Existing Contracts with a Bankrupt Japanese Company: What are the Trustee's Options?

When a Japanese company enters formal bankruptcy proceedings (破産手続 - hasan tetsuzuki), one of the significant areas of concern for its business partners, suppliers, customers, and other counterparties is the fate of their existing contracts. The commencement of bankruptcy does not automatically terminate these agreements. Instead, Japanese bankruptcy law grants the court-appointed bankruptcy trustee (破産管財人 - hasan kanzainin) specific powers to decide the future of these contracts, primarily focusing on what is most beneficial for the bankruptcy estate and the collective body of creditors.

This article explores how a Japanese bankruptcy trustee handles ongoing "executory contracts" – generally defined as contracts where both parties still have significant performance obligations remaining (双務未履行契約 - sōmu mirikō keiyaku) – and the implications of the trustee's decisions for the non-bankrupt counterparties.

The Trustee's Fundamental Choice: Assume or Reject (履行の選択又は解除)

The cornerstone of contract treatment in Japanese bankruptcy is found in Article 53, Paragraph 1 of the Bankruptcy Act (破産法 - Hasan Hō). This provision grants the bankruptcy trustee the option to either:

1. Assume the contract (履行を選択する - rikō o sentaku suru): The trustee chooses to continue with the contract, meaning the bankruptcy estate will perform the debtor's obligations and will be entitled to the counterparty's performance.
2. Reject (or terminate/cancel) the contract (解除する - kaijo suru): The trustee chooses to disavow the contract, relieving the estate of future performance obligations.

This choice is a discretionary power of the trustee, to be exercised in the best interests of the bankruptcy estate – typically meaning the option that maximizes asset value or minimizes liabilities for the estate.

Ipso Facto Clauses: Limited Effect

Many commercial contracts contain ipso facto clauses, which stipulate that the contract automatically terminates or grants the non-debtor party the right to terminate upon the other party's bankruptcy filing. In Japan, the general principle is that such clauses are not automatically enforceable to prevent the trustee from exercising their statutory option under Article 53. The underlying policy is to allow the trustee the opportunity to assume contracts that are beneficial to the estate, rather than allowing valuable contractual rights to be lost simply due to the bankruptcy filing itself. If such clauses were broadly enforced, they could significantly hinder the trustee's ability to preserve value. However, the specific enforceability can sometimes depend on the nature of the contract and other circumstances, though the default position favors the trustee's choice.

Consequences of Rejection (解除 - kaijo)

If the trustee decides to reject an executory contract, the following consequences generally ensue:

• Termination of the Contract: The contract is effectively terminated as of the rejection. The bankruptcy estate is no longer obligated to perform any future obligations under that contract.
• Counterparty's Claim for Damages: The non-bankrupt counterparty is typically entitled to claim damages resulting from the termination. This damage claim is treated as a general unsecured bankruptcy claim (一般破産債権 - ippan hasan saiken) (Bankruptcy Act, Article 54, Paragraph 1). This means the counterparty will share in any distributions from the estate pro rata with other general unsecured creditors, and full recovery is often unlikely.
• Restitution for Prior Performance: If the bankrupt debtor had already received benefits from the counterparty under the contract before rejection (e.g., goods delivered but not paid for), or if the counterparty had already paid for goods or services not yet received from the debtor, complex issues of restitution may arise. If the counterparty has performed and the benefit remains in the estate, they may have a claim for restitution, which could, in certain circumstances, be treated as an administrative claim (財団債権 - zaidan saiken) or a right of reclamation (取戻権 - torimodoshi-ken) if they retain ownership of specific assets (Bankruptcy Act, Article 54, Paragraph 2).

The trustee's decision to reject is common for contracts that are burdensome to the estate or offer no clear benefit to its administration and liquidation efforts.

Consequences of Assumption (履行の選択 - rikō no sentaku)

If the trustee determines that a contract is beneficial to the bankruptcy estate, they may choose to assume it. The implications are significantly different:

• Continuation of the Contract: The bankruptcy estate effectively steps into the shoes of the debtor with respect to the contract. Both the estate and the counterparty are expected to continue performing their respective obligations.
• Treatment of Counterparty's Claims: When a contract is assumed, claims arising from that contract are generally elevated in priority. Obligations that the estate incurs post-assumption, as well as pre-existing obligations under the assumed contract, are typically treated as administrative expense claims (財団債権 - zaidan saiken) (Bankruptcy Act, Article 148, Paragraph 1, Item 7). This is a significant advantage for the counterparty, as administrative claims are paid in full before general unsecured bankruptcy claims, provided the estate has sufficient funds.
• Curing Defaults: Generally, if the trustee wishes to assume a contract that is in default, they may need to cure the existing defaults or provide adequate assurance of future performance.
• Court Approval: The assumption of an executory contract by the trustee, particularly if it involves obligations exceeding a certain monetary threshold (e.g., 1 million yen as mentioned in some contexts regarding trustee actions requiring court permission under Article 78 of the Bankruptcy Act), may require the permission of the bankruptcy court.

Assumption is typically considered for contracts that are essential for the continued (albeit temporary) operation of a business if a going-concern sale is contemplated, or if the contract itself is a valuable asset (e.g., a favorable lease in a prime location that can be assigned, or a profitable long-term supply agreement).

The Counterparty's Right to Demand a Decision (催告権 - saikokuken)

The non-bankrupt counterparty is not left entirely in limbo while the trustee considers their options. Japanese bankruptcy law provides a mechanism for the counterparty to seek clarity:

• Demand for Decision: The counterparty can formally request (催告 - saikoku) the trustee to decide whether to assume or reject the contract within a "reasonable period" specified by the counterparty (Bankruptcy Act, Article 53, Paragraph 2).
• Deemed Rejection: If the trustee fails to provide a definitive answer (i.e., to assume the contract) within the period designated in the demand, the contract is deemed to have been rejected by the trustee. This provision protects the counterparty from prolonged uncertainty.

This right to demand a decision is an important tool for counterparties to expedite the resolution of their contractual relationship with the bankrupt entity.

Treatment of Specific Types of Contracts

The general principles of assumption and rejection apply broadly, but the nuances can vary depending on the type of contract:

1. Sales Contracts (売買契約 - baibai keiyaku)

• Debtor as Seller: If the debtor (seller) is bankrupt and has not yet delivered goods for which the buyer has paid, the buyer's claim for the goods or refund is a bankruptcy claim. If the contract is executory (e.g., goods not delivered, payment not fully made), the trustee may assume if the sale is profitable for the estate, or reject. If rejected after the buyer has paid, the buyer has a restitution claim for payments made, which may be an administrative or bankruptcy claim depending on specifics.
• Debtor as Buyer: If the debtor (buyer) is bankrupt, the seller who has delivered goods but not been paid has a bankruptcy claim. If goods are undelivered and unpaid, the trustee may assume if the goods are needed by the estate or can be profitably resold, or reject.

2. Lease Agreements (賃貸借契約 - chintaishaku keiyaku)

• Debtor as Lessee (Tenant): The trustee will usually reject leases for business premises unless they are essential for a short period to wind down operations, or if the lease is below market rate and can be profitably assigned (with landlord consent and court approval). Unpaid pre-petition rent is a bankruptcy claim. Rent for any period the trustee uses the premises post-petition becomes an administrative claim.
• Debtor as Lessor (Landlord): If the tenant has perfected their leasehold rights (e.g., for buildings, by taking possession; for land with a building owned by the tenant, by registering the building), the trustee generally cannot unilaterally terminate the lease simply due to the lessor's bankruptcy (Bankruptcy Act, Article 56, Paragraph 1). The tenant's right to continue occupying the premises under the terms of the lease is protected. The trustee will collect rent, and the property may be sold subject to the lease.

3. License Agreements (ライセンス契約 - raisensu keiyaku)

• Debtor as Licensor: Similar to leases, if the debtor is the licensor and the licensee has perfected their rights to use the intellectual property (e.g., through registration for patents or exclusive licenses, or by other means recognized for establishing rights against third parties), the trustee generally cannot terminate the license agreement due to the licensor's bankruptcy (Bankruptcy Act, Article 56, Paragraph 1). The licensee can continue to use the IP under the license terms, and the trustee would be entitled to receive ongoing royalties.
• Debtor as Licensee: If the debtor is the licensee, the trustee will evaluate whether the license is beneficial to the estate. If it is critical for the debtor's business (if any part is continued or sold as a going concern) or has assignment value, the trustee might assume it. Otherwise, it will be rejected, and the licensor will have a damage claim.

4. Continuous Supply Contracts (継続的供給契約 - keizokuteki kyōkyū keiyaku)

These include contracts for utilities (electricity, gas, water) or ongoing supply of raw materials.

• A significant protection for the bankrupt estate is that the supplier generally cannot refuse to continue providing the goods or services post-petition solely on the grounds of unpaid pre-petition amounts, provided the trustee requests continued supply and undertakes to pay for post-petition supplies (Bankruptcy Act, Article 55, Paragraph 1).
• Claims for supplies made during the period that includes the bankruptcy filing date (e.g., a monthly utility bill for the month in which bankruptcy was filed) are treated as administrative expenses (Article 55, Paragraph 2). This ensures essential services can continue, allowing the trustee to manage the estate.

5. Employment Contracts (雇用契約 - koyō keiyaku)

In most corporate liquidations, business operations cease, and the trustee will terminate employment contracts if this has not already been done by the debtor prior to filing. Unpaid wages and certain severance payments owed to employees have a priority status in bankruptcy, often partly as administrative claims and partly as priority bankruptcy claims.

6. Construction Contracts (請負契約 - ukeoi keiyaku)

Japanese law contains special provisions for construction contracts. Article 642 of the Civil Code (民法 - Minpō) provides that if either the contractor or the customer in a construction contract becomes bankrupt, the other party (or the trustee) can terminate the contract. This differs from the general rule in Article 53 of the Bankruptcy Act, where only the trustee has the initial option. If terminated, the contractor is entitled to remuneration for the completed portion of the work and compensation for any damages. The specifics of how claims are calculated, especially for work-in-progress, can be complex.

7. Finance Lease Contracts (ファイナンス・リース契約 - fainansu rīsu keiyaku)

Finance leases, where the lease term covers most of the asset's economic life and the total lease payments approximate the asset's purchase price plus interest, are often treated differently from operational leases. In substance, they resemble secured financing. Consequently, the lessor in a finance lease is often treated as having rights analogous to a secured creditor (holding a right of separation - 別除権 - betsujo-ken), rather than the contract being subject to the general assumption/rejection rules of Article 53 in the typical lease sense. The trustee will usually arrange for the return of the asset to the finance lessor.

Unlisted Contracts (申立書に記載のない契約)

The trustee is tasked with identifying all of the debtor's assets and liabilities, including all existing contracts. If a counterparty becomes aware that their contract was not listed in the debtor's bankruptcy petition, it is advisable for them to proactively bring the contract to the trustee's attention. This ensures that the trustee is aware of the contractual relationship and can make an informed decision regarding its assumption or rejection.

Practical Considerations for Counterparties

For businesses that have contracts with a Japanese entity now in bankruptcy:

• Await Trustee's Decision: Understand that the trustee will need time to assess the contract.
• Right to Demand: If uncertainty is detrimental, exercise your right to demand a decision (催告権 - saikokuken).
• Communication: Communicate formally with the trustee, providing copies of the contract and any relevant correspondence if requested.
• Claim Filing: If the contract is rejected or if there are pre-petition amounts owing even if assumed, ensure a proof of claim is filed by the deadline.
• Performance Post-Petition: Be cautious about performing further under the contract after the bankruptcy commencement unless and until the trustee formally assumes the contract and provides assurance of payment for post-petition performance.

Conclusion

The treatment of existing contracts is a critical aspect of Japanese bankruptcy proceedings. The bankruptcy trustee wields significant power to assume or reject executory contracts based on the best interests of the estate. This framework aims to maximize the value available for creditors while also providing a mechanism for counterparties to seek clarity on the status of their agreements. For any business with contractual ties to a Japanese entity undergoing bankruptcy, a clear understanding of these rules, the trustee's options, and their own rights and obligations is essential for navigating the process and protecting their interests. Engaging with Japanese legal counsel can be invaluable in these situations.