Set-off Against Insolvent Counterparty: Implications for Multi-Entity Corporate Groups in Japan

Under Japanese law, the concept of set-off is, in principle, strictly limited to bilateral relationships between two parties. However, where multiple companies within a corporate group transact with an external counterparty, there is a significant risk that—if the external counterparty enters insolvency proceedings—attempts at multi-party or cross-affiliate set-off may not be enforceable, notwithstanding prior contractual arrangements among the parties. This position is reflected in the Supreme Court decision of July 8, 2016 (the “Case”), concerning a claim for settlement payments.

The Case involved a dispute between the Japanese subsidiary of Lehman Brothers Securities (which later entered insolvency proceedings, as everyone knows of that Lehman shock event) (“Company A”) and two Japanese companies, Company B and Company C (which were sister companies within the same corporate group). After Lehman Brothers Securities filed for Chapter 11 proceedings in the United States, Company A commenced civil rehabilitation proceedings in Japan. At the time of the filing, Company B held a claim (X) against Company A arising from derivatives transactions, while Company C owed a debt (Y) to Company A due to the similar derivatives transactions.

Company B asserted that, based on contractual provisions permitting group-wide netting, the claim held by B against Company A and the obligation owed by Company C to Company A should be set off.

The Supreme Court rejected this argument and held that, in civil rehabilitation proceedings, only bilateral set-off between Company A and Company B, or between Company A and Company C, is permissible. In reaching this conclusion, the Court relied on Article 92(1) of the Civil Rehabilitation Act and Article 505(1) of the Civil Code. Importantly, the Court emphasized that extending set-off across multiple group companies would undermine the pari passu principle—i.e., the principle of equal treatment of rehabilitation creditors—which is a fundamental policy underlying Japanese insolvency law.

This decision remains authoritative. Accordingly, in transactions between corporate groups and external counterparty—particularly in financial transactions—parties cannot rely on one-to-many set-off mechanisms as a reliable means of mitigating counterparty insolvency risk. Instead, alternative structures should be considered.

That said, while direct multi-party set-off is restricted, it MAY remain possible in practice to achieve similar economic outcomes through appropriate structuring, provided that legal requirements are carefully observed.

Potential Approaches for Compliance

If one seeks to structure arrangements that comply with the bilateral set-off requirement, the following approaches* MAY be considered:

• (a) Assignment (or assumption) structure
  For example, subject to prior identification of relevant affiliates, future claims acquired by Company B against Company A may be assigned to Company C upon the occurrence of an event of default by Company A.
  Practical note: The effectiveness of such arrangements depends on proper perfection (e.g., notice or registration requirements) and timing. Assignments effected shortly before insolvency may be subject to avoidance (clawback) risk.
• (b) Novation structure
  For example, Company A, Company B, and Company C may enter into a tripartite agreement providing that, upon the occurrence of specified trigger events (such as loss of the benefit of time by A), Company C replaces Company B as creditor in respect of claims against Company A.
  Practical note: Novation arrangements may also be scrutinized under avoidance rules if implemented when insolvency is imminent.
• (c) Guarantee structure
  • (Option 1) Company B and Company C mutually guarantee each other’s obligations to Company A;
  • (Option 2) Company B and Company C jointly and severally guarantee Company A’s obligations to them (In such cases, payment by a guarantor may give rise to subrogation claims, which could then potentially be used for set-off).
  Practical note: Set-off based on subrogation arises only after actual payment and is therefore not automatically available.
• (d) Security assignment structure
  For example, entering into a security assignment agreement (in Japanese "譲渡担保契約") covering receivables to arise in the future.
  Practical note: As with outright assignments, perfection requirements and the risk of avoidance must be carefully considered.

Notwithstanding the above, NONE of these structures can be regarded as entirely risk-free. Their effectiveness depends heavily on factors such as timing, perfection requirements, and potential avoidance challenges in insolvency proceedings. It hopes that legislative clarification or reform may be warranted to facilitate one-to-many set-off arrangements in the future.

(*For further details, see Practice of Contract Clauses to Avoid Losing Litigation in Corporations, pp. 122–127.)