Corporate Governance

Corporate Governance in Japan: Director Duties, Board Discretion, and Shareholder Relations

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read
Slide summarising Japanese governance updates: board discretion case, 30 % illiquidity discount precedent, strict “just-cause” dismissal test, and activist-driven reforms.

TL;DR

  • Japanese courts continue to affirm wide board discretion—so long as directors follow internal rules, conduct proper investigations, and act in shareholders’ common interest.
  • The Supreme Court okayed a 30 % non-liquidity discount when valuing restricted shares, stressing transparency and avoidance of double-counting.
  • “Just cause” for dismissing directors remains narrow; group-company dynamics alone seldom suffice.
  • Rising activism and the Corporate Governance Code push boards toward greater disclosure, capital-efficiency focus, and constructive shareholder dialogue.

Table of Contents

  • Board Discretion and the Duty of Care: The Retirement Bonus Case
  • Valuation of Restricted Shares: The Non-Liquidity Discount
  • Director Accountability and Shareholder Relations
  • Conclusion

Japan's corporate governance landscape has undergone significant evolution, driven by regulatory reforms like the Corporate Governance Code, increased foreign investment, and rising shareholder engagement. For international businesses and investors interacting with Japanese companies, understanding the nuances of board operations, director responsibilities, and the dynamics of shareholder relations is vital. Recent court decisions shed light on key areas, including the scope of board discretion, the valuation of non-listed shares, and director accountability.

Board Discretion and the Duty of Care: The Retirement Bonus Case

A fundamental aspect of corporate governance is the division of power between shareholders and the board of directors. While shareholders typically set broad frameworks (e.g., director compensation limits), the board often executes the specifics. A decision by the Kushiro District Court, Obihiro Branch on January 16, 2023, examined the board's discretion regarding director retirement bonuses (役員退職慰労金, yakuin taishoku irōkin).

In this case, the shareholders of a supermarket company had approved, in accordance with the company's internal regulations, the granting of a retirement bonus to a retiring representative director. The shareholders' resolution delegated the determination of the specific amount, timing, and method of payment to the board of directors. The internal regulations provided a formula for a base amount (based on final monthly compensation and years of service) and allowed the board to add a merit bonus (up to 50% of the base) for distinguished service or to reduce the base amount for significant misconduct or harm caused to the company.

Following the shareholder resolution, the board initiated an investigation into allegations of power harassment by the retiring director. Based on the findings of a third-party committee, the board decided approximately seven months later to significantly reduce the base bonus amount and completely deny any merit bonus. The former director sued, arguing the board breached its duty of care (善管注意義務, zenkan chūi gimu) by delaying the decision and improperly reducing the payout.

The District Court ruled in favor of the company, affirming the board's actions. Key takeaways from the judgment include:

  1. Scope of Delegated Discretion: When shareholders explicitly delegate the determination of specifics (like timing and amount adjustments based on established internal rules) to the board, the board possesses considerable discretion in exercising that authority.
  2. Reasonableness of Process: The court found the seven-month delay reasonable, given the need for a thorough investigation into the harassment allegations by a third-party committee. Acting prudently based on professional advice was seen as consistent with the board's duty.
  3. Decision within Internal Rules: The decision to reduce the bonus based on findings of misconduct (power harassment causing harm to the company) fell within the scope of the reduction clause in the company's pre-approved retirement bonus regulations. As long as the board's decision aligns with established internal rules and the mandate given by shareholders, and isn't an abuse of discretion, it is generally upheld.

This case illustrates that while boards operate under authority delegated by shareholders, they retain significant discretion in implementing those mandates, provided they act reasonably, follow established procedures and internal rules, and exercise their duty of care, including conducting necessary investigations before making potentially adverse decisions regarding compensation.

Valuation of Restricted Shares: The Non-Liquidity Discount

Valuing shares in non-listed companies or restricted shares (譲渡制限株式, jōto seigen kabushiki) presents unique challenges in Japan, particularly in contexts mandated by the Companies Act (会社法, Kaishahō). One such context is when a shareholder requests the company's approval to transfer restricted shares, and the company refuses, triggering a process where the company or a designated buyer must purchase the shares (Art. 138, 140). If the parties cannot agree on a price, they can petition the court to determine a fair sale price (Art. 144(2)).

A key question in these valuations is whether a "non-liquidity discount" (or "discount for lack of marketability," DLOM) should be applied. This discount reflects the fact that shares in non-listed companies are harder to sell compared to publicly traded shares. The Supreme Court of Japan addressed this in a decision on May 24, 2023.

The case involved a dispute over the sale price determined by the court under Article 144(2). The lower court (Hiroshima High Court) had applied a non-liquidity discount (specifically, 30%) to the value derived from the Discounted Cash Flow (DCF) method. The shareholders selling the shares appealed, arguing that such a discount was inappropriate in this mandatory sale context and inconsistent with prior case law concerning share buybacks from dissenting shareholders in reorganizations.

The Supreme Court upheld the High Court's decision, ruling that:

  1. Non-Liquidity Discount is Permissible: A non-liquidity discount can be applied when determining the purchase price under Article 144(2) if the court deems it appropriate under the circumstances. The court reasoned that the purpose of this procedure is to provide shareholders seeking to transfer their shares with a means of exit comparable to a voluntary sale, where such discounts are common.
  2. Valuation Method (DCF) Not a Bar: Using the DCF method does not automatically preclude applying a non-liquidity discount.
  3. Avoid Double-Counting: However, the discount should not result in double-counting the lack of marketability. If the valuation methodology (like the inputs used in a DCF analysis, such as a higher discount rate reflecting the risk of illiquidity) already adequately accounts for the lack of marketability, applying an additional explicit percentage discount would be inappropriate. In this specific case, the Supreme Court noted that the lower court's DCF calculation appeared to use market data from comparable listed companies without explicitly adjusting for the target shares' lack of marketability within the DCF inputs themselves, thus justifying a separate discount.

This decision provides important clarity, confirming that lack of marketability can be a valid factor reducing the court-determined price for restricted shares in refusal-of-transfer scenarios. It highlights the importance for valuators and courts to be transparent about whether and how illiquidity is factored into their calculations, either within the primary valuation model or as a separate discount, to avoid double-counting. This has significant implications for minority shareholders seeking exit opportunities and for companies managing share transfers. While a 30% discount was applied in this instance (a rate often seen in Japanese practice, sometimes drawing reference from tax valuation guidelines), the appropriate level of discount remains a case-specific determination.

Director Accountability and Shareholder Relations

The relationship between boards, management, and shareholders is a dynamic area in Japanese corporate governance. Issues of director accountability, particularly in cases of alleged underperformance or misconduct, and the increasing influence of shareholders, including activists, are prominent themes.

Grounds for Director Dismissal

Under the Companies Act (Article 339), shareholders can dismiss a director at any time by a resolution of the shareholders' meeting. However, if a director is dismissed mid-term without "just cause" (正当な理由, seitō na riyū), the director can claim damages from the company, typically equivalent to the remuneration they would have received for the remainder of their term.

What constitutes "just cause" is crucial. It generally requires objective circumstances making it unreasonable to entrust the director with further duties. Examples include serious health issues preventing duty performance, clear legal violations or misconduct, gross incompetence, or significant, demonstrable failures in management judgment leading to harm. Poor business performance alone is often insufficient unless directly attributable to the director's specific failures or incompetence, especially if external factors (like market downturns) played a role.

A Tokyo High Court decision on September 7, 2022, touched upon dismissal within a group company structure. While the specifics are complex, the case involved an individual serving as a director in both the parent holding company (listed) and its wholly-owned subsidiary (operating an art auction business). Following a management dispute at the parent level where this individual was removed from the parent's board, he was subsequently dismissed from the subsidiary's board as well. The subsidiary argued his actions as a parent company director (related to the management dispute, including disseminating critical statements about another executive) constituted just cause for dismissal from the subsidiary.

The High Court (affirming the District Court) rejected this argument, finding no just cause for the subsidiary dismissal. While the High Court acknowledged that in a group structure where the subsidiary's management aligns with the parent's strategy, the director's suitability at the parent level could be considered when assessing their suitability for the subsidiary role, it found the specific actions taken as a parent director did not automatically render him unfit for the subsidiary role or constitute just cause for that specific dismissal. This suggests that while group dynamics are relevant, justification for dismissal generally needs to relate to the director's conduct or capacity concerning the specific company from which they are being dismissed. Simply being removed from a parent board does not automatically constitute just cause for removal from a subsidiary board.

Shareholder Engagement and Activism

The landscape of shareholder relations in Japan is shifting. Spurred by the Corporate Governance Code and the Stewardship Code (which encourages institutional investors to engage actively with investee companies), shareholder engagement is increasing.

  • Corporate Governance Code Emphasis: The Code encourages boards to secure their accountability to shareholders, enhance transparency, and engage in constructive dialogue. Recent revisions and discussions often focus on increasing the number and effectiveness of independent outside directors, strengthening board oversight (especially through nomination and compensation committees), and improving capital efficiency (e.g., addressing low Price-to-Book Ratios - PBRs). Companies listed on the Prime market, in particular, face heightened expectations regarding governance practices and disclosure, including English language disclosure.
  • Rising Shareholder Activism: Japan has become a significant focus for shareholder activism. Activist funds, both domestic and foreign, are increasingly proposing measures related to capital allocation (e.g., share buybacks, increased dividends), board composition, business strategy reviews, and governance improvements. While proposals directly targeting director dismissals are less common than demands for strategic or capital changes, activism undoubtedly increases pressure on boards and management for performance and accountability. Companies are becoming more sophisticated in their engagement with activists, but hostile situations and proxy fights are also becoming more frequent. Research indicates a record number of shareholder proposals in recent years, particularly targeting companies perceived as having inefficient capital structures or governance weaknesses.

For foreign companies engaging with Japanese partners or subsidiaries, understanding this context is important. Boards are under increasing scrutiny regarding performance, capital efficiency, and responsiveness to shareholder concerns. The presence of activist shareholders can significantly influence corporate strategy and governance dynamics.

Conclusion

The Japanese corporate governance environment is characterized by an evolving balance between board authority, director accountability, and shareholder rights. Recent court decisions provide critical interpretations regarding the scope of board discretion in implementing shareholder mandates (like retirement bonuses), the valuation principles applicable to non-listed shares (confirming the potential for non-liquidity discounts), and the standards for director dismissal.

Simultaneously, regulatory pressures from the Corporate Governance Code and market pressures from increasingly engaged shareholders, including activists, are pushing companies towards greater transparency, enhanced board oversight, improved capital efficiency, and more constructive shareholder dialogue. For foreign entities operating in or investing in Japan, staying abreast of these legal and market developments is essential for navigating board responsibilities, managing director relationships, understanding share valuation issues, and engaging effectively within Japan's dynamic corporate governance framework.