Practical Commentary on the Reduction of Capital and Reserve Funds under Japanese Corporate Law

The Japanese Corporate Law (日本の会社法) outlines procedures for stock companies to reduce their capital stock and reserves, which are the financial foundation of the company. These procedures can serve as powerful tools to implement a variety of management strategies, such as compensating for accumulated losses, improving capital efficiency, or optimizing tax positions. However, capital stock and reserves play a crucial role as collateral for the company’s creditors. Therefore, any act of reducing these amounts is strictly regulated under Japanese Corporate Law to protect the interests of creditors. The process is not merely an internal accounting matter but a complex one involving multiple legal requirements, such as resolutions at shareholders’ meetings and creditor protection procedures. A precise understanding and proper execution of these procedures are essential for the sound operation of a stock company. This article focuses on the specific procedures for reducing the amount of capital stock (capital reduction) and reserves under Japanese Corporate Law, detailing the resolution requirements and important exceptions, all based on the provisions of the law.

The Principles of Reducing Capital Stock Under Japanese Corporate Law

When a joint-stock company decides to reduce its capital stock, the basic procedures are stipulated in Article 447, Paragraph 1 of the Japanese Companies Act. This provision demands strict procedures because a reduction in capital stock represents a significant change to the financial foundation of the company.

As a principle, a special resolution at the shareholders’ meeting is required to reduce the capital stock. A special resolution requires the attendance of shareholders with a majority of the voting rights and the approval of at least two-thirds of the voting rights of the attending shareholders. The law sets such a high threshold because capital stock is the basis of a company’s credit and serves as the ultimate guarantee to creditors. Its reduction directly affects the risk to creditors and the very essence of shareholders’ investments, and therefore should not be made lightly by management but requires broad consensus among shareholders.

At this shareholders’ meeting, based on Article 447, Paragraph 1 of the Japanese Companies Act, the following three specific items must be determined:

1. The amount of capital stock to be reduced
2. If all or part of the reduced capital stock is to be allocated to reserves, the details and the amount to be allocated to reserves
3. The effective date when the reduction of the capital stock will take effect

Furthermore, the amount of capital stock to be reduced cannot exceed the amount of capital stock on the effective date. This provision is in place to prevent the capital stock from becoming negative.

Exceptions to Resolution Requirements for Decreasing the Amount of Stated Capital Under Japanese Corporate Law

While a special resolution at a shareholders’ meeting is generally required to decrease the amount of stated capital, Japanese Corporate Law provides exceptions under certain circumstances that relax this stringent requirement. These exceptions are significant as they enhance procedural flexibility and cater to specific management objectives.

The first exception pertains to the reduction of stated capital to offset losses. According to Article 309, Paragraph 2, Item 9 of the Japanese Companies Act, if the reduction of stated capital at an ordinary shareholders’ meeting does not exceed the amount of the loss calculated by the method prescribed by the Ministry of Justice ordinance as of the date of that meeting, the decision can be made by an ordinary resolution instead of a special resolution. An ordinary resolution has more relaxed requirements than a special resolution. The rationale for this exception is that the procedure does not result in the outflow of company assets to the outside but is an internal accounting process to reorganize the figures on the balance sheet and restore financial health. Since there is no decrease in company assets, the risk to creditors is deemed low, and a more straightforward procedure is permitted.

The second exception is when the amount of stated capital is decreased simultaneously with the issuance of shares. Under Article 447, Paragraph 3 of the Japanese Companies Act, if a stock company decreases the amount of stated capital at the same time as issuing shares and the amount of stated capital after the effective date of the decrease does not fall below the amount before the effective date, no resolution of the shareholders’ meeting is required. In companies with a board of directors, the decision can be made by a resolution of the board, and in companies without a board of directors, by a decision of the directors. The underlying principle here is that there is no actual decrease in the amount of stated capital, so there is no risk of impairing the security of creditors. This procedure is more akin to a ‘restructuring’ of capital rather than a decrease, allowing for swift decision-making at the board level without going through a shareholders’ meeting.

Reduction of Reserve Funds: Procedures and Objectives Under Japanese Corporate Law

Similar to the reduction of capital stock, a joint-stock company in Japan can decrease the amount of its reserve funds (capital reserve and retained earnings reserve). This procedure is stipulated in Article 448 of the Japanese Companies Act and is personalityized by generally having a lighter procedural burden compared to the reduction of capital stock.  

When reducing the amount of reserve funds, the principle requirement is an ordinary resolution at the shareholders’ meeting. This is a lower threshold compared to the special resolution required for the reduction of capital stock. At the shareholders’ meeting, the following matters must be determined based on Article 448, Paragraph 1 of the Japanese Companies Act:  

1. The amount of reserve funds to be reduced
2. If the whole or part of the reduced reserve funds is to be allocated to capital stock, the details and the amount to be allocated to capital stock
3. The effective date when the reduction of the reserve funds takes effect

The general purpose of this procedure is to transfer the reduced amount of reserve funds to other capital surplus funds. These other capital surplus funds can then be used to cover future deficits or serve as a source for the distribution of future surplus funds, thereby increasing financial strategic flexibility.  

Furthermore, there are exceptional provisions for the reduction of reserve funds similar to those for the reduction of capital stock. Article 448, Paragraph 3 of the Japanese Companies Act states that if the reserve funds are reduced simultaneously with the issuance of shares and the amount of reserve funds after the effective date does not fall below the amount before the effective date, the resolution of the shareholders’ meeting can be replaced by a resolution of the board of directors (or a decision by the directors).  

Creditor Protection Procedures: The Most Crucial Process in Capital Reduction

The most important and time-consuming process in the procedure of reducing the amount of capital or legal reserves is the creditor protection procedure based on Article 449 of the Japanese Companies Act. Capital and legal reserves serve to protect the interests of creditors by retaining the company’s assets internally. Therefore, reducing these amounts has the potential to diminish the collateral relied upon by creditors, and the law obligates companies to provide creditors with the opportunity to object.

To carry out this procedure, a company must generally take the following two measures:

1. Public Notice in the Official Gazette: The company must publish the details of the capital reduction in the Official Gazette to inform the public.
2. Individual Notification to Known Creditors: The company must notify each known creditor individually, in writing or otherwise.

In both the public notice and individual notifications, it is necessary to clearly state the details of the reduction, matters related to the company’s latest balance sheet, and that creditors have a certain period of more than one month to express any objections. Considering that it takes about one to two weeks from the application for publication to the actual appearance in the Official Gazette, the creditor protection procedure, from initiation to completion, requires at least approximately two months. Without the completion of this procedure, the reduction of the capital or reserves does not have legal effect.

However, there are alternative methods available to reduce the practical burden of individual notifications. Companies that have stipulated a method of public notice other than the Official Gazette in their articles of incorporation (such as publication in a daily newspaper or electronic notice) can omit individual notifications to known creditors by performing a “double notice,” which includes both the Official Gazette and the method prescribed in the articles of incorporation.

If a creditor raises an objection within the period, the company must either settle the claim, provide adequate security, or entrust adequate property to a trust company or similar entity. However, if the company can prove that the reduction of the capital or reserves will not “harm the said creditor,” these measures are not necessary.

Cases Where Creditor Protection Procedures Are Not Required

In the context of reducing the amount of capital or reserves, creditor protection procedures are generally mandatory. However, under Japanese Corporate Law, there are specific and limited circumstances where these procedures are deemed unnecessary. The existence of these exceptions varies significantly between the reduction of capital and the reduction of reserves.

When reducing the amount of capital, creditor protection procedures are almost always required. Legally, there are virtually no exceptions that allow for the omission of this procedure. This reflects the position that capital is the foundation of a company’s creditworthiness.

On the other hand, when reducing the amount of reserves, Article 449, Paragraph 1 of the Japanese Corporate Law stipulates two important exceptions where creditor protection procedures are not necessary.

When the Entire Amount of Reduced Reserves Is Converted into Capital

In this case, funds are merely transferred from the reserves to the capital. Since capital is considered to have a stronger binding effect on company assets than reserves, this transfer is seen not as weakening but rather as strengthening creditor protection. Therefore, creditor protection procedures are deemed unnecessary.

When Reducing Reserves to Offset Losses Under Specific Conditions

Specifically, this applies when (a) the reduction is resolved at the regular shareholders’ meeting, and (b) the amount of the reduced reserves does not exceed the amount of the company’s losses on the date of the resolution. This procedure is considered an internal accounting process aimed at improving the balance sheet without external outflow of company assets, and thus, it is judged not to harm creditors, allowing for the omission of the procedure.

The existence of these exceptions allows for the reduction of reserves, especially for purposes such as offsetting losses, to be executed much more swiftly and conveniently than the reduction of capital.

Comparing Procedures: Reduction of Capital Stock and Reserve Funds in Japan

As we have explained, even when the objectives are similar, there are several important differences in the procedures set forth by Japanese corporate law for the reduction of capital stock and reserve funds. The reduction of capital stock is considered a more fundamental change to the company’s financial foundation, and therefore, it generally requires a strict decision-making process through a special resolution at the shareholders’ meeting, along with almost unavoidable creditor protection procedures. In contrast, the reduction of reserve funds is positioned as part of a more flexible financial strategy, and in principle, a simple resolution at the shareholders’ meeting suffices, with the significant advantage that creditor protection procedures are exempted for specific purposes such as deficit compensation or transfer to capital stock. Furthermore, since the amount of capital stock is a registered item, any reduction necessitates a change in registration, whereas the amount of reserve funds is not a registered item, so no registration is needed unless it is transferred to capital stock.  

Summarizing these differences, the following table is presented:

Analysis of Case Law: Interpreting the “Risk of Prejudice to Creditors”

When a company faces objections from creditors, the interpretation of the requirement that there is “no risk of prejudice to creditors” is of utmost importance in practice. An important precedent that illustrates the Japanese courts’ criteria for this determination is the Osaka High Court’s decision on April 27, 2017 (Case Number: Heisei 28 (2016) No. 2880).

In this case, a company (Company Y) significantly reduced its capital, which led to an objection from one of its creditors (Company X). However, Company Y refused to provide security, citing Article 449, Paragraph 5 of the Japanese Companies Act, claiming that there was “no risk of prejudice to creditors.” Dissatisfied with this, Company X filed a lawsuit seeking to invalidate the reduction of capital, among other things.

The court rejected a formalistic approach that would automatically consider a reduction in capital as increasing the abstract risk to creditors. Instead, it established a standard that the reduction of capital should be judged by considering whether it imposes an unfair additional risk on the specific creditors, taking into account the concrete circumstances. The court listed the following factors to be considered:

• Whether a distribution of surplus funds is planned immediately after the reduction of capital
• The amount and repayment period of the creditor’s claim
• The risk associated with the company’s business activities
• The scale of the reduction in capital

In this case, the court found that Company X’s claim was relatively small and that Company X had already obtained a judgment ordering payment from Company Y, which could be enforced at any time. Therefore, the court concluded that the reduction in capital did not concretely make it difficult for Company X to recover its claim. As a result, the court accepted Company Y’s argument and concluded that there was “no risk of prejudice to creditors.”

This judgment marks an important turning point in legal interpretation. It establishes that the presence or absence of “risk of prejudice to creditors” should not be judged solely on the abstract reduction of financial basis but should be assessed from a more substantive perspective, considering whether there is a concrete danger to the individual creditor’s ability to recover their claim. This precedent indicates that a company may proceed with the reduction of capital procedures even in the face of objections from creditors, provided it can prove based on concrete facts that there is no risk of prejudice.

Conclusion

As detailed in this article, reducing the amount of capital stock and reserves under Japanese Corporate Law is an effective option in a company’s financial strategy. However, its implementation is contingent upon strictly adhering to complex legal procedures, such as the requirements for a resolution at the shareholders’ meeting and creditor protection procedures. It is crucial to understand the differences between the reduction of capital stock, which generally requires a special resolution and almost invariably necessitates creditor protection procedures, and the reduction of reserves, which is subject to more flexible requirements. Choosing the appropriate procedure according to the objective is key to the success of the strategy. When considering these procedures, expert knowledge is indispensable to avoid legal risks and ensure smooth execution.

Monolith Law Office has a wealth of experience in providing legal services related to the reduction of capital stock and reserves for numerous clients within Japan. Our firm employs several English-speaking professionals with foreign legal qualifications, enabling us to offer accurate and practical support for the complex procedures under Japanese Corporate Law from an international perspective. If you are considering these procedures, please do not hesitate to consult with us.