Explanation of Indemnification Agreements and D&O Insurance under Japanese Corporate Law

One of the most significant recent developments in Japanese corporate law is the introduction of new systems for managing the personal liability risks faced by corporate executives, brought about by the legal amendments of 2019 (Heisei 31). These reforms aim to encourage Japanese companies to engage in more proactive and strategic management, often referred to as “offensive management,” within the global competitive landscape. Inherent risks accompany such managerial decisions, but the fear of excessive personal liability can lead to a chilling effect on executive decision-making, potentially hindering corporate growth. To address this issue, Japanese corporate law has established a clear legal framework to appropriately mitigate individual risks and create an environment where talented individuals can confidently utilize their abilities. At the heart of this framework are the new regulations concerning “indemnification contracts” and “Directors & Officers (D&O) liability insurance.” These systems bring clarity to previously ambiguous legal areas, playing a crucial role in enhancing the transparency and effectiveness of corporate governance. This article provides a detailed explanation of these two important risk management systems under Japanese corporate law, outlining their content, procedures, and practical significance.  

Establishment of New Risk Management Systems Under the Revised Japanese Companies Act

Prior to the 2019 revision of the Japanese Companies Act, there was no clear legal basis for companies to bear the costs related to the management’s liability for compensation. In practice, attempts were made to address this based on provisions of the Japanese Civil Code related to mandate contracts (for example, Article 650, Paragraph 3 of the Japanese Civil Code), but the scope and procedures for compensation were unclear, lacking legal stability.

A particularly significant challenge was the issue of “conflicts of interest.” When a company bears expenses for a specific individual, it could constitute a “conflict of interest transaction,” where the interests of the company and that individual conflict. If it falls under the conflict of interest transactions stipulated in Article 356, Paragraph 1 of the Japanese Companies Act, strict procedures such as approval by the board of directors are required, leading to procedural complexity and legal uncertainty.

To resolve such issues, the 2019 revision of the Japanese Companies Act introduced provisions for “compensation contracts” in the newly established Article 430-2, and for “directors’ and officers’ liability insurance contracts” in Article 430-3. The purpose of this legal amendment is not merely to protect individuals from legal risks. It includes a broader economic policy intention. By providing a clear and stable framework for legal protection, companies can more easily secure talented individuals from both domestic and international sources. Moreover, individuals responsible for management can make decisions involving appropriate risk-taking, necessary for the sustainable growth of the company, without being unduly fearful of unjust litigation risks. Therefore, these legal systems are positioned as strategic means to transform the management culture of Japanese companies into something more dynamic and competitive through the direct effect of reducing individual risks, and consequently, to promote the overall growth of Japan’s economy.

Compensation Agreements: An Explanation Based on Article 430-2 of the Japanese Companies Act

A compensation agreement is a contract directly concluded between a company and an individual, in which the company promises to compensate for certain expenses or losses incurred in connection with the execution of duties. This system is detailed in Article 430-2 of the Japanese Companies Act.  

To enter into this agreement, a resolution of the shareholders’ meeting is generally required. However, in companies with a board of directors, the content can be determined by a resolution of the board of directors. In this case, the individual eligible for compensation, being a director with a special interest (interested director), cannot participate in the decision-making process.  

The scope of compensation is clearly defined by law and can be broadly categorized into two types:

1. Defense costs: These are expenses such as attorney fees incurred in dealing with allegations of legal violations or claims seeking accountability (Article 430-2, Paragraph 1, Item 1 of the Japanese Companies Act). This may also include costs arising during the preliminary investigation stage before formal litigation is initiated.  
2. Compensation and settlement payments to third parties: These are the amounts paid in responsibility for damages caused to third parties in the execution of duties, including compensation and settlement payments (Article 430-2, Paragraph 1, Item 2 of the Japanese Companies Act).  

On the other hand, to prevent abuse of this system and maintain individual discipline, strict limitations are imposed on compensation. According to Article 430-2, Paragraph 2 of the Japanese Companies Act, a company cannot compensate for the following expenses or losses:

• Defense costs when an individual acts with the purpose of obtaining illicit benefits for themselves or a third party, or with the intent to harm the company (purpose of profit or harm).  
• The full amount of compensation and settlement payments to third parties when the individual has acted with malice or gross negligence (Article 430-2, Paragraph 2, Item 3 of the Japanese Companies Act).  
• Amounts payable in fulfillment of responsibilities to the company itself (duty of care as stipulated in Article 423, Paragraph 1 of the Japanese Companies Act).  

This provision demonstrates an important principle underlying the Japanese Companies Act: the compensation system is intended to protect individuals from unavoidable business risks associated with honest managerial decisions, not to exonerate individuals from the consequences of intentional misconduct or significant breaches of duty of care.

Furthermore, compensation agreements, due to their procedures and scope being specially regulated by Article 430-2, are not subject to the application of general conflict of interest transaction regulations (such as Article 356 of the Japanese Companies Act) (Article 430-2, Paragraph 6 of the Japanese Companies Act). This legal simplification facilitates the use of the system.  

Directors and Officers Liability Insurance (D&O Insurance): An Explanation Based on Article 430-3 of the Japanese Companies Act

The Directors and Officers Liability Insurance contract, commonly known as D&O Insurance, is a system regulated by Article 430-3 of the Japanese Companies Act. It is an insurance contract where the company becomes the policyholder and enters into an agreement with a third-party insurance company, with the company’s management team as the insured parties.

For a company to enter into a D&O insurance contract and bear the insurance premiums, there are legally clear procedures that must be followed. Specifically, the content of the insurance contract must be determined by a resolution of the shareholders’ meeting, or in the case of a company with a board of directors, by a resolution of the board of directors, as stipulated by Article 430-3, Paragraph 1 of the Japanese Companies Act. This provision legally justifies the company’s payment of insurance premiums, resolving the previously ambiguous situation.

Similarly to indemnity contracts, the conclusion of D&O insurance contracts is also exempt from the general provisions on conflict of interest transactions (Article 356 of the Japanese Companies Act), as per Article 430-3, Paragraph 2 of the Japanese Companies Act. This is to avoid double regulation, as Article 430-3 has its own detailed procedural provisions.

The scope of coverage provided by D&O insurance varies depending on the individual insurance contract, but generally includes both damages and litigation costs incurred in responding to lawsuits. However, not all liabilities are covered, and there are significant exclusions. For example, the following cases are typically excluded from insurance payouts:

• Individual criminal acts or acts committed with knowledge of violating laws and regulations.
• Acts carried out to fraudulently obtain personal benefits.
• Physical injury to persons or damage to property that should be covered by other liability insurance policies.

Furthermore, when a public company enters into a D&O insurance contract, it is obligated to disclose an overview of the content in its business report. This ensures transparency for shareholders and investors.

Comparative Analysis of Indemnification Agreements and D&O Insurance Under Japanese Law

Indemnification agreements and D&O insurance both aim to mitigate personal liability risks, yet they have significant differences in functionality and personalityistics. Rather than being alternative options, they complement each other, and combining them can create a more robust risk management framework.

One of the most notable differences is the speed of funding. Indemnification agreements allow for rapid provision of defense costs, such as attorney fees needed in the early stages of litigation, because the company pays the expenses directly. The possibility of the company making advance payments is also permitted, which is a significant advantage for an individual’s cash flow. On the other hand, D&O insurance requires a claims process with the insurance company, which can take time before payment is made.

In terms of the breadth of coverage, D&O insurance generally excels. Indemnification agreements do not cover losses due to an individual’s malice or gross negligence as prohibited by law, whereas D&O insurance may cover such cases depending on the terms of the insurance policy. Additionally, D&O insurance can set coverage amounts that are capable of addressing extremely high damage claims.

The source of funds is another important point of comparison. The funds for indemnification agreements come from the company’s own capital, which can pose a risk of insufficient coverage depending on the company’s financial situation. In contrast, D&O insurance ensures a stable source of funds as the final payment is borne by a third-party insurance company, independent of the company’s financial status.

Considering these personalityistics, the optimal use of both systems becomes clear. Legal disputes, such as lawsuits, create two different types of financial burdens for an individual: the immediate ‘cash flow problem’ of paying attorney fees and the future ‘payment capacity problem’ of paying a large compensation amount if the case is lost. Indemnification agreements effectively address the ‘cash flow problem’ due to their promptness. Meanwhile, D&O insurance serves as the ultimate safety net for the ‘payment capacity problem.’ Therefore, many advanced companies use indemnification agreements as the ‘first line of defense’ for rapid initial response and D&O insurance as the ‘final line of defense’ against catastrophic damages, operating both in conjunction.

The following table summarizes the main features of both systems.

Practical Significance: Recent Case Law Examples

The risk of compensation liability that management faces is not merely theoretical. Japanese courts have historically issued judgments in corporate management-related litigation that impose extremely high damages on individuals. The case law introduced in this section does not analyze the content of that liability in detail but aims to concretely demonstrate the scale of the financial risks that individuals may bear.

For instance, in a shareholder derivative lawsuit concerning losses due to fraudulent transactions at a major bank, the Osaka District Court in 2000 ordered a former branch manager to pay damages exceeding 530 million US dollars.  

Furthermore, in litigation over a major food manufacturer’s use of unauthorized food additives, the Supreme Court of Japan in 2008 confirmed a judgment ordering two former directors to pay a total of over 5.3 billion yen in damages.  

Additionally, in a case where former executives were sued by shareholders for involvement in concealing losses (so-called “loss carry-forward”) at a major manufacturer, the Tokyo High Court ordered five former directors to pay a total of approximately 58.3 billion yen in damages, a decision that was upheld by the Supreme Court of Japan.  

These examples clearly show that the amount of compensation an individual may be responsible for as a result of management decisions can reach levels that are utterly unmanageable with personal assets. In light of such realities, establishing risk management systems such as indemnity contracts and D&O insurance is no longer an option but a mandatory requirement in modern corporate management.

Summary

The 2019 amendment to the Japanese Companies Act (2019年の日本の会社法改正) has established regulations concerning indemnification contracts and Directors & Officers (D&O) liability insurance, resolving longstanding legal uncertainties. As a result, companies in Japan can now provide clearer and more stable protection to their management personnel, laying an important foundation for the realization of sound corporate governance and the sustainable growth of businesses. Understanding these systems correctly and implementing and operating them effectively according to the specific circumstances of one’s company is essential in modern corporate management.

At Monolith Law Office, we have a wealth of experience in providing legal services related to indemnification contracts and D&O insurance, as discussed in this article, to numerous clients within Japan. We offer comprehensive legal services, from drafting and reviewing contracts, advising on proper board resolutions, to supporting the selection and claims process of complex D&O insurance contracts. Our firm also employs several attorneys who are native English speakers with foreign legal qualifications, allowing us to integrate international insights with deep expertise in Japanese law. This enables us to provide smooth and high-quality support to both domestic and international clients operating in Japan. Please entrust the construction of your business’s critical risk management framework to our firm.