission:

  • Buyer's Right to Rescind: The buyer can choose to terminate the contract by abandoning the tetsuke they have already paid to the seller. No further obligation or explanation is typically required if this right is exercised within the permissible timeframe.
  • Seller's Right to Rescind: The seller can terminate the contract by refunding twice the amount of tetsuke they received from the buyer. A crucial aspect, clarified by the revised Civil Code (effective April 1, 2020), is that the seller must make an "actual tender" (genjitsu no teikyō) of this doubled amount. This means merely expressing an intention to pay or promising to pay is insufficient; the seller must prepare the funds and place them in a state where the buyer can receive them (e.g., bringing the cash, preparing a bank check, or making arrangements for a verifiable bank transfer). If the buyer refuses to accept, the seller may need to deposit the funds with an official depository (kyōtaku) to solidify the rescission.

This right of tetsuke kaijo is presumed to exist whenever tetsuke is paid, even if the contract does not explicitly mention such a rescission right. Conversely, parties can mutually agree to waive or exclude this tetsuke kaijo right in their contract, although this requires clear and explicit language.

The Critical Limitation: "Commencement of Performance" (Rikō no Chakushu)

The most significant constraint on the right to tetsuke kaijo is the proviso in Article 557(1): it can only be exercised "until either party commences performance of the contract." Once one party has "commenced performance" (rikō no chakushu), the other party loses their right to rescind via tetsuke kaijo.

The rationale behind this limitation is to protect the reliance interest of the party who has started to take material steps towards fulfilling their contractual obligations. As the transaction moves beyond mere agreement into actual execution, the stability of the contract is given greater weight.

What Constitutes "Commencement of Performance"?
Determining what actions constitute "commencement of performance" is often the most contentious aspect of tetsuke kaijo disputes and is highly fact-dependent. Japanese courts have provided guidance over time. The prevailing interpretation, as established by landmark Supreme Court precedents (e.g., Judgment of November 24, 1965, Minshū Vol. 19, No. 8, p. 2019), is that "commencement of performance" means:

"To embark upon the execution of the performance which is the substance of the contractual obligation, i.e., to perform a part of the act of performance in a manner objectively recognizable from the outside, or to perform a prerequisite act indispensable for tendering performance."

Mere preparatory actions that are not intrinsically tied to the core obligations or not externally visible may not suffice.

Examples for the Buyer:

  • Making an Interim Payment (uchikin or chūkan-kin): Payment of a sum beyond the initial tetsuke, specifically designated as part of the purchase price, is a clear example of commencement of performance.
  • Initiating Specific Loan Execution for Final Payment: While merely applying for a loan might be preparatory, the actual drawing down of funds specifically for the property purchase, or taking irrevocable steps towards loan execution tied to the closing, could be seen as commencement.
  • Taking Possession and Starting Alterations (if contractually permitted pre-closing): If the buyer, with the seller's agreement, takes early possession and begins significant, non-remediable alterations to the property.

Examples for the Seller:

  • Initiating Property Subdivision or Boundary Confirmation Procedures: If the contract requires the seller to subdivide the land or complete a formal boundary survey before transfer, taking official steps to do so (e.g., filing applications with the Legal Affairs Bureau).
  • Vacating Tenants or Removing Encumbrances: If the seller is obligated to deliver the property free of tenants or specific encumbrances, actively and demonstrably undertaking these actions (e.g., formally terminating a lease with a tenant, paying off a mortgage to clear title specifically for the sale).
  • Initiating Title Transfer Registration Procedures: Delivering necessary documents to a judicial scrivener (shihō shoshi) with instructions to proceed with the title registration for the buyer, especially if this is done in a way that is difficult to unilaterally retract.

Burden of Proof:
The party who opposes the tetsuke kaijo—that is, the party claiming that the other party can no longer rescind because "commencement of performance" has already occurred—bears the burden of proving that such commencement has indeed taken place.

Effects of a Valid "Tetsuke Kaijo"

When tetsuke kaijo is validly exercised:

  • The contract is effectively terminated, and both parties are released from their primary obligations to buy or sell the property.
  • The matter is generally considered settled by the forfeiture of the tetsuke (if the buyer rescinds) or the payment of double the tetsuke (if the seller rescinds). Typically, no further claims for damages arising from the rescission itself can be made by either party. The tetsuke itself acts as a pre-agreed "cost" of withdrawal.
  • This contrasts with rescission due to a contractual default (saimu furikō kaijo), where the non-breaching party can typically claim actual damages in addition to terminating the contract.

Strategic Considerations for Parties in Real Estate Deals

Understanding the nuances of tetsuke kaijo is crucial for both buyers and sellers in managing their risks and options.

For Buyers:

  • Paying tetsuke offers flexibility to withdraw if circumstances change, but this comes at the cost of the tetsuke amount.
  • Be mindful that actions beyond initial due diligence, such as making substantial interim payments or taking steps that clearly indicate an intent to proceed with the purchase unequivocally, might be construed as "commencement of performance," thereby forfeiting the right to tetsuke kaijo.

For Sellers:

  • To exercise tetsuke kaijo, the "actual tender" of double the tetsuke is a strict requirement. Simply stating intent is not enough.
  • If a seller wishes to prevent a buyer from exercising tetsuke kaijo, they might try to strategically "commence performance" of their own obligations, provided such actions are genuine and substantial. Conversely, if they wish to keep their own option to rescind open, they might delay such actions.

Contractual Drafting Points:

  • Nature of Tetsuke: While kaiyaku tetsuke is presumed, parties can, in theory, define it differently (e.g., solely as shōyaku tetsuke or iyaku tetsuke), though this is less common for the standard rescission right.
  • Amount of Tetsuke: This is a key point of negotiation. A higher tetsuke makes rescission more costly for both parties.
  • Exclusion or Modification of Tetsuke Kaijo: Parties can agree to completely waive the right of tetsuke kaijo or modify its terms (e.g., shorten or extend the period for its exercise, or change the amount for rescission). Such clauses need to be very clear.
  • Defining "Commencement of Performance": While parties might attempt to list specific actions that would (or would not) constitute "commencement of performance" in their contract, courts will ultimately interpret this concept based on the overall circumstances and established legal principles. However, clear contractual language can provide some guidance and reduce ambiguity.

"Tetsuke Kaijo" in Commercial Real Estate Transactions

The principles of tetsuke kaijo apply equally to commercial real estate transactions. However, given the often larger sums involved and the complexity of commercial deals, the negotiation of tetsuke amounts and rescission clauses can be more intense. Due diligence periods are often tied to tetsuke arrangements, allowing buyers to investigate the property thoroughly before committing fully or risking a larger portion of their capital.

A Brief Comparison with U.S. Earnest Money Practices

While "earnest money deposits" are common in U.S. real estate transactions to demonstrate a buyer's seriousness, the legal framework differs. In the U.S., the consequences of a party backing out of a deal and the disposition of the earnest money are heavily dictated by the specific terms of the contract, including whether the earnest money serves as liquidated damages. The statutory right of either party to rescind by simply forfeiting (buyer) or doubling and tendering (seller) the earnest money, as provided by Japan's Civil Code Article 557, is a distinct feature not typically found as a default statutory right in U.S. state laws. Remedies in the U.S. are more often tied to breach of contract principles and specific contractual provisions regarding default and damages.

Conclusion: A Unique Aspect of Japanese Contractual Flexibility

Tetsuke kaijo provides a unique mechanism for contractual flexibility in Japanese real estate transactions, allowing parties a way out of a deal, albeit at a predetermined cost. It reflects a balance between allowing parties to change their minds in the early stages and protecting the growing reliance interests as a transaction moves towards completion.

The critical threshold of "commencement of performance" remains the most litigated and fact-sensitive aspect of this right. Parties entering into significant real estate deals in Japan should be acutely aware of how their actions, or the actions of their counterparty, might impact the availability of tetsuke kaijo. Given the potential financial implications, obtaining knowledgeable legal counsel to navigate these provisions and to advise on specific contractual language is always a prudent step.