Offsetting Debts in Japan: When Can I Use Set-Off Against a Financially Distressed Counterparty?

The right of set-off (相殺 - sōsai), allowing parties who owe each other mutual debts to cancel them out to the extent of the smaller debt, is a commercially intuitive and efficient mechanism. In Japan, as in many jurisdictions, it serves not only as a straightforward method of settling accounts but also as a powerful de facto form of security, especially for financial institutions. However, the exercise of this right becomes significantly more complex and scrutinized when one of the parties is financially distressed or facing formal insolvency proceedings. This article examines the Japanese legal framework governing set-off, particularly in challenging financial circumstances, including its interaction with individual enforcement actions, formal insolvency proceedings, and private workouts.

The Basics of Set-Off (Sōsai) Under Japanese Law

Under the Japanese Civil Code (Articles 505 et seq.), for a party to unilaterally effect a set-off, certain conditions must generally be met:

1. Mutuality of Debts: Two parties must owe obligations to each other.
2. Same Kind of Obligations: The objects of both obligations must be of the same kind (e.g., both monetary).
3. Maturity of the Active Claim: The claim that the party wishing to set off (the active claim or jidō-saiken - 自動債権) holds against the other party must be due.
4. Maturity of the Passive Claim (Generally): The claim that the other party holds (the passive claim or judō-saiken - 受動債権, against which set-off is asserted) must also generally be due. However, the party wishing to set off can waive the "benefit of time" (kigen no rieki - 期限の利益) for their own obligation (the passive claim) if it is not yet due, thereby making it fit for set-off.
5. No Bar to Set-Off: The nature of the debts or contractual agreements must not prohibit set-off.

Set-off is effected by a unilateral declaration from one party to the other and extinguishes the mutual debts retroactively to the point when they first became eligible for set-off (sōsai tekijō - 相殺適状).

Set-Off in the Face of Individual Enforcement Action (e.g., Attachment of Claims)

A common scenario testing the limits of set-off arises when a creditor (Creditor X) of a debtor (Debtor A) attaches a claim that Debtor A holds against a third party (Third-Party Obligor B, e.g., a bank holding Debtor A's deposit). If Third-Party Obligor B also has a claim against Debtor A (e.g., a loan owed by Debtor A to the bank), can B still set off its loan against the attached deposit, thereby reducing what Creditor X can recover?

The Japanese Civil Code Article 511 addresses this: "A third party obligor who has received an order of prohibition of payment [e.g., an attachment order] may not assert a set-off based on a claim acquired after such prohibition against an attaching creditor." This implies that if the third-party obligor’s claim against the debtor was acquired before the attachment, set-off might still be possible.

Japanese case law has significantly shaped the interpretation of this principle, generally moving to protect the "expectation of set-off" (sōsai kitai - 相殺期待) held by the third-party obligor:

• Early Developments: Initial court decisions were stricter, often requiring that both mutual debts be mature and fit for set-off before the attachment. However, an early Great Court of Cassation (Daishin-in, the precursor to the Supreme Court) decision on May 30, 1933 (Showa 8), allowed a bank to set off its due loan against an attached deposit even if the deposit (the bank's debt) was not yet mature at the time of attachment, by permitting the bank to unilaterally waive the benefit of time for the deposit. This was affirmed by the Supreme Court on July 19, 1957 (Showa 32).
• The Shift to an "Unrestricted View": A landmark Supreme Court Grand Bench decision on June 24, 1970 (Showa 45), solidified what is often termed the "unrestricted view" (museigen-setsu - 無制限説). This ruling held that a third-party obligor could generally set off a claim acquired against the debtor before the attachment, even if one or both claims were not yet mature at the time of attachment, provided they subsequently became fit for set-off. The rationale was that an attachment by one of the debtor’s creditors should not strip the third-party obligor of pre-existing defenses or rights it held against the debtor, including the potential to set off. This significantly broadened the scope for set-off post-attachment. Prior to this, a Supreme Court Grand Bench decision on December 23, 1964 (Showa 39), had taken a more restrictive stance, focusing on the relative maturity dates of the claims.

Contractual Set-Off ("Set-Off Expectation" - Sōsai Yoyaku)

Leveraging this judicial stance, contractual set-off provisions (sōsai yoyaku - 相殺予約, literally "set-off reservation" or expectation) became standard in many commercial agreements, particularly bank transaction agreements (ginkō torihiki yakujōsho - 銀行取引約定書). These clauses typically allow a party (e.g., a bank) to declare all debts immediately due and to set them off against any claims the counterparty (debtor) has against them upon the occurrence of certain trigger events, such as the attachment of the counterparty's assets or the filing of an insolvency petition. The "unrestricted view" from the judiciary largely supported the enforceability of these contractual expectations of set-off against attaching creditors.

Furthermore, arrangements like "directed deposits" (furikomi shitei - 振込指定), where a debtor instructs its own customers to make payments into an account held with its lender bank, serve to channel funds into the lender's control, thereby enhancing the bank's practical ability to exercise set-off.

Set-Off When Your Counterparty Enters Formal Insolvency Proceedings

When a counterparty becomes subject to formal insolvency proceedings under Japanese law (such as bankruptcy - 破産 hasan, civil rehabilitation - 民事再生 minji saisei, or corporate reorganization - 会社更生 kaisha kōsei), the right of set-off is generally preserved and treated as a form of de facto security. However, insolvency statutes impose crucial restrictions to prevent abuse and ensure fairness to the general body of creditors.

Set-Off Generally Upheld as a Secured Claim Equivalent

The Bankruptcy Act (Article 67(1)) explicitly allows a bankruptcy creditor who also owes a debt to the bankrupt estate to effect a set-off outside the formal bankruptcy procedures. This right is considered a powerful one, effectively giving the creditor with a set-off right a status similar to that of a secured creditor up to the amount of the mutual claim.

Expansion of Set-Off Rights in Bankruptcy

In some ways, bankruptcy can expand set-off possibilities. For instance, under Article 67(2) of the Bankruptcy Act, claims do not necessarily need to be mature to be set off. This is because bankruptcy proceedings often have the effect of accelerating claims against the debtor (e.g., Article 103(3) of the Bankruptcy Act regarding "presentification" - 現在化 genzaika - of claims for distribution purposes).

Crucial Restrictions in Insolvency – Preventing Unfair Advantages

The most significant aspect of set-off in insolvency is the array of restrictions designed to prevent creditors from unfairly improving their position on the eve of or during insolvency. These are primarily found in Articles 71 and 72 of the Bankruptcy Act (with similar provisions in the Civil Rehabilitation Act and Corporate Reorganization Act). These rules are complex but generally target situations where set-off would be inequitable:

1. Post-Petition Acquisitions/Assumptions:
   • A creditor cannot set off a claim against the debtor that was acquired after the commencement of insolvency proceedings (Bankruptcy Act Art. 71(1)(i)).
   • A party cannot set off if the debt owed to the insolvent debtor (the passive claim) was assumed from another party after the commencement of insolvency proceedings (Bankruptcy Act Art. 72(1)(i)).
2. Pre-Petition, Post-Crisis Acquisitions/Assumptions with Knowledge ("The Knowledge of Crisis" Rule):
   These are the most heavily litigated restrictions.
   • Acquiring a Claim Against the Debtor: A creditor is barred from set-off if they acquired a claim against the debtor (the active claim for set-off) before insolvency proceedings commenced but after the debtor had already suspended payments (shiharai teishi - 支払停止), or after a petition for insolvency was filed, and the creditor knew of the suspension of payments or the filing at the time of acquiring the claim (Bankruptcy Act Art. 71(1)(ii) & (iv)). An exception exists if the claim was acquired based on a statutory cause or a cause that arose before the creditor gained such knowledge.
   • Assuming a Debt Towards the Debtor: Similarly, a party is barred from set-off if they assumed a debt towards the debtor (the passive claim) before insolvency proceedings commenced but after the debtor had suspended payments or an insolvency petition was filed, and the party knew of these circumstances at the time of assuming the debt (Bankruptcy Act Art. 72(1)(ii) & (iv)). Again, exceptions apply for statutory causes or causes predating knowledge.

The rationale behind these restrictions is to prevent creditors from:

• Buying claims against the soon-to-be-insolvent debtor at a discount specifically to set them off against their own full-value debt to the debtor.
• Arranging for others to take over their debts to the insolvent debtor to create artificial set-off opportunities.

Set-Off in Rehabilitation-Type Proceedings (Civil Rehabilitation and Corporate Reorganization)

While the general principle of preserving set-off and similar anti-abuse restrictions apply:

• There is typically no automatic "presentification" or acceleration of claims solely for set-off purposes as seen in bankruptcy. Under the Corporate Reorganization Act (Article 48(1)) and Civil Rehabilitation Act (Article 92(1)), set-off generally requires that both the claim and the debt are fit for set-off (e.g., mature) by the expiry of the period for filing proofs of claims.
• This makes contractual clauses in loan agreements (like sōsai yoyaku) that trigger the acceleration of the debtor's obligations upon the filing for such proceedings particularly important for creditors wishing to preserve their set-off rights.

The Murky Waters of Set-Off in Private Workouts (Shiteki Seiri)

Private workouts or informal restructurings operate outside the direct application of statutory insolvency laws. Consequently, the specific statutory restrictions on set-off found in the Bankruptcy Act do not automatically apply. This can create uncertainty.

However, the principles underpinning those statutory restrictions – namely, fairness to the creditor body and prevention of opportunistic behavior – may still be invoked through broader legal doctrines, most notably the doctrine of abuse of rights (kenri no ran'yō - 権利の濫用).

The "Same Bank Set-Off" (Dōkō Sōsai - 同行相殺) Dilemma

A classic example where the abuse of rights doctrine is debated in the context of set-off during a private workout is the "same bank set-off." This typically involves a bank that:

1. Has a loan outstanding to Debtor A (who is in financial distress).
2. Holds deposits for Debtor A.
3. Also has a relationship with Creditor B, who holds a bill of exchange or promissory note issued by Debtor A.
   Knowing Debtor A is in trouble, the bank might purchase or discount this bill from Creditor B (perhaps Creditor B is also a customer of the bank and itself facing issues if Debtor A defaults on the bill) and then promptly set off the amount of the bill against Debtor A's deposit.

If Creditor B was solvent and the bank could have sought payment from Creditor B (e.g., through recourse on the discounted bill), but instead chose to set off against Debtor A's deposit (which would otherwise be available to Debtor A's general creditors in a workout), this could be seen as an abuse. It effectively allows the bank to preferentially recover on the bill (or help Creditor B do so indirectly) at the expense of Debtor A’s other creditors.

The Supreme Court, in a decision on May 2, 1978 (Showa 53), concerning a similar scenario, leaned towards permitting such set-offs, emphasizing the bank's freedom to choose its methods of recourse. However, this area remains contentious, and the specific facts, such as the bank's knowledge, motives, and the impact on the viability of a workout plan for other creditors, would be critical in any abuse of rights analysis.

Academics have also proposed a "set-off avoidance theory" (sōsai hinin ron - 相殺否認論), suggesting that principles similar to statutory avoidance powers in formal insolvency should be applied by analogy to particularly egregious set-offs in the lead-up to a private workout. However, the doctrine of abuse of rights is generally seen as a more direct and flexible tool, as it doesn't require fitting the set-off (which is often a unilateral act not involving a "transaction" by the debtor) into an avoidance framework designed for bilateral acts.

Strategic Considerations for Creditors

Navigating set-off rights in Japan, especially when a counterparty is financially vulnerable, requires careful planning and awareness:

• Pre-existing, Well-Documented Mutual Debts: The cleaner the pre-existing mutuality of debt, the stronger the set-off position.
• Value of Contractual Set-Off Clauses: Well-drafted sōsai yoyaku clauses in loan and transaction agreements are vital for defining trigger events and ensuring claims are mature when needed, particularly for rehabilitation-type proceedings.
• "Knowledge of Crisis" Threshold: Creditors must be acutely aware of the restrictions tied to acting after knowing of a debtor’s suspension of payments or insolvency filing. Acquiring claims or engineering debt assumptions at this stage is highly risky for set-off purposes.
• Workouts vs. Formal Proceedings: In private workouts, while set-off might be technically available, creditors (especially major financial institutions involved in a collective restructuring effort) often face pressure to forbear from exercising set-off to facilitate a consensual plan. The threat of a set-off being deemed an abuse of rights also plays a role. In formal proceedings, the rules are more codified but equally strict.

Conclusion

The right of set-off is a valuable and often potent tool for creditors in Japan, offering a direct means of recovery and a de facto security. However, its strength is not absolute, particularly when a counterparty slides into financial distress. Japanese law, through the Civil Code, specific insolvency statutes, and evolving judicial interpretations (including the doctrine of abuse of rights), seeks to strike a delicate balance. It aims to protect the legitimate expectations of creditors who hold mutual claims, while simultaneously preventing opportunistic actions that could undermine the fairness of individual enforcement, the viability of private workouts, or the equitable distribution principles central to formal insolvency proceedings. A thorough understanding of these rules and their underlying principles is essential for any party engaging in credit transactions in Japan.