Contractor Bankruptcy in Japan: Applicability of General Rules for Executory Contracts and Return of Advance Payments

Date of Judgment: November 26, 1987 (Showa 62)
Case Name: Claim for Administrative Expense Priority
Court: Supreme Court of Japan, First Petty Bench

This blog post discusses a pivotal 1987 Supreme Court of Japan ruling that addressed whether the general provisions of the (now former) Japanese Bankruptcy Act concerning the trustee's power to assume or reject bilateral executory contracts apply when a contractor in a work contract becomes bankrupt. The decision also clarified the nature of an orderer's claim for the return of advance payments when such a contract is terminated post-bankruptcy.

Facts of the Case

The plaintiff, X (the orderer, and appellant to the Supreme Court), had entered into a contract with A Construction Company (hereinafter "A") for the construction of a combined office and residential building . The total contract price was a point of contention, with X asserting it was 20 million yen (the judgment text states 21 million yen ). X paid A a total of 16 million yen in advance before A's bankruptcy.

While construction was underway, with approximately 60% of the work completed, A was declared bankrupt. Y was appointed as A's bankruptcy trustee (the defendant, and appellee before the Supreme Court). At the time of the bankruptcy declaration, the contract was still executory on both sides – A had not completed construction, and X had not made full payment.

X formally requested Y, under Article 59, Paragraph 2 of the old Bankruptcy Act (equivalent to current Article 53), to decide whether to terminate the contract or to demand its performance. The contract was subsequently considered terminated (the judgment notes Y acknowledged termination, though whether a formal reply was given is unclear from the facts presented by the Supreme Court ). X then sued Y, seeking the return of the portion of the advance payment that exceeded the value of the work completed (16 million yen paid minus 12 million yen for work done, resulting in a 4 million yen claim). X asserted this claim as an administrative expense claim (財団債権 - zaidan saiken), which would give it priority over general unsecured bankruptcy claims, based on Article 60, Paragraph 2 of the old Bankruptcy Act (equivalent to current Article 54).

Y contested the amounts claimed for the contract price and the value of work completed, and more fundamentally, argued that Articles 59 and 60 of the old Bankruptcy Act did not apply in cases of contractor bankruptcy.

Lower Court Rulings

The Osaka District Court (court of first instance) largely sided with X, recognizing X's right to an administrative claim for 3.4 million yen (partially granting the claim).

The Osaka High Court (appellate court) overturned the District Court's decision, dismissing X's claim. The High Court reasoned that Article 59 of the old Bankruptcy Act was not applicable because:

1. Article 62 of the old Bankruptcy Act (a special provision related to an orderer's bankruptcy, which cross-referenced Article 59, Paragraph 2 for the contractor's or trustee's termination rights) did not mention the application of these rules in the case of a contractor's bankruptcy.
2. Even for contracts involving substitutable performance (not just personal services), Article 64 of the old Bankruptcy Act (a provision, since abolished, that allowed the trustee to complete the work using the bankrupt’s materials or by employing third parties) provided a mechanism for the completion of construction work. Therefore, the High Court found little substantive reason to apply Article 59.

X appealed this decision to the Supreme Court.

The Supreme Court's Ruling

The Supreme Court reversed the High Court's decision and remanded the case for further proceedings.

The Court held that Article 59 of the old Bankruptcy Act (allowing the trustee to choose between terminating or performing a bilateral executory contract) does apply when a contractor is declared bankrupt, unless the work stipulated in the contract is of such a nature that it cannot be completed by anyone other than the bankrupt (i.e., where the trustee has no practical option to choose performance).

The Supreme Court's reasoning was as follows:

1. General Principle of Article 59: Article 59 is a general provision for bilateral contracts. It acknowledges that obligations in such contracts are legally and economically interrelated and typically function as mutual security for each party. When one party to an executory bilateral contract becomes bankrupt, Article 59, in conjunction with Article 60, grants the bankruptcy trustee the right to choose between terminating the contract or demanding performance of the counterparty's obligations. This is intended to protect the interests of the bankruptcy estate while also providing protection to the counterparty corresponding to the trustee's choice.
2. No Explicit Exclusion: There is no provision in the Bankruptcy Act that explicitly excludes the application of Article 59 when a contractor becomes bankrupt. This countered the High Court's first point.
3. No Substantive Reason for Exclusion (Generally): Unless the work is of a nature that the trustee has no option to choose performance (i.e., it's strictly personal to the bankrupt), there is no substantive reason to exclude the application of Article 59.
4. Insufficiency of Article 64: The High Court suggested that Article 64 of the old Bankruptcy Act could provide an adequate resolution. However, the Supreme Court stated that even if Article 64 could be applied to contracts where Article 59 was deemed inapplicable, and even if its proper application might lead to a somewhat reasonable outcome, it would not be a sufficient basis to deny the application of Article 59. This is because if the bankruptcy estate could not complete the work (due to its own circumstances, etc.), the orderer's protection would be significantly lacking.

Therefore, the Supreme Court concluded that Article 59 applied to the contract in question, unless the work was so personal that the trustee could not choose performance. If the contract was indeed terminated, X (the orderer) would be entitled to claim the return of the advance payment, less the value of the work already completed, as an administrative expense claim under Article 60, Paragraph 2 of the old Bankruptcy Act. The High Court erred in not considering this and summarily dismissing X's claim .

Commentary and Elaboration

1. Academic Debate on Article 59's Applicability to Contractor Bankruptcy

While provisions like Civil Code Article 642 and Bankruptcy Act Article 53, Paragraph 3 (old Article 62) address an orderer's bankruptcy, the old Bankruptcy Act only had Article 64 (now abolished) specifically mentioning contract performance in a contractor's bankruptcy. Whether the general rule of Article 53 (old Article 59) applied was debated.

• Legislative Intent and Early Views: The drafting notes for the old Bankruptcy Act indicated that Article 59 was indeed intended to apply to contractor bankruptcies. However, older academic theories often denied its application, envisioning contractors as artisans (e.g., carpenters, tailors) whose personal labor was for subsistence and whose decision to work was a personal freedom. Providing such personal labor was not considered part of the bankruptcy estate's administration or disposition, thus outside the trustee's control. Under this "non-application theory," remuneration for work completed by the bankrupt contractor after the bankruptcy declaration would be their free property, not part of the estate. Old Article 64 was interpreted as giving the trustee an "intervention right" to bring the contract into the estate for its benefit.
• Criticism and Evolving Theories: This older view faced criticism as modern work contracts often involve corporations performing substitutable tasks (like large construction projects). The idea that remuneration for partially completed work could become the bankrupt's free property was also questioned. By the time of the 2004 Bankruptcy Act reforms, the majority view had shifted to "dichotomous theories" (二分説 - nibun-setsu), which distinguished situations where Article 53 (old Article 59) would apply from those where it wouldn't. Old Article 64 was thought to apply in cases where Article 53 did not. The criteria for this distinction varied among scholars:
  • (A) Based on whether the bankrupt contractor's obligation was personal labor (maintaining the old view for such cases) versus impersonal work by a corporation (applying Article 53).
  • (B) Based on whether the work was a non-substitutable duty versus a substitutable one (applying Article 53 to substitutable duties).
  • (C) Based on the necessity of liquidating assets (applying Article 53 where necessary).
• Full Application Theory: Another strong view advocated for the full application of Article 53 (old Article 59) regardless of whether the contractor was an individual or a corporation. Under this perspective, remuneration for partially completed work would naturally belong to the bankruptcy estate, and old Article 64 was merely a provision detailing the method of performance if the trustee chose to have the contract fulfilled. Some scholars continue to support this comprehensive application under current law.

2. Analysis of the Supreme Court's Stance in the 1987 Judgment

The Supreme Court, in this 1987 decision, positioned Article 59 (old) as a general rule for bilateral contracts, predicated on the balance of counter-performance.

• It countered the High Court's reasoning by emphasizing the lack of an explicit statutory exclusion for contractor bankruptcies and by deeming the protections under old Article 64 insufficient. (It's noteworthy that old Article 64 was later abolished, considered to lack rationality and necessity ).
• The critical standard adopted by the Court appears to be the substitutability of the contractor's work. If the work is not so personal that it can only be performed by the bankrupt, Article 59 applies. This aligns the decision closely with the dichotomous theory (B) mentioned above. Some might interpret this as merely contrasting with personal labor.
• The judgment seems to limit the contractor's ability to retain the contract outside bankruptcy proceedings to cases where the work is of a non-substitutable nature. This has drawn criticism: even if work is substitutable, if it's the contractor's personal livelihood (akin to an employment contract), simply relying on the trustee to exercise their choice under Article 53, Paragraph 1 appropriately to "leave" the work with the contractor might be inadequate protection. Consequently, there is strong support for the view that Article 53 should not apply to work contracts that are essentially for the contractor's personal labor (similar to employment contracts). Conversely, Professor Ito argues that Article 53 applies to contractor bankruptcies regardless of whether the contractor is an individual or a corporation; remuneration for services provided by the bankrupt contractor post-petition at the trustee's request should be paid by the trustee to the contractor under a new work or employment contract.

3. Treatment of the Orderer's Claim for Return of Advance Payment

When Article 53 (old Article 59) applies to a contractor's bankruptcy and the contract is terminated by the trustee:

• Termination is generally prospective, affecting only the unperformed portion.
• The already completed portion of the work (出来高部分 - dekidaka bubun) is considered to belong to the orderer.
• The claim for payment for this completed portion (and any unpaid fees) belongs to the contractor's bankruptcy estate. (There is a 1981 Supreme Court case that limited termination based on breach of contract concerning already completed sections of work ).

A key issue is whether the orderer's claim for the return of an advance payment that exceeds the value of the work performed should be treated as an administrative expense claim under Article 54, Paragraph 2 (old Article 60, Paragraph 2). This 1987 Supreme Court judgment affirmed that it should. This classification is highly beneficial to the orderer, as administrative claims are paid with priority from the bankruptcy estate.

However, this aspect of the ruling has also been debated:

• Arguments against Administrative Claim Status:
  • Article 54, Paragraph 2 is primarily intended to protect parties in situations where both sides have restitution obligations that are in a relationship of simultaneous performance (see Civil Code Article 546). In the case of an advance payment, the bankruptcy estate (the contractor's) typically does not have a corresponding restitution claim against the orderer that would be offset by the orderer's claim for return of the unearned advance.
  • The orderer's advance payment can be viewed as an unsecured extension of credit to the contractor.
  • The orderer already retains the value of the work completed for which part of the advance was used.
    Thus, some argue the claim for return of excess advance payment should be a general unsecured bankruptcy claim.
• Arguments Supporting Administrative Claim Status (and the Supreme Court's decision):
  • It creates a balance with the scenario where the trustee chooses to perform the contract, in which case the counterparty's (orderer's) claims arising from that continued performance are often treated as administrative expenses (see Bankruptcy Act Art. 148(1)(vii)).
  • It promotes fairness, considering the trustee is granted a special statutory right to terminate the contract, which can be particularly advantageous to the estate. Treating the restitution claim as an administrative expense compensates the orderer for this.
  • Practical considerations also support this view: for instance, an individual ordering a home construction is often a consumer, and treating them like a financial institution providing unsecured credit may be inappropriate. Furthermore, advance payments are often specifically used for purchasing materials and are not identical to general unsecured credit. Many commentators, therefore, agree with the Supreme Court's stance on this point.

Conclusion

The Supreme Court's 1987 decision was significant in affirming that the general rules for handling executory contracts in bankruptcy (specifically, Article 59 of the old Bankruptcy Act) generally apply when a contractor becomes bankrupt, unless the work is of a strictly personal nature. This provided clarity on the bankruptcy trustee's powers and the orderer's position. Furthermore, by recognizing the orderer's claim for the return of unearned advance payments as an administrative expense claim upon termination, the Court offered a substantial measure of protection to orderers, a stance that, while debated, acknowledges the practical realities and equitable considerations in such situations. This ruling remains a key reference for understanding the treatment of work contracts in Japanese contractor bankruptcies.