Mutual Debts with a Japanese Company: How Does "Set-Off" (Sosai) Work Under Japanese Law and What Are Its Functions?

Japanese Attorney at Law - Bengoshi L.L.

• 7 min read

In the course of business, it's common for two companies to owe each other money or other obligations. When your company has an outstanding claim against a Japanese counterparty, and simultaneously owes a debt to that same counterparty, Japanese law provides a powerful and efficient mechanism for settling these mutual obligations: "Sosai" (相殺), or "Set-Off." Governed by Article 505 et seq. of the Japanese Civil Code, set-off allows one party to extinguish their debt by applying a mutual claim they hold against the other party, often with significant practical advantages.

What is "Set-Off" (Sosai) in Japanese Law?

Set-off, at its core, is a unilateral legal act by which one party (the "setting-off party") declares to the other party that their mutual claims are extinguished up to the corresponding amount of the lesser claim. It does not require the consent of the other party once the conditions for set-off are met.

  • The Mechanism: Set-off is typically effected by a declaration of intent (ishi-hyoji 意思表示) from the setting-off party to their counterparty (Japanese Civil Code Art. 506, Para. 1). This declaration expresses the intention to offset the mutual debts.

The Dual Functions of Set-Off

Set-off serves two primary and highly practical functions in Japanese commercial law:

  1. Simplified Settlement Function (Kessai Kan'i-ka Kino 決済簡易化機能):
    This is the most straightforward function. Instead of both parties making separate payments or deliveries to each other (which involves transaction costs, potential delays, and risks), set-off allows for a net settlement. It simplifies transactions and avoids the inefficiency of circular payments.
    • Example: Company A owes Company B ¥1,000,000. Company B owes Company A ¥800,000. Either party can declare set-off. The result is that Company A now only owes Company B ¥200,000, and Company B's debt to Company A is extinguished.
  2. Security/Guarantee Function (Tanpo-teki Kino 担保的機能):
    This is often the more strategically important function. Set-off provides a form of de facto security for a party's claim. If your company holds a claim against a Japanese counterparty (this is your "active claim" for set-off purposes) and also owes a debt to them (your "passive claim"), you can ensure collection of your active claim by setting it off against your passive claim.
    • This is particularly valuable if there are concerns about the counterparty's solvency. Even if the counterparty becomes insolvent and cannot pay its general creditors in full, a party with a valid set-off right can often achieve full satisfaction of their claim up to the amount of the debt they owed, effectively giving them a preferential position over other unsecured creditors. This "self-help" collection aspect makes set-off a powerful tool.

Requirements for "Fitness for Set-Off" (Sosai Tekijo) (Art. 505, Para. 1)

For a set-off to be validly declared, the mutual claims must be in a state of "fitness for set-off" (sosai tekijo). This means several conditions, outlined in Article 505, Paragraph 1 of the Civil Code, must be met:

  1. Existence of Mutual Claims Between the Same Parties:
    The two parties must each hold a claim against the other. Critically, these claims must generally be between the exact same legal entities acting in the same capacity. For example, a claim owed by Company X to Company Y cannot typically be set off by Company X against a claim that Company Y owes to a subsidiary or parent of Company X, unless specific legal grounds for disregarding corporate separateness exist (which is rare for set-off purposes).
  2. Claims Must Be of the Same Kind (Doshu no Mokuteki 同種の目的):
    The subject matter of both claims must be of the same kind.
    • Monetary Obligations: This is the most common scenario. Two monetary claims (e.g., both denominated in Japanese Yen, or both in U.S. Dollars) can be set off against each other.
    • Generic Goods: Claims for the delivery of generic goods of the same kind, quality, and quantity can also be set off if the place of performance for both obligations is the same.
    • Specific Things: Claims for the delivery of specific, unique items (e.g., "this particular painting") are generally not suitable for set-off, as their individual nature makes netting them out inappropriate.
  3. The Active Claim (Jido Saiken 自動債権) Must Be Due (Rikoki ni aru koto 履行期にあること):
    The "active claim" is the claim that the party wishing to declare set-off holds against the other party. This claim must be due and payable. One cannot use a claim that is not yet due to extinguish a debt one owes.
    • Passive Claim Need Not Be Due: Conversely, the "passive claim" (judo saiken 受動債権) – the debt owed by the party declaring set-off – does not need to be due. A party can choose to waive the "benefit of time" (kigen no rieki 期限の利益) for a debt they owe (i.e., agree to pay it early) and use it to set off against a due claim they hold against the other party.
  4. The Nature of the Passive Claim (Judo Saiken) Must Permit Set-Off:
    The nature of the debt owed by the party declaring set-off must not be one that inherently prohibits set-off (Art. 505, Para. 1, proviso). Certain obligations are considered unsuitable for extinguishment by set-off because of their specific purpose or character. Examples of claims that typically cannot be the passive claim in a set-off (i.e., you cannot declare set-off against them if you owe them) include:
    • An obligation to return a specifically entrusted item where the identity of the item is key (e.g., a bailment of a unique object).
    • Certain claims for support or alimony, due to their personal and often essential nature.
    • Claims that, by their nature or by agreement, demand actual specific performance for a particular purpose that would be defeated by set-off (e.g., an obligation to make a public apology is not settable off by a monetary claim).

Declaration and Effect of Set-Off (Article 506)

Once the claims are fit for set-off, the act itself is straightforward:

  • Declaration of Intent (Art. 506, Para. 1):
    Set-off is effected by a unilateral declaration from one party (the setting-off party) to the other. This declaration communicates the intent to set off the mutual claims. It can be done in or out of court (e.g., by written notice).
    • The declaration cannot be made subject to conditions or a future effective date. It must be an unconditional, present intention to set off.
  • Retroactive Effect (Art. 506, Para. 2):
    This is a crucial feature of Japanese set-off. Once a valid set-off is declared, the mutual claims are deemed to have been extinguished up to the amount of the lesser claim retroactively to the point in time when they first became "fit for set-off" (sosai tekijo ni natta toki 相殺に適するようになった時).
    • Impact on Interest: This means that no interest is considered to have accrued on the extinguished portions of the debts from the moment the claims first became mutually settable.
    • Impact on Statute of Limitations (Prescription): If a claim was fit for set-off before its statutory prescription period expired, set-off can still be validly declared using that claim (as the active claim) even if it has subsequently prescribed. The retroactive effect "saves" the claim for set-off purposes, relating the extinguishment back to the time of fitness.

Prohibitions on Set-Off

While powerful, the right to set-off is not unlimited. Japanese law imposes certain prohibitions:

  1. Prohibition by Agreement (Art. 505, Para. 2):
    Parties are free to mutually agree in their contract to prohibit or restrict the right of set-off with respect to claims arising from that contract.
    • However, such a contractual prohibition on set-off cannot be asserted against a third party (e.g., an assignee of one of the claims) who acquired their interest in good faith and without gross negligence concerning the existence of such a prohibition.
  2. Claims Arising from Torts (Art. 509):
    This is an important public policy-based restriction.
    • Rule: A party whose obligation (their passive claim) arose from their own tortious act (e.g., liability for damages caused by their negligence or intentional wrongdoing) generally cannot declare set-off using a monetary claim they hold against the tort victim.
    • Rationale: This rule prevents tortfeasors from effectively forcing the settlement of their tort liability by "self-help" – i.e., compelling the victim to accept the set-off rather than receiving direct compensation for the harm suffered. It ensures the victim has the right to direct redress for the tort.
    • Exception: This prohibition does not apply if the claim against the tortfeasor (which the tortfeasor wants to use as their active claim for set-off) was acquired by the tortfeasor from a third party before the tort occurred.
    • Victim's Right to Set-Off: Importantly, the victim of the tort can choose to set off their tort claim (as their active claim) against a debt they owe to the tortfeasor. The prohibition is one-sided, restricting only the tortfeasor.
  3. Claims Not Permitted for Attachment (Art. 510):
    An obligation that is not permitted to be attached (seized in execution), such as certain welfare benefits or legally protected portions of wages, cannot be used as the passive claim in a set-off. The debtor whose obligation is of such a nature can refuse a set-off declared against it.
  4. Attached Claims (Art. 511) – A Brief Note:
    When a claim (which would be the passive claim for the party whose debt has been attached by a third-party creditor) has been so attached, the ability of the holder of that attached claim to then use it to set off against a claim they subsequently acquire against the attaching creditor's debtor is restricted. This is a complex area aimed at protecting the efficacy of the attachment by preventing the third-party obligor (whose debt was attached) from diminishing the value of the attached claim after the attachment.

Conclusion

Set-off (Sosai) under Japanese law is a highly effective and commonly used mechanism for businesses to manage mutual debts. Its dual functions of simplifying settlements and providing a potent form of de facto security make it an invaluable tool. However, its application requires careful attention to the specific conditions for "fitness for set-off" (sosai tekijo) – ensuring mutuality, same kind of claims, and the due status of the active claim – as well as an understanding of the explicit prohibitions, particularly concerning tort claims and contractual restrictions. The retroactive effect of a valid set-off can also have significant implications for interest calculations and the statute of limitations, further highlighting the importance of mastering this area of Japanese contract law.