The Role and Responsibilities of Directors under Japanese Corporate Law

To ensure successful business operations in Japan, a deep understanding of its legal framework, especially the roles and responsibilities of directors as defined by the Japanese Companies Act, is essential. This is particularly important for foreign directors, as it is crucial knowledge for ensuring the sound management of a company and effectively managing personal legal risks. The Japanese Companies Act imposes clear duties on directors and establishes strict liabilities for any failure to fulfill these obligations.

The Japanese legal system can be challenging to comprehend due to its unique customs and language barriers. Rather than merely reacting to legal issues as they arise, understanding legal requirements in advance and building a robust compliance framework is critical for avoiding unforeseen risks and supporting the sustainable growth of a business.

This article provides a detailed explanation of the key roles and responsibilities of directors under Japanese corporate law, citing specific legal provisions and Japanese case law.

The Fundamental Duties of Directors Under Japanese Corporate Law

Japanese Corporate Law stipulates two basic duties that directors owe to their companies: the “duty of care” and the “duty of loyalty.” These are the most important principles that directors must adhere to in the performance of their duties.

Duty of Care

The duty of care refers to the obligation of directors to perform their duties with the care of a prudent manager. The legal basis for this duty is found in Article 644 of the Japanese Civil Code (Duty of Care of a Mandatary), and Article 330 of the Japanese Corporate Law clarifies that the relationship between a stock company and its officers and accounting auditors shall follow the provisions concerning mandates, thereby making it clear that the relationship between directors and the company is that of a mandate. The term “care of a prudent manager” means the level of care and ability to pay attention that is normally expected of a professional in a particular position, in this case, a business manager. This standard of care varies depending on the size and type of the company, the specific position and expertise of the director, and the circumstances in which the company finds itself. For example, directors of large corporations or financial institutions may be required to exercise a higher degree of care. This is reflected in the Supreme Court decision of July 9, 2009 (Heisei 21), which indicates that the level of internal control systems required varies according to the size and type of the company. A director’s responsibility extends not only to the execution of individual business operations but also to the establishment and maintenance of an appropriate internal control system to prevent improper conduct by the company. This is considered part of the fundamental duty of care that directors must exercise in the performance of their duties.

The Business Judgment Rule

There is always a risk involved in the business decisions made by directors. A decision made in the best interest of the company can potentially result in damage to the company. If directors were always held responsible in such cases, their actions could become excessively cautious, potentially hindering the company’s development. Therefore, the “business judgment rule” is sometimes applied under Japanese Corporate Law. This principle states that if directors have acted in the belief that their decision was not grossly unreasonable, after a rational information gathering and deliberation process under the circumstances at the time, they will not be deemed to have violated the duty of care even if the decision ultimately results in damage to the company. The application of this principle focuses not on the outcome of the decision itself but on whether the process leading to the decision was rational. For example, in the Supreme Court decision of July 15, 2010 (Heisei 22), it was determined that a director’s duty of care is not violated as long as there is nothing grossly unreasonable about the process or content of the decision regarding the stock repurchase price. This judgment valued the fact that the directors had thoroughly deliberated at the management meeting and sought the opinion of attorneys, among other appropriate processes. This highlights the importance of clearly documenting the decision-making process and ensuring its rationality.

Duty of Loyalty

The duty of loyalty is stipulated in Article 355 of the Japanese Corporate Law, which mandates that directors must perform their duties faithfully for the corporation, in compliance with laws and regulations, the articles of incorporation, and the resolutions of the shareholders’ meeting. There is academic debate over whether the duty of care and the duty of loyalty are distinct concepts or essentially the same. However, in the resolution of specific practical cases, they are closely related, and it is common to treat them as essentially the same duty. For example, engaging in competitive transactions that harm the company can be evaluated as a violation of both the duty of care and the duty of loyalty. This indicates that it is important for directors to act in the best interests of the company and exercise appropriate care to fulfill both duties. As long as directors prioritize the company’s interests and perform their duties accordingly, these obligations can be understood as a unified concept.

Directors’ Responsibilities to the Company Under Japanese Corporate Law

Directors may be held liable for damages to the company if they neglect their duties. This is the legal consequence of directors failing to properly fulfill their responsibilities in their role.

Director’s Duty of Diligence and Liability for Negligence Under Japanese Corporate Law

Article 423, Paragraph 1 of the Japanese Companies Act stipulates that “Directors, accounting advisors, auditors, executive officers, or accounting auditors (hereinafter referred to as ‘officers, etc.’ in this chapter) shall be liable to compensate the stock company for damages incurred due to their negligence in performing their duties.” Negligence in this context refers to actions that violate the previously mentioned duties of due care and loyalty. Specifically, this includes violations of laws and regulations, inappropriate management decisions, and breaches of monitoring and supervisory duties due to deficiencies in the internal control system.

The liability for negligence in the performance of a director’s duties can potentially amount to a significant sum, depending on the size of the company and the nature of the damages. For instance, in a case where the use of unapproved additives was concealed, the Osaka High Court’s decision on June 9, 2006 (Heisei 18), ordered directors and auditors to pay several hundred million yen in damages, a ruling that was upheld by the Supreme Court. In another case involving window-dressing financial statements to hide losses, the Tokyo High Court’s decision on May 16, 2019 (Reiwa 1) ordered multiple officers to pay a total of approximately 59.4 billion yen in damages, which was also confirmed by the Supreme Court. These precedents clearly demonstrate that not just mere failures in management decisions, but also serious misconduct, gross negligence, or deficiencies in an organization’s compliance system can impose substantial financial liabilities on individual directors. This underscores the importance of directors acting with integrity and performing appropriate supervision.

Restrictions and Liabilities on Competitive Transactions Under Japanese Corporate Law

Directors are restricted from engaging in certain transactions to avoid conflicts of interest with the company, one of which is competitive trading. Article 356, Paragraph 1, Item 1 of the Japanese Companies Act stipulates that a director must obtain approval from the board of directors in a company with a board, or from the shareholders’ meeting in a company without a board, when attempting to engage in a transaction that falls within the same category as the company’s business. This regulation aims to prevent directors from exploiting the company’s customer information and know-how for personal gain, thereby harming the company’s interests.

If a director conducts a competitive transaction without the company’s approval and causes damage to the company, the director is liable for damages to the company. Furthermore, Article 423, Paragraph 2 of the Japanese Companies Act presumes that the amount of profit gained by the director or a third party from such a transaction is the amount of damage incurred by the company. This provision is designed to alleviate the burden on the company to prove the specific amount of damage and to facilitate the pursuit of the director’s liability. For example, the Tokyo District Court’s decision on March 26, 1981 (Yamazaki Baking case) illustrates an instance where a breach of the duty to avoid competition was recognized. The presumption of the amount of damage indicates that engaging in competitive transactions without approval poses a significant risk for directors.

Restrictions and Responsibilities Regarding Conflict of Interest Transactions Under Japanese Corporate Law

Similar to competitive trading, transactions involving conflicts of interest are significant restrictions for directors. Article 356, Paragraph 1, Items 2 and 3 of the Japanese Companies Act stipulate that when a director engages in a transaction with the corporation on their own behalf or on behalf of a third party (direct transaction), or when the corporation engages in a transaction that conflicts with the interests of a director with a third party (indirect transaction), the approval of the board of directors or the shareholders’ meeting is required.

If the approval process is neglected, the transaction is generally considered invalid in relation to the company (theory of relative invalidity). However, specific transactions that are deemed not to harm the company’s interests do not require approval. This principle demonstrates the practical approach of Japanese corporate law, which does not require formal approval when there is no substantive harm, as the purpose of the regulation is to protect the company’s interests.

Specifically, the following are examples of transactions that are exempt from approval:

• When a director lends money to the company interest-free and without collateral: Supreme Court of Japan decision, December 6, 1963 (Showa 38).
• When the company fulfills the obligations of a director: Great Court of Judicature decision, February 20, 1924 (Taisho 13).
• Transactions conducted based on standard trading terms: Tokyo District Court decision, February 24, 1982 (Showa 57).
• Transactions between the company and a shareholder who owns all the shares: Supreme Court of Japan decision, August 20, 1970 (Showa 45).
• Transactions with the consent of all shareholders: Supreme Court of Japan decision, September 26, 1974 (Showa 49).

These exceptions are based on the rationale that if a transaction does not have the potential to harm the company’s interests or if all shareholders, who are the ultimate owners of the company, consent to the transaction, then the purpose of the conflict of interest regulations is not compromised.

Director’s Liability to Third Parties Under Japanese Corporate Law

Directors are not only responsible to the company but may also incur liability for damages to third parties in the performance of their duties. This is because the actions of directors can potentially affect a wide range of stakeholders, not just the company itself.

Explanation of Article 429 of the Japanese Companies Act

Article 429, Paragraph 1 of the Japanese Companies Act stipulates that “When a director or similar officer has acted with malice or gross negligence in the performance of their duties, they are liable to compensate for the damages incurred by third parties as a result.” The term “third parties” here includes shareholders, creditors, business partners, and others. Directors are liable not only for direct damages where a third party is directly harmed by the director’s dereliction of duty but also for indirect damages where a third party suffers as a result of damage to the company’s property. The fact that a director’s responsibility extends beyond the internal affairs of the company to external stakeholders is a point that directors should pay particular attention to.

Furthermore, Article 429, Paragraph 2 of the Japanese Companies Act specifies liability for certain acts. This includes false notifications in the solicitation of shares or stock options, false statements in financial documents or business reports, false registrations, and false public notices. The liability for these acts can be established as “negligence liability,” even if the director did not act with malice or gross negligence. However, if the director can prove that they were not negligent in carrying out the act in question, they will not be held responsible. This provision particularly emphasizes the duties of directors regarding certain critical information disclosures and registrations, highlighting the importance of their duty of care in these areas.

Requirements for Malice or Gross Negligence

The term “malice” as defined in Article 429, Paragraph 1 of the Japanese Companies Act refers to a director’s awareness that their action constitutes a dereliction of duty. On the other hand, “gross negligence” refers to a case where a director commits a dereliction of duty due to significant carelessness. Under the liability of Paragraph 1 of Article 429, the third party who suffered damages must prove the director’s malice or gross negligence.

The scope of liability to third parties is also demonstrated through case law. For example, in a decision by the Osaka High Court on December 28, 1977 (Showa 52), liability for damages to third parties was recognized even for directors who were nominally appointed but involved in fraudulent registration. Additionally, in a Tokyo District Court decision on September 3, 1990 (Heisei 2), third-party liability was affirmed for individuals who, although not formally officers, had actual control over the company’s critical decisions (de facto directors). These cases indicate that not only the title of director but also the actual authority and involvement are significant factors in determining liability, serving as a reference for directors to understand their position within a Japanese company.

Exemption and Limitation of Directors’ Liability Under Japanese Corporate Law

Japanese Corporate Law aims to attract competent individuals to director positions and prevent them from becoming overly risk-averse in their management decisions by establishing systems that exempt or limit the potential liabilities directors may incur.

Means of Exemption from Liability

There are several methods to exempt directors from their liability for damages to the company:

• Exemption by unanimous shareholder consent: Under Article 424 of the Japanese Companies Act, directors’ liability to the company can be completely exempted with the consent of all shareholders. However, in publicly traded companies with many shareholders, obtaining the consent of all shareholders is practically difficult.
• Partial exemption by shareholders’ meeting resolution: Article 425 of the Japanese Companies Act stipulates that directors’ liability can be partially exempted by a special resolution of the shareholders’ meeting, provided the directors acted in good faith and without gross negligence.
• Partial exemption by board of directors’ resolution: Article 426 of the Japanese Companies Act provides that, if stipulated in the articles of incorporation, companies with a board of directors can partially exempt directors’ liability through a resolution of the board.

Liability Limitation Agreements

Liability limitation agreements are an important system for limiting the liability of directors who do not execute business, namely, external directors. Based on Article 427 of the Japanese Companies Act, a stock company can enter into a liability limitation agreement with directors (typically external directors) other than those who execute business, provided that the articles of incorporation allow for it.

This agreement allows for setting a cap on the amount of compensation liability, provided the director acted in good faith and without gross negligence. This cap cannot be less than the minimum liability limit set by the Japanese Companies Act (for example, for external directors, the total amount of compensation for the past two years and profits from stock options).

It is important to note that liability limitation agreements apply only to the duty of care owed to the company and do not cover liabilities for damages caused to third parties. Also, if an external director who has entered into a liability limitation agreement later becomes an executive director, the effect of the agreement is lost going forward.

These systems of exemption and limitation of liability are policy considerations designed to recruit capable external directors and enable them to perform their duties without bearing excessive personal liability risks while enhancing the company’s supervisory function. Especially in the context of Japanese corporate governance reforms, where the role of independent external directors is emphasized, these systems hold significant importance. When considering serving as a director in a Japanese company, such mechanisms for limiting liability are crucial elements from the perspective of individual risk management.

Summary

Deeply understanding the roles and responsibilities of directors under Japanese Corporate Law is extremely important for conducting business in Japan. It is necessary to accurately grasp a wide range of legal aspects, from basic duties such as the duty of care and loyalty, to liability for negligence in office, restrictions on competing transactions and conflicts of interest, and even responsibilities to third parties. A comprehension based on these laws and precedents serves as a foundation to avoid unforeseen legal risks and contributes to the sustainable growth and long-term value creation of a company. Legal compliance should be viewed not as a mere burden but as an investment in the stability and continuity of the business.

Monolith Law Office boasts a wealth of experience in serving numerous clients within Japan, particularly in the field of directors’ roles and responsibilities under Japanese Corporate Law. Our firm includes several attorneys who are native English speakers with foreign legal qualifications, enabling us to provide strong support to overcome the language and cultural barriers foreign clients face and smoothly navigate Japan’s complex legal environment.

With expertise in Japanese legal matters and an understanding of international business practices, our firm offers precise and practical legal advice to foreign investors and companies facing challenges in the Japanese market. If you are interested in consulting on this topic or comprehensive legal support for your business operations in Japan, please do not hesitate to contact Monolith Law Office.