My Japanese Customer Made a Partial Payment for Multiple Debts. How is Payment "Appropriated" (Bensai no Jūtō) Under Japanese Law if We Don't Agree?

It's a common scenario in business: a customer owes your company for several different invoices or is behind on multiple installment payments, and then makes a payment that is insufficient to cover all outstanding amounts. When this happens, the question arises: which specific debt or portion of a debt does this partial payment satisfy? Under Japanese law, this process is known as "Appropriation of Performance" (弁済の充当 - Bensai no Jūtō), and the Civil Code provides a clear hierarchy of rules to determine how such payments should be applied, especially when the parties themselves have not reached an explicit agreement.

What is "Appropriation of Performance" (Bensai no Jūtō)?

Appropriation of performance refers to the legal rules and procedures for determining which specific obligation(s) a debtor's performance (typically a payment) is applied to when that performance is insufficient to discharge all obligations of the same kind owed by that debtor to the same creditor. This is crucial because the allocation can affect the remaining balances on different debts, the accrual of interest or delay damages, the liability of guarantors for specific debts, and the enforceability of security interests tied to particular obligations.

Situations requiring appropriation rules commonly include:

1. Multiple Distinct Obligations: A debtor owes a creditor for several separate and distinct obligations of the same kind (e.g., a business has multiple outstanding invoices with a supplier for different deliveries of goods, and makes a lump-sum payment less than the total of all invoices).
2. Single Obligation with Multiple Performance Components: An obligation might involve several distinct performance components or installments, and the debtor's performance only covers some of them (e.g., a loan agreement with monthly repayment installments, where the debtor pays an amount covering some, but not all, missed installments).
3. Obligation Comprising Principal, Interest, and Costs: A single obligation might involve payments due for the principal amount, accrued interest, and any associated costs (e.g., collection expenses). If a payment is insufficient to cover all three components, rules are needed to determine the order of application.

The Hierarchy of Appropriation Rules in Japan

Japanese law establishes a clear order of priority for determining how a payment is appropriated. This hierarchy ensures that the parties' intentions are respected first, followed by rights of designation, and finally, by default statutory rules if no specific intentions are expressed.

1. Agreement Between Parties (合意充当 - Gōi Jūtō) - Article 490

The paramount rule is that if the debtor and creditor have an agreement regarding the order of appropriation, that agreement governs. This is stipulated in Article 490 of the Civil Code.

• Scope of Agreement: Such an agreement can be made at the time the original obligations arise, at the time of payment, or even subsequently. It can cover currently existing debts or, as affirmed by the Supreme Court of Japan in a judgment on July 24, 2014 (Hanrei Times 1408-57), even future debts that may arise between the parties.
• Subsequent Modification: Parties can also mutually agree to change a prior appropriation that has already taken legal effect (Supreme Court of Japan, July 1, 1960, Minshu Vol. 14, No. 9, p. 1641). However, such a subsequent re-appropriation agreement cannot prejudice the rights of any third party who may have acquired a legitimate interest based on the original appropriation (e.g., a guarantor whose liability was reduced by the initial appropriation).
• Practicality: In business relationships involving ongoing accounts or multiple transactions, it is often prudent to include clauses in master agreements or terms and conditions specifying how payments will be applied, particularly if the creditor wishes to prioritize certain types of debt (e.g., older debts, unsecured debts, or higher-interest debts).

2. Designation by the Payer or Payee (指定充当 - Shitei Jūtō) - Article 488, Paragraphs 1 & 2

If there is no overarching agreement on appropriation, the right to designate which debt(s) the payment covers falls, in the first instance, to the party making the payment, and then potentially to the party receiving it.

• (a) Designation by the Payer (Debtor) - Article 488(1): At the time of making the performance (payment), the payer (debtor) has the right to designate which specific debt or debts the payment is intended to satisfy. Provided the payment is otherwise valid (e.g., for the correct amount for the designated debt if full payment for that debt is intended), the creditor generally cannot refuse this designation.
• (b) Designation by the Payee (Creditor) - Article 488(2): If the payer makes no designation at the time of payment, the payee (creditor), at the time of receiving the performance, has the right to designate how the payment will be appropriated. However, this right is not absolute. The payer can "immediately object" to the payee's designation. If the payer does so, the payee's designation does not take effect, and the appropriation will then be determined according to the statutory default rules (discussed below). The immediacy of the objection is key to preserving the payer's ultimate control before statutory rules kick in.
• Form of Designation (Article 488(3)): A designation of appropriation is made by a declaration of intent to the other party. While no specific form is mandated, for clarity and evidence, a written designation is advisable.
• Default Nature: These rules on designation are default provisions (任意法規 - nin'i hōki). Parties can agree to different terms, such as giving the creditor the primary or sole right to designate appropriation. However, excessively delayed designations, particularly if they disadvantage third parties who have since acquired interests, might be challenged under the principle of good faith.

3. Statutory Appropriation (法定充当 - Hōtei Jūtō) - Article 488, Paragraph 4

If there is no agreement on appropriation, and neither the payer nor the payee makes a valid and effective designation (or if the payee's designation is successfully objected to by the payer), the Japanese Civil Code provides a default order of appropriation (statutory appropriation). These rules aim to apply the payment in a manner generally considered fair and reasonable.

Statutory Appropriation for Multiple Obligations (Article 488, Paragraph 4)

When a payment is insufficient to cover multiple distinct debts of the same kind owed by the debtor to the creditor, and no agreement or valid designation governs, Article 488, Paragraph 4 prescribes the following hierarchical order:

1. Debts Currently Due vs. Not Yet Due (Art. 488(4)(i)):
   The payment is first applied to obligations that are already due and payable. If all outstanding debts are due, or if all are not yet due, this criterion does not resolve the order, and the next rule applies.
2. Greatest Benefit to the Debtor (Art. 488(4)(ii)):
   Among debts that are in the same category regarding their due status (i.e., all are due, or all are not yet due), the payment is appropriated to the debt(s) the discharge of which would be most beneficial to the debtor. The law presumes certain discharges are more beneficial:
   • Interest-bearing debts are generally prioritized over non-interest-bearing debts.
   • Debts carrying a higher interest rate are prioritized over those with a lower rate.
   • Debts for which the debtor is currently being sued are prioritized over those not subject to litigation.
   • Whether a debt secured by collateral (where discharge would free the collateral) or a debt with a surety is "more beneficial" than an unsecured or non-guaranteed debt can be context-dependent and may require an overall assessment of the debtor's financial situation and the nature of the securities/guarantees involved.
3. Earlier Due Date (Art. 488(4)(iii)):
   If, after applying the "benefit to the debtor" criterion, several debts still rank equally, the payment is applied to the debt(s) that became due and payable at an earlier date.
4. Pro Rata Application (Art. 488(4)(iv)):
   If all the preceding criteria still leave multiple debts of equal standing (e.g., several debts with the same due date and offering the same "benefit" to the debtor upon discharge), the payment is then appropriated proportionally to the amount of each such debt.

Statutory Appropriation Involving Principal, Interest, and Costs (Article 489)

When a payment is made towards an obligation that includes not only the principal amount but also accrued interest and any incurred costs (e.g., collection expenses), and the payment is insufficient to cover all these components for one or more debts, Article 489 provides specific appropriation rules, again applicable in the absence of a contrary agreement between the parties.

1. Order of Priority for a Single Debt (Art. 489(1)):
   For any single debt that has these three components, a partial payment is applied in the following strict order:
   • First: To Costs (費用 - hiyō).
   • Second: To Interest (利息 - risoku) (this includes accrued contractual interest as well as any applicable delay interest).
   • Third: To Principal (元本 - ganpon).
     This order (costs > interest > principal) cannot be unilaterally altered by the payer's or payee's designation; it applies by default unless the parties have explicitly agreed otherwise (under Article 490).
2. Appropriation Across Multiple Debts, Each with Principal, Interest, and Costs (Art. 489(2)):
   If the debtor owes multiple debts, and each (or some) of these debts has outstanding principal, interest, and cost components, and a payment is made that is insufficient to cover all components across all debts:
   • First, the payment is conceptually allocated among the categories of costs, interest, and principal across all relevant debts, adhering to the general priority of costs first, then interest, then principal (as per Art. 489(1)).
   • Then, within each category (e.g., among all outstanding cost components for the different debts, or among all outstanding interest components for the different debts, or among all principal components), the rules of Article 488, Paragraph 4 (benefit to debtor, earlier due date, pro rata) are applied to determine which specific debt's cost, interest, or principal is satisfied by the allocated portion of the payment.

Appropriation for Obligations Requiring Multiple Performances (e.g., Installments) (Article 491)

If a single underlying obligation is structured to require several distinct performances or payments over time (e.g., an installment sale contract with monthly payments, or a construction contract with milestone payments), and the debtor makes a payment that is insufficient to cover all overdue installments or components, the appropriation rules outlined in Articles 488 and 489 (for multiple distinct obligations and for principal/interest/costs) apply correspondingly to determine which specific installment(s) or components thereof are deemed satisfied.

Broader Relevance of Statutory Appropriation Principles

The detailed rules for statutory appropriation, particularly the hierarchical considerations such as the benefit to the debtor and due dates, are considered by Japanese legal thought to reflect objective principles of reasonableness and fairness in allocating payments. Consequently, these principles are sometimes applied by analogy in other legal contexts where a limited fund must be distributed among multiple claims or components of claims, such as in the distribution of proceeds from a judicial auction of a debtor's property during civil execution proceedings (see, e.g., Supreme Court, December 18, 1987, Minshu Vol. 41, No. 8, p. 1592; Supreme Court, January 20, 1997, Minshu Vol. 51, No. 1, p. 1).

However, it's important to note that in formal collective proceedings like bankruptcy or certain types of execution involving multiple creditors, specific procedural rules designed to ensure fairness among all participating creditors may override private agreements or simple statutory appropriation rules that would apply in a bilateral context.

Practical Implications for Businesses

Understanding the Japanese rules on appropriation of performance is vital for both creditors and debtors:

• Clarity through Agreement: The most effective way to manage appropriation is through clear contractual agreement. When multiple debts are anticipated or exist, businesses should, where possible, stipulate the desired order of appropriation in their master agreements or standard terms. Creditors often prefer to apply payments to older, unsecured, or higher-interest debts first.
• Exercising Designation Rights: In the absence of an agreement, the party making a partial payment (debtor) should clearly designate its intended application at the time of payment. If no such designation is made, the recipient (creditor) should promptly consider making their own designation, while being mindful of the payer's right to immediately object. Written communication for any designation is highly recommended for evidentiary purposes.
• Meticulous Record-Keeping: Accurate and detailed records of all debts, payments, any designations made or received, and any agreements concerning appropriation are essential for correctly applying the rules and for resolving any subsequent disputes.
• Impact on Guarantees and Security: The manner in which payments are appropriated can significantly affect the outstanding balance of specific debts. This, in turn, can impact the extent of liability for any guarantors associated with those particular debts or the amount that can be recovered from collateral securing specific obligations.

Conclusion

The Japanese Civil Code provides a structured and hierarchical approach to the appropriation of performance (Bensai no Jūtō) when a payment is insufficient to discharge all of a debtor's obligations to a creditor. Party agreement takes precedence, followed by the right of designation (first by the payer, then by the payee subject to the payer's objection), and finally by a detailed set of statutory default rules. These statutory rules prioritize debts that are due, those whose discharge is most beneficial to the debtor, and those with earlier due dates, with pro rata application as a final resort. A distinct order also applies to the components of a single debt involving costs, interest, and principal. For businesses, a proactive approach involving clear contractual stipulations on appropriation, or diligent exercise of designation rights, coupled with careful record-keeping, is crucial for effectively managing financial obligations and recoveries in Japan.