When is Set-Off Prohibited Under Japanese Law, Even if Mutual Debts Exist?

Set-off (相殺 - Sōsai), the ability to extinguish mutual debts by a unilateral declaration, is a powerful and efficient tool in Japanese commercial law. It simplifies settlements and provides a valuable security function. However, this right is not absolute. The Japanese Civil Code, along with judicial interpretation, imposes several important prohibitions and limitations on the exercise of set-off, even when parties owe each other debts that might otherwise seem suitable for netting. Understanding these restrictions is crucial for businesses to accurately assess when set-off is a permissible and effective remedy.

This article explores the key scenarios where set-off is prohibited under Japanese law.

1. Prohibition Based on the Nature of the Obligation (Article 505(1) Proviso)

The general rule for set-off in Article 505, Paragraph 1 of the Civil Code contains a significant proviso: set-off is not allowed if "the nature of the obligation does not permit it" (債務の性質が相殺を許さないとき - saimu no seishitsu ga sōsai o yurusanai toki). This means that certain types of obligations, due to their inherent characteristics or the specific purpose they serve, are deemed unsuitable for extinguishment through a simple netting against another claim.

Key examples include:

• Obligations to Perform a Specific, Non-Fungible Act (不代替的作為債務 - Fudaitaiteki Sakui Saimu):
  Where an obligation requires a unique, personal, or non-interchangeable performance, it cannot be "set off" against, for example, a monetary debt. The creditor is entitled to that specific performance, not merely its monetary equivalent offset by another claim.
  • For instance, if a renowned artist is commissioned to paint a specific mural (a non-fungible act), the artist cannot refuse to paint it by claiming to set off the value of their service against an unrelated monetary debt owed to them by the commissioning party. The commissioner contracted for the unique artwork, not a financial settlement via set-off. (Illustrative, based on genericized CASE 421, 422).
• Obligations Where Actual Tender and Receipt are Essential:
  Some obligations carry an implicit or explicit requirement for actual, physical performance or delivery, often due to underlying reasons of trust, safety, specific reliance, or the need for verifiable action. Allowing set-off might undermine these essential aspects.
  • For example, if a bailee is obligated to return a specifically entrusted item (e.g., a valuable document held for safekeeping), they generally cannot refuse to return it by setting off a monetary claim they have against the bailor. The bailor's primary interest is the return of the specific item.
  • Similarly, obligations that involve a public duty or a fiduciary responsibility requiring a specific act of performance might be considered unsuitable for set-off if netting would obscure the fulfillment of that duty.

This prohibition underscores that set-off is primarily suited for fungible obligations, most commonly monetary debts, where the identity of the specific currency units or generic goods is not critical.

2. Contractual Prohibition of Set-Off (相殺禁止特約 - Sōsai Kinshi Tokuyaku) (Article 505(2))

Japanese law respects party autonomy, and Article 505, Paragraph 2 allows parties to agree contractually to prohibit or restrict the right of set-off with respect to specific obligations or all obligations arising between them.

• Effect Between Contracting Parties: If such a "no-set-off agreement" (sōsai kinshi tokuyaku) exists, it is binding on the contracting parties. A party who has agreed not to set off a particular claim cannot later unilaterally effect a statutory set-off concerning that claim. (Illustrative, based on genericized CASE 423: A loan agreement might stipulate that the borrower cannot set off any future claims they might acquire against the lender against their repayment obligation for that specific loan).
• Assertion Against Third Parties: A crucial aspect of Article 505, Paragraph 2 is how such a no-set-off agreement affects third parties. The provision states: "The manifestation of intention set forth in the preceding paragraph [i.e., a contractual prohibition of set-off] may not be asserted against a third party acting in good faith and without negligence."
  • This means if a claim that is subject to a no-set-off agreement between the original debtor and creditor is subsequently assigned to a third party (or if a third party otherwise acquires an interest in it, e.g., through attachment), that no-set-off agreement cannot be used to prevent the third party from exercising set-off if they acquired their interest in the claim without knowledge (good faith) of the no-set-off agreement and were not negligent in failing to discover it. (Illustrative, based on genericized CASE 424).
  • This rule is designed to protect the security of transactions involving assigned claims. A third party acquiring a claim should generally be able to rely on its apparent features, including its potential for set-off, unless they were aware or should have been aware of a restriction.
• Rationale for Allowing Contractual Prohibition: Parties may wish to prohibit set-off for various commercial reasons, such as ensuring predictable cash flows, maintaining the integrity of specific payment streams (e.g., in project finance waterfalls), or because one of the claims is intended for a particular purpose that set-off would frustrate.
• Implicit No-Set-Off Agreements: While explicit contractual clauses are the clearest way to prohibit set-off, in rare cases, a court might infer a no-set-off agreement from the particular nature of the transaction or a consistent course of dealing between the parties, though this would require strong evidence of a mutual understanding to that effect.

3. Prohibition of Set-Off Against Certain Claims Arising from Torts (Article 509)

Article 509 of the Civil Code places significant restrictions on the ability of a tortfeasor (the party who committed the wrongful act) to use set-off against the tort victim's claim for damages. This provision is rooted in public policy considerations aimed at ensuring effective redress for victims of certain types of wrongdoing.

The key prohibitions under Article 509 are:

• Claims Arising from Intentional Unlawful Acts (悪意による不法行為 - Akui ni yoru Fuhōkōi):
  If a claim for damages has arisen from an intentional unlawful act (often referred to as a malicious tort), the debtor of that tort claim (i.e., the tortfeasor) cannot assert set-off against the victim's damage claim by using an unrelated monetary claim that the tortfeasor happens to hold against the victim.
  • For example, if Debtor A intentionally damages Creditor B's property, Debtor A cannot then refuse to pay damages to Creditor B by claiming to set off a pre-existing loan that Creditor B owes to Debtor A. (Illustrative, based on genericized CASE 426).
  • Rationale: This rule serves several purposes:
    • It ensures that victims of intentional wrongdoing receive actual compensation, preventing tortfeasors from effectively "paying" for their intentional harm with a pre-existing claim.
    • It discourages self-help or retaliatory conduct where a party might intentionally commit a tort to create a set-off situation.
    • It upholds the deterrent and punitive aspects associated with liability for intentional torts.
  • Scope of "Intentional Unlawful Act": This requires "intent" (akui) in relation to the unlawfulness of the act itself. The tortfeasor must have acted knowing their conduct was wrongful or illegal. Simple negligence in committing a tort does generally not trigger this specific prohibition, meaning a party liable for a merely negligent tort might (subject to other rules) be able to set off their own claim against the victim's damage claim arising from that negligence.
  • Extension to Gross Negligence: While Article 509 explicitly refers to "intentional" acts, some legal scholars and lower court decisions have debated whether this prohibition should be extended by analogy to torts committed with gross negligence (重過失 - jūkashitsu), given that gross negligence often involves a high degree of culpability approaching that of intent. However, the prevailing Supreme Court stance has generally required actual intent for this specific prohibition to apply, unless a particular statute dictates otherwise.
• Claims for Damages for Harm to Life or Body (生命・身体の侵害による損害賠償請求権 - Seimei / Shintai no Shingai ni yoru Songai Baishō Seikyūken):
  Article 509 also categorically prohibits the debtor of a claim for damages arising from harm to a person's life or body (whether that harm was caused intentionally or negligently) from asserting set-off against that claim.
  • For instance, if a driver negligently injures a pedestrian, and the driver happens to have an unrelated monetary claim against that pedestrian, the driver cannot use their claim to set off against the pedestrian's claim for personal injury damages. (Illustrative, based on genericized CASE 427).
  • Rationale: This provides robust protection for claims related to fundamental personal integrity, ensuring that compensation for physical injury or loss of life is actually paid and not negated by unrelated financial dealings.
• Who is Barred from Set-Off? Only the Tortfeasor/Harm-Causer:
  It is crucial to note that the prohibition in Article 509 operates to prevent the tortfeasor (the party liable for the tort damages) from initiating the set-off. It does not prevent the tort victim (the party entitled to the tort damages) from choosing to use their tort claim (as an active claim) to set off against a debt they might owe to the tortfeasor (which would be a passive claim for the victim). The victim retains the option to effect set-off if they find it advantageous. (Illustrative, based on genericized CASE 428).

4. Prohibition of Set-Off Against Claims Exempt from Attachment (Article 510)

Article 510 of the Civil Code prohibits set-off when the passive claim (the debt owed by the party wishing to effect set-off) is a claim that is legally exempt from attachment (差押えが禁じられた債権 - sashiosae ga kinjirareta saiken).

• Rationale: Certain types of claims are protected from seizure by creditors under Japanese civil execution law and other specific statutes. These exemptions are typically designed to ensure the debtor's basic livelihood, such as a portion of wages necessary for subsistence, certain social welfare benefits, or essential pensions. Allowing these protected claims to be effectively seized or extinguished through set-off by the party who owes them would defeat the social policy purpose behind the exemption.
• The Protected Claim is the Passive Claim: The prohibition applies when the attachment-exempt claim is the one owed by the party who wants to make the set-off (i.e., it's their debt). The party who is entitled to receive the attachment-exempt payment (e.g., the employee entitled to protected wages) can still choose to use that claim as an active claim to set off against a debt they owe to their employer (though specific labor law restrictions on wage deductions might also apply). (Illustrative, based on genericized CASE 429: An employer generally cannot set off an unrelated claim for damages against an employee against the portion of that employee's wages that is legally protected from attachment).
• Scope of Exemptions: The specific claims that are exempt from attachment are defined in the Civil Execution Act and other relevant legislation.

Conclusion: Navigating the Boundaries of Set-Off

While set-off (Sōsai) offers a valuable and efficient means of settling mutual debts in Japan, its application is carefully circumscribed by law. The prohibitions on set-off—stemming from the inherent nature of certain obligations, contractual agreements between the parties, specific public policy concerns regarding tort claims (particularly those involving intentional acts or harm to life or body), and the protection of claims exempt from attachment—serve to ensure fairness, protect vulnerable interests, and uphold the underlying purposes of specific legal duties. For businesses, recognizing these limitations is as important as understanding the right of set-off itself. A thorough assessment of the nature of the mutual claims and any applicable prohibitions is essential before attempting to unilaterally effect a set-off, to ensure that the action is legally valid and will achieve its intended purpose of effective debt extinguishment.