Work Contracts and Orderer Bankruptcy in Japan: Who Owns the Completed Work?

Date of Judgment: June 23, 1978 (Showa 53)
Case Name: Claim for Procedures to Cancel Ownership Preservation Registration
Court: Supreme Court of Japan, Second Petty Bench

This blog post examines a 1978 Supreme Court of Japan decision that addressed a crucial issue in construction and work contracts: when an orderer (client) goes bankrupt and the contract is terminated, who holds the rights to the work already completed by the contractor? This case, though decades old, touches upon fundamental principles that have seen further statutory development and continue to be relevant in Japanese bankruptcy law.

Facts of the Case

The dispute arose from a construction contract between an orderer, referred to as A, and a contractor, Y. During the construction of a building under this contract, A was declared bankrupt. A's bankruptcy trustee, X, exercised the right to terminate the construction contract under the provisions of Article 642, Paragraph 1 of the Japanese Civil Code (as it then existed).

Following the termination, X asserted that the partially constructed building belonged to A (and thus, A's bankruptcy estate). X then demanded that Y cancel the ownership preservation registration (a type of initial title registration) that Y had already filed for the building.

The court of first instance ruled against the trustee X. However, the High Court (Nagoya High Court, Kanazawa Branch) overturned this, ruling in favor of X and ordering the cancellation of Y's registration. The contractor, Y, appealed this decision to the Supreme Court.

The Supreme Court's Ruling

The Supreme Court dismissed Y's appeal, affirming the High Court's decision. The Court's reasoning was concise:

"When a work contract is terminated pursuant to Article 642, Paragraph 1 of the Civil Code, the contractor may join in the distribution of the bankruptcy estate for remuneration for work already performed and for expenses not included therein; however, as a counterpart to this, it is appropriate to interpret that the results of the work already performed belong to the bankruptcy estate."

This judgment established that upon termination of a work contract under the specific bankruptcy provision, while the contractor has a monetary claim against the estate for work done, the physical output of that work becomes part of the bankruptcy estate.

Commentary and Elaboration

1. Nature of Work Contracts in Japan

A work contract (請負契約 - ukeoi keiyaku) under the Japanese Civil Code (Article 632) is an agreement where one party (the contractor) promises to complete a certain piece of work, and the other party (the orderer) promises to pay remuneration for the result of that work. It is a consensual, onerous, and informal bilateral contract. If the contract involves the delivery of a tangible object (like a building), the payment of remuneration and the delivery of the object are generally considered to be concurrent obligations (Civil Code Art. 633). For work not requiring physical delivery (e.g., services, intangible results like information), remuneration is typically due after the work is completed (Civil Code Arts. 633 proviso, 624(1)). Building construction is a prime example, but it also includes the creation of intangible results such as transportation services or musical performances.

2. Historical Context: Work Contracts and Bankruptcy (Pre-2004 Reforms)

When either the contractor or the orderer entered bankruptcy proceedings before the work was completed and full payment made, the treatment of such "bilateral executory contracts" became an issue.

At the time of this Supreme Court judgment, the prevailing view was that in the case of an orderer's bankruptcy, a special provision, Article 642 of the old Civil Code (before its amendment by Act No. 76 of 2004), applied instead of the general rules for bilateral contracts in bankruptcy (then Article 59 of the old Bankruptcy Act, now Article 53 of the current Bankruptcy Act). Under this special provision (old Civil Code Art. 642), not only the orderer's bankruptcy trustee but also the contractor could choose to terminate the contract. This right for the contractor to terminate was a key distinction from the general bankruptcy rules for other types of contracts.

The termination was understood as a "解約告知" (kaiyaku kokuchi), meaning it extinguished the contract's effect prospectively (i.e., for the future). If the contract was terminated, the contractor was entitled to a claim for remuneration proportional to the work already completed and for any expenses incurred that were not included in the remuneration; this claim was treated as a general bankruptcy claim against the estate (old Civil Code Art. 642(1)). However, neither the bankruptcy estate nor the contractor could claim damages arising from this specific type of termination (old Civil Code Art. 642(2)). This differed from the general rule (old Bankruptcy Act Art. 59, now Art. 53), where the non-bankrupt party could claim damages if the trustee terminated.

This special treatment for work contracts faced criticism. Some scholars argued that, similar to the (since-repealed) special provision for a lessee's bankruptcy (old Civil Code Art. 621), there was little rationale for it, and the general bankruptcy rules (old Art. 59) should apply instead. Eclectic views also existed, suggesting that for individual contractors (like carpenters or gardeners), allowing termination had some justification by analogy to employment contracts (Civil Code Art. 631), but for corporate contractors, the general bankruptcy rules should apply. Another view proposed applying Civil Code Art. 642 for contractor-initiated termination and old Bankruptcy Act Art. 59 for trustee-initiated termination.

3. Legislative Developments (Post-2004 Reforms)

Despite criticisms, when the Civil Code was amended in 2004 (Act No. 76 of 2004), the legislators chose to largely maintain the framework allowing both the orderer's bankruptcy trustee and the contractor to decide between performance and termination of the work contract. This differed from the approach taken for lessee bankruptcy, where the special termination rights were abolished. The reasons for retaining this for work contracts included:

• Unlike a lessor, a contractor has an active duty to provide services and complete the work. If forced to continue, the contractor faces the risk that remuneration for post-petition work, even if classified as an administrative expense claim (財団債権 - zaidan saiken), might not be paid in full if the estate is insufficient.
• The orderer's position in a work contract is generally not considered to have the same degree of property value as a lessee's rights.
• For service-type contracts like work contracts, establishing a relationship of simultaneous performance between service provision and payment is inherently difficult. Thus, without a clear resolution of creditworthiness concerns, there was no straightforward way for the contractor (who typically performs first) to refuse further service other than terminating the contract, even if rights like the defense of insecurity (fuan no kōben) were invoked.

It's important to note that this special rule (Civil Code Art. 642) does not apply in Civil Rehabilitation proceedings or Corporate Reorganization proceedings. In those rehabilitative procedures, the general principles for bilateral executory contracts grant the choice to terminate or perform only to the debtor (or their trustee/supervisor) to facilitate business restructuring (Civil Rehabilitation Act Art. 49, Corporate Reorganization Act Art. 61).

Under the current Bankruptcy Act (Art. 53(2) and (3)), both the trustee and the contractor can now make a demand upon the other party to definitively state whether they will terminate the contract or demand performance. If no definite answer is given within the specified period, termination is presumed.

4. Termination of Work Contracts: Details and Ownership

• When Can the Contractor Terminate?
  The contractor's right to terminate under Civil Code Art. 642 in the event of the orderer's bankruptcy is limited to situations where the work is still incomplete. If only the delivery of the completed work remains, there's no need to protect the contractor with a termination right. The 2017 Civil Code amendments (related to claims) affirmed that the contractor's right to terminate is limited to the period before work completion.
• Consequences of Termination:
  Upon termination, both the contractor and the bankruptcy trustee are relieved of their obligations for the unperformed part of the contract.
• Ownership of Completed Work:
  If the output of the contractor's work (the "出来高" - dekidaka, or completed portion) belongs to the contractor and is in the possession of the bankrupt estate, the contractor can exercise a right of retrieval (取戻権 - torimodoshi-ken, Bankruptcy Act Art. 62). However, if the completed work belongs to the bankruptcy estate, as the Supreme Court held in the present case, the contractor cannot retrieve it. The commentary suggests that in the 1978 case, the building was likely near completion because the contractor Y had already filed for an ownership preservation registration.The question of who owns a building under construction where no special agreement exists is complex in Japanese law. Case law has often held that ownership vests in the party who supplied all or the main materials (often the contractor). Conversely, a majority of legal scholars argue for orderer ownership from the outset. However, the contractor-ownership theory also remains influential.
• Trustee's Termination After Work Completion:
  Allowing the orderer's bankruptcy trustee to terminate the contract even after the work is completed can lead to a situation where the bankruptcy estate acquires the completed object (similar to if the trustee had chosen performance), yet the contractor's claim for remuneration is only treated as a general bankruptcy claim. This potential imbalance, especially when compared to sales contracts (where a buyer cannot terminate if the seller goes bankrupt after the seller's performance if Bankruptcy Act Art. 53 applies), was a point of discussion during the 2017 Civil Code reform process.
  However, the focus of the reforms was more on restricting the contractor's termination rights. The trustee's right to terminate remained largely subject to bankruptcy law and was not significantly altered by these Civil Code changes.
  While the trustee can generally terminate even after work completion, this right is not absolute. If the trustee's termination would create a grossly unfair situation for the counterparty (the contractor), its exercise may be disallowed (based on a 2000 Supreme Court precedent, Case No. 81(1) in the cited "本書").

5. Contractor's Claims Upon Termination

• Remuneration for Work Done:
  The contractor's claim for remuneration for work already performed and for incurred expenses becomes a bankruptcy claim (Reformed Civil Code Art. 642(2)).
• Damages:
  The current law (Reformed Civil Code Art. 642(2), prior Art. 642(3) as amended) now stipulates that if the bankruptcy trustee terminates the contract, the contractor's resulting claim for damages also becomes a bankruptcy claim. This change was made out of consideration for the counterparty who, despite no fault of their own, suffers a loss due to the trustee's termination.
  In contrast, if the contractor initiates the termination (as permitted under Civil Code Art. 642), they are not entitled to claim damages. This is because the law grants them the benefit of an early exit from the contract despite the absence of a breach by the orderer.

6. If the Contract is Affirmed (Choice of Performance)

If both the orderer's bankruptcy trustee and the contractor elect to continue the contract instead of terminating it under Civil Code Art. 642, both parties are obligated to perform their contractual duties according to the contract's terms. (The commentary notes that in practice, for large-scale construction projects like those involving a general contractor – the orderer – going bankrupt, continuing numerous sub-contracts is often highly unrealistic due to difficulties in managing limited budgets for completed work and coordinating the interests of many subcontractors and suppliers ).

If the contractor completes the work in response to a demand for performance from the trustee:

• The contractor's claim for remuneration for work performed after the commencement of bankruptcy proceedings becomes an administrative expense claim (Bankruptcy Act Art. 148(1)(vii)), which has priority over general bankruptcy claims.
• For the portion of work completed before the bankruptcy proceedings commenced, there's a split in legal opinion regarding its treatment if the contract is affirmed:
  • One view is that it should also be an administrative expense claim, especially if the work is indivisible.
  • Another view is that it should be a general bankruptcy claim, reasoning that remuneration can be calculated for the completed portion and the claim itself is divisible.
  • According to the commentary, practice tends to treat the pre-petition portion as a general bankruptcy claim.

Conclusion

The 1978 Supreme Court decision, by ruling that the results of already performed work belong to the bankruptcy estate upon termination under old Civil Code Article 642(1), clarified a key aspect of work contracts in the context of an orderer's bankruptcy. While the contractor received a bankruptcy claim for the value of this work, they lost ownership or control over the physical asset itself. This principle, set against the backdrop of a unique statutory provision, has been influential. Subsequent legal reforms have further refined the rights and obligations of parties in such situations, generally aiming to balance the contractor's interests with the objectives of bankruptcy proceedings, but the core concept of the bankruptcy estate subsuming the benefits of work performed, with the contractor being relegated to a monetary claim, remains a fundamental aspect of these scenarios. Understanding this framework is crucial for contractors engaging in projects in Japan, particularly when assessing counterparty insolvency risk.