Set-Off Rights in Japanese Bankruptcy: When is it Prohibited?

The right of set-off (相殺権 - sōsai-ken), where parties with mutual debts can offset their obligations against each other, is a well-established principle in commercial law. In the context of Japanese bankruptcy proceedings (破産手続 - hasan tetsuzuki), this right is generally preserved, offering a straightforward way to settle mutual accounts and providing a form of de facto security to a creditor who also happens to be a debtor to the bankrupt entity. However, to ensure fairness and prevent actions that could undermine the collective interests of all creditors, the Japanese Bankruptcy Act (破産法 - Hasan Hō) imposes specific and important restrictions on when this right can be exercised. These restrictions are collectively known as the "prohibition of set-off" (相殺禁止 - sōsai kinshi).

Understanding these prohibitions is crucial for any party that has mutual dealings with a Japanese entity that enters bankruptcy.

The Right of Set-Off (相殺権 - Sōsai-ken) in Japanese Bankruptcy: General Principles

Article 67 of the Japanese Bankruptcy Act generally permits a creditor of the bankrupt debtor to set off their claim against any debt they owe to the debtor, provided both the claim and the debt arose before the commencement of bankruptcy proceedings and are suitable for set-off (i.e., they are of the same kind, typically monetary).

This recognition is based on two key functions of set-off:

1. Simplified Settlement: Set-off allows for an efficient and straightforward way to clear mutual debts without the need for cross-payments.
2. Security Function: For a creditor who also owes a debt to the bankrupt party, the right to set off effectively provides a form of security. They can satisfy their claim against the debtor (at least in part) by reducing the amount they have to pay into the bankruptcy estate, often resulting in a better recovery than if they had to pay their debt in full and then only receive a pro-rata dividend on their claim.

To exercise the right of set-off, the party wishing to do so (either the creditor or, in limited cases, the bankruptcy trustee) must typically make a declaration of intent to set off (意思表示 - ishi hyōji) to the other party. The debts are then considered extinguished to the extent of the offset, effective from the moment the debts first became eligible for set-off (相殺適状 - sōsai tekijō).

Prohibition of Set-Off (相殺禁止 - Sōsai Kinshi): Protecting Creditor Equality

While the right of set-off is broadly upheld, the Bankruptcy Act introduces significant prohibitions in Articles 71 and 72. These rules are designed to prevent abuse and maintain fairness among the general body of creditors, particularly by restricting set-offs that arise from actions taken when the debtor's financial crisis was already apparent or when bankruptcy was imminent. Such actions could unfairly deplete the estate or give one party an unwarranted advantage.

The prohibitions generally revolve around the timing of when a debt to the estate was incurred by a creditor, or when a claim against the estate was acquired by a debtor to the estate, relative to certain "crisis period" milestones and the knowledge of the party involved.

Scenario 1: Creditor Incurs a Debt to the Estate During a "Crisis Period" (Bankruptcy Act, Article 71)

This scenario addresses situations where a creditor of the bankrupt entity (who holds a pre-existing claim against the debtor) subsequently becomes a debtor to the bankrupt entity's estate (i.e., incurs an obligation to pay money to the estate). Set-off by such a creditor is prohibited if their debt to the estate was incurred under the following circumstances:

1. After Commencement of Bankruptcy Proceedings (Art. 71(1)(i)): If the creditor incurs the debt owed to the bankruptcy estate after the bankruptcy proceedings have formally commenced. This is an absolute prohibition, irrespective of the creditor's knowledge.
2. After Suspension of Payments or Debtor's Insolvency, with Knowledge (Art. 71(1)(ii) & (iii)):
   • If the debt to the estate was incurred after the debtor suspended payments (支払停止 - shiharai teishi), and the creditor knew of such suspension at the time they incurred the debt. (Art. 71(1)(iii))
   • If the debt to the estate was incurred after the debtor became unable to pay its debts generally (支払不能 - shiharai funō), and the creditor knew of this inability to pay at the time they incurred the debt. (Art. 71(1)(ii))
     A common example is a bank (creditor via a loan) accepting a deposit (incurring a debt to the debtor) from the debtor after the bank becomes aware that the debtor has suspended its general payments or is insolvent. The bank would generally be prohibited from setting off this newly acquired deposit liability against its pre-existing loan claim.
3. After a Bankruptcy Petition was Filed, with Knowledge (Art. 71(1)(iv)): If the debt to the estate was incurred after a bankruptcy petition was filed against (or by) the debtor, and the creditor knew of such filing at the time they incurred the debt.

Exceptions to Prohibition under Article 71(2):
Despite the above prohibitions (excluding the absolute prohibition for debts incurred post-commencement), a creditor may still be permitted to set off if their debt to the bankruptcy estate was incurred due to:

• (a) A statutory cause: Such as through inheritance, corporate merger, or obligations arising from negotiorum gestio (事務管理 - jimu kanri - management of another's affairs without mandate) or unjust enrichment (不当利得 - futō ritoku).
• (b) A cause that arose before the creditor became aware of the debtor's suspension of payments, inability to pay, or the filing of a bankruptcy petition. This is a significant exception. For example, if a creditor was contractually obligated to make a payment to the debtor under a contract signed long before any financial distress was known, and this payment (debt to the estate) fell due after the creditor learned of the crisis, set-off might still be allowed because the underlying cause of the debt predated the creditor's knowledge of the crisis. The PDF, for instance, notes that for a bank, a bill of exchange entrusted by the debtor for collection before the crisis, with proceeds credited after the crisis became known, might fall under this exception, allowing set-off.
• (c) A cause that arose more than one year before the filing of the bankruptcy petition, provided the creditor did not know at the time the cause arose that a bankruptcy petition had already been filed.

Scenario 2: Debtor to the Estate Acquires a Claim Against the Estate During a "Crisis Period" (Bankruptcy Act, Article 72)

This scenario addresses situations where a party who owes a debt to the bankrupt entity's estate subsequently acquires a claim against the bankrupt entity (typically by purchasing it from another creditor), often with the intention of using it for set-off. Set-off by such a debtor to the estate is prohibited if their claim against the estate was acquired under the following circumstances:

1. After Commencement of Bankruptcy Proceedings (Art. 72(1)(i)): If the debtor to the estate acquires the claim against the estate after the bankruptcy proceedings have formally commenced. This is an absolute prohibition.
2. After Debtor's Suspension of Payments or Insolvency, with Knowledge (Art. 72(1)(ii) & (iii)):
   • If the claim against the estate was acquired after the bankrupt debtor suspended payments, and the acquirer knew of such suspension at the time of acquisition. (Art. 72(1)(iii))
   • If the claim against the estate was acquired after the bankrupt debtor became unable to pay its debts generally, and the acquirer knew of this inability to pay at the time of acquisition. (Art. 72(1)(ii))
     This prevents, for example, a company that owes money to the bankrupt debtor from buying up claims from other creditors at a discount after learning of the debtor's insolvency, solely for the purpose of setting them off against their own debt.
3. After a Bankruptcy Petition was Filed, with Knowledge (Art. 72(1)(iv)): If the claim against the estate was acquired after a bankruptcy petition was filed, and the acquirer knew of such filing at the time of acquisition.

Exceptions to Prohibition under Article 72(2):
Similar to Article 71, there are exceptions. Set-off by the debtor to the estate is still permitted if their claim against the estate was acquired due to:

• (a) A statutory cause.
• (b) A cause which arose before the acquirer (the debtor to the estate) became aware of the bankrupt's suspension of payments, inability to pay, or the filing of a bankruptcy petition.
• (c) A cause which arose more than one year before the filing of the bankruptcy petition, provided the acquirer did not know at the time the cause arose that a bankruptcy petition had already been filed.
• (d) A contract concluded between the acquirer (the debtor to the estate) and the bankrupt debtor themselves (not a third party), provided this contract was entered into before the acquirer became aware of the bankrupt's crisis. This exception might cover, for instance, new loans extended to the debtor by the acquirer during a crisis period (which might be seen as a rescue financing attempt), where the loan contract itself is the source of the claim.

The Bankruptcy Trustee's Role in Scrutinizing Set-Offs

The bankruptcy trustee plays a critical role in examining any asserted rights of set-off.

• Investigation: The trustee will investigate the timing and circumstances under which the mutual debts and claims arose, paying close attention to the "crisis period" milestones (suspension of payments, inability to pay, petition filing, commencement of proceedings) and the parties' knowledge of these events.
• Challenging Prohibited Set-Offs: If the trustee determines that a set-off has been improperly asserted or effected in violation of the prohibitions under Article 71 or 72, they will challenge it. This may involve demanding repayment of the amount improperly set off, or, if necessary, initiating legal proceedings to recover the funds for the benefit of the bankruptcy estate.
• Determining "Knowledge": A key factual issue in many set-off disputes is determining precisely when a party had "knowledge" (悪意 - akui, meaning awareness of the fact, not necessarily malicious intent) of the debtor's suspension of payments or inability to pay. This often involves examining correspondence (e.g., receipt of a notice of financial distress or a formal notice of suspension of payments from the debtor or their counsel), public announcements, or other evidence. The timing of a bill of exchange dishonor (手形不渡情報 - tegata fuwatari jōhō) can also be critical evidence of payment suspension and constructive knowledge for financial institutions.

Practical Implications and Common Scenarios

• Bank Deposits and Loans: This is a frequent area for set-off disputes. Banks, as creditors holding loan claims, often seek to set off these claims against deposits held by the bankrupt debtor. The prohibitions under Article 71 are particularly relevant here. If a bank accepts significant deposits after it has clear knowledge of the debtor's inability to pay or suspension of payments, its ability to set off those newly deposited funds against pre-existing loans will be severely restricted.
• Mutual Trade Debts: Where two companies owe each other money from ongoing trade, set-off is common. However, if one company, knowing the other is about to go bankrupt, purchases claims against the failing company from other creditors at a discount to create a set-off opportunity against its own debt, this would likely be prohibited under Article 72.
• Set-Off Declaration (意思表示 - Ishi Hyōji): Generally, a party wishing to effect a set-off must communicate this intention to the other party (or the trustee). Some contracts, like standard bank loan agreements, may contain clauses allowing for automatic set-off without a separate declaration, but the underlying validity of such set-off in bankruptcy is still subject to Articles 71 and 72.

Time Limit for Exercising Set-Off by Creditors (催告権 - Saikokuken)

Under Article 73 of the Bankruptcy Act, the bankruptcy trustee can issue a formal demand (催告 - saikoku) to a creditor who has a right of set-off, requiring them to declare within a specified period (not less than one month) whether or not they intend to exercise that right. If the creditor fails to make such a declaration within the stipulated period after receiving the trustee's notice, they may lose their right to assert the set-off against the bankruptcy trustee. This mechanism allows the trustee to clarify the status of mutual debts and ascertain the net amount due to or from the estate.

Set-Off by the Trustee (管財人からの相殺)

The bankruptcy trustee's ability to initiate a set-off is very limited (Bankruptcy Act, Article 102). It is generally only permitted if the set-off is deemed to be in the "general interest of the creditors" and the trustee obtains permission from the court. This usually requires a showing that the set-off would result in a net benefit to the estate, for example, by securing a greater recovery on a claim owed to the estate than would be achievable through other means, especially if the counterparty is also financially distressed.

Agreements Regarding Set-Off (相殺を有効とする合意)

The prohibitions on set-off outlined in the Bankruptcy Act are generally considered mandatory rules designed to protect the integrity of the bankruptcy process and ensure creditor equality. Therefore, any agreement between the debtor (made pre-bankruptcy when already in crisis) or between the trustee and a creditor that purports to validate a set-off that would otherwise be prohibited under Articles 71 or 72 would likely be considered ineffective or void.

Conclusion

While the right of set-off is a recognized and often utilized mechanism in Japanese commercial dealings and is generally preserved in bankruptcy, the Bankruptcy Act imposes crucial limitations to prevent abuse and uphold fairness among creditors. These prohibitions primarily target set-offs arising from debts incurred or claims acquired during a "crisis period" when the debtor's insolvency was known or should have been known. Bankruptcy trustees are tasked with diligently scrutinizing asserted set-offs and challenging those that fall foul of these rules, thereby working to maximize the assets available for equitable distribution to all creditors.