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Bankruptcy of the Owner or the Contractor of Construction and the Effects on the Bilateral Construction Contract

2010.11.24

1. Termination or Cancellation of a Bilateral Contract when both parties have failed to perform their obligations 
 
It is usually the case that any obligations under a construction contract are fulfilled over long periods of time and the construction amount is paid in several installments corresponding to the level of progress. One of the characteristics of a long-term contract such as construction contracts is that there is a high risk of rehabilitation proceedings or bankruptcy proceedings commencing against either the owner ("Owner") or the contractor ("Contractor") of construction during the term of the contract. 
 
In between the time when the contractor commences construction and the time of completion of construction work, the Owner's obligation to pay the construction amount ("balance") and the Contractor's obligation to complete the construction are not yet fulfilled, which constitutes a 'mutually unfulfilled bilateral contract.' Under the Debtor Rehabilitation and Bankruptcy Act (the "Insolvency Act"), with respect to a mutually unfulfilled bilateral contract, the receiver (in the case of rehabilitation proceedings) or a trustee in bankruptcy (in the case of bankruptcy proceedings) may select from the following options; (i) terminate or cancel the contract, or (ii) fulfill the obligations of the debtor and request the other party to also fulfill its obligations (Articles 119 (1) and 335 (1) of the Insolvency Act). Pursuant to the above provisions, since the receiver or trustee in bankruptcy of the Owner or the Contractor may "terminate or cancel" the contract instead of choosing to fulfill its obligations, there seems to be room for interpretation that the contract may be terminated retrospectively in the context. 
 
On the other hand, the Civil Act prescribes that when the Owner has been declared bankrupt, the Contractor or trustee in bankruptcy may terminate the contract. In such cases, the Contractor or trustee in bankruptcy may apply to be included in the distribution of property amongst the creditors with respect to any consideration for the completed work and other expenses not included in such consideration (Article 647 (1) of the Civil Act). However, the Civil Act does not have any special provision when the Contractor has been declared bankrupt. It only stipulates that the Owner may terminate the contract by compensating for any damages before the Contractor completes the construction (Article 637 of the Civil Act). 
 
In the above cases, although the term "termination" is used, it is still possible to claim for consideration and expenses for the completed work. Thus, the contract may be extinguished (with the same effects as a 'termination' of a contract) and the parties will be released from any future obligations but it is not possible to terminate the contract retrospectively. 
 
Meanwhile, if both the Owner and the Contractor choose to perform the mutually unfulfilled bilateral contract, the claim of the other party becomes a public interest claim or a preferential claim (Article 179 (1) 7 and Article 473 (7) of the Insolvency Act). In this case, the main issue is whether the claim for progress payment with respect to the work completed by the Contractor prior to the decision to commence rehabilitation or bankruptcy proceedings ought to be deemed as (i) a rehabilitation claim or a bankruptcy claim since the some work has been completed, or (ii) a public interest claim or a preferential claim since the construction obligation has not yet been fully completed. 
 
In the following paragraphs, we will examine the issues outlined above based on the judgment of the Supreme Court. 
 
 
2. Effect of the Owner's Bankruptcy on the Contract 
 
The Supreme Court ruled that the provision on the mutually unfulfilled bilateral contract under the former Bankruptcy Act (currently, the Insolvency Act) does not apply in cases where the Owner has been declared bankrupt, and instead, Article 674 (1) of the Civil Act will apply, and thus the contract is terminated and the parties are no longer bound by the terms of the agreement (Supreme Court Case No. 2001Da13624 dated August 27, 2002). 
 
According to the above ruling, the right to terminate a mutually unfulfilled bilateral contract by the trustee in bankruptcy under the former Bankruptcy Act cannot be exercised; however, the right to terminate such contract under Article 674 of the Civil Act can be exercised. Specifically, (i) it is not possible to retrospectively invalidate or void the contract from the beginning through to termination, and (ii) the restituted claim which arises from the termination of the contract will not be a preferential claim but a bankruptcy claim. That is, the trustee in bankruptcy of the Owner cannot claim for a refund of the progress payment with respect to the completed work but the trustee can claim for the construction amount paid (with the exception of progress payment), through bankruptcy proceedings only, as part of a bankruptcy claim on an equal basis to other creditors and can claim an amount proportionate to the claim amount. 
 
 
3. Status of Claim for Progress Payment upon the Owner's Bankruptcy 
 
The Supreme Court ruled that when the Owner is subject to a decision on commencement of corporate reorganization proceedings whilst the construction is in progress under the former Corporate Reorganization Act (corresponding to the rehabilitation proceedings under the Insolvency Act), the Contractor's claim for progress payment with respect to the completed work prior to the decision on such commencement falls under a public interest claim (Supreme Court Case No. 2002Da65691 dated February 11, 2003). 
 
The grounds for the above ruling are as follows: (i) in general, the work to be fulfilled by the Contractor under the contract is indivisible and thus, the claim for payment of such work cannot be divided into claims arising out of the commencement of the corporate reorganization proceedings and claims arising for other reasons, and (ii) with respect to the payment method of the construction amount, there is a discrepancy between the agreement to pay on a regular basis according to the rate of completed work and the agreement to confirm the completed work for each interim period of construction progress and to pay the construction amount accordingly. 
 
However, if there is an agreement to divide the entire construction into several types of work each with its own independent value (for example, in the case where each step of the entire construction work such as excavation work, air-conditioning work, facility work, and finishing work may each be a separate sub-contract) and to separately set a construction amount to be paid for each task, then payment for each task can be deemed as a debt in its own right. Therefore, there is a possibility that the claim for such payment is likely to be acknowledged as a public interest claim or a preferential claim. 
 
Meanwhile, any creditor who desires to participate in the rehabilitation or bankruptcy proceedings is required to report the rehabilitation claim or bankruptcy claim (Articles 148 (1) and 447 (1) of the Insolvency Act) and the entry into the list of rehabilitation creditors or the list of bankruptcy creditors has the same effect as a final and conclusive judgment (Articles 168 and 460 of the Insolvency Act). Despite this, the Supreme Court ruled that even in the case where the claim for progress payment of the Contractor is recognized as a public interest claim, if the Contractor has reported such claim for progress payment as a reorganization claim under the former Corporate Reorganization Act (corresponding to a rehabilitation claim under the Insolvency Act), it would be difficult to say that the Contractor has consented to the treatment of the claim for progress payment as a reorganization claim, or that the Contractor has waived his status as a public interest creditor (Supreme Court Case No. 2004Da3512 and 3529 dated August 20, 2004). 
 
The reasoning for the above ruling are as follows; 
 
Firstly, the fact that the entry into the list of reorganization creditors (corresponding to the list of rehabilitation creditors under the Insolvency Act) has the same effect as the final and conclusive judgment simply means that it has a confirmatory and an incontestable effect within the reorganization proceedings, but that it has the effect of excluding further litigation on the same matter. Thus, an act of simply reporting the public interest claim as a reorganization claim and entering it into a list of reorganization creditors, etc. does not mean that the nature of a public interest claim can be altered into that of a reorganization claim. 
 
Secondly, if the public interest creditors experience difficulties in making a clear decision on whether their claim falls under a public interest claim or a reorganization claim, they might report it as a reorganization claim in order to preserve their rights if their claim cannot be recognized as a public interest claim when they have not reported their claim as reorganization one. 
 
 
4. Effect of the Contractor's Bankruptcy upon the Contract 
 
Unlike the cases where the Owner is declared bankrupt as outlined above, the Supreme Court once ruled that when the Contractor is declared bankrupt, Article 50 of the former Bankruptcy Act (Article 335 of the Insolvency Act) which stipulates that the trustee can either terminate the contract or fulfill the debtor's obligations and require the other party to carry out its obligations under the contract shall apply because there is no provision on the exclusion of such Article (Supreme Court's Case No. 2001Da24174 and 24181 dated October 9, 2001). The current Act prescribes to the above effect that when the Contractor is declared bankrupt, the trustee in bankruptcy may require the debtor or a third party to perform any uncompleted construction work by providing any necessary materials (Article 341 (1) of the Insolvency Act). 
 
However, in the case of the above ruling, the Contractor was declared bankrupt with only the warranty obligations left and after going through the completion inspection (the Contractor had also failed to pay the balance of the construction amount). The Supreme Court decided that once the construction had been completed, the construction contract could not have been terminated and the Contractor ought to be deemed to have performed its obligations under the Contract. In conclusion, the relevant contract could not be deemed as a bilateral contract not fulfilled by both parties at the time of declaration of bankruptcy and thus, Article 50 of the former Bankruptcy Act did not apply. 
 
In the above case, although it seems unfair because the Owner's claim for compensation against the Contractor which arises as a result of a warranty becomes a bankruptcy claim, the Owner's claim can be preserved by exercising the right of set-off since the claim for compensation arising from the warranty, which is a bankruptcy claim, becomes an automatic claim and the claim for construction amount falling under the property divisible for distribution among creditors becomes a passive claim.

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