Director's Liability in Japan: What are the Standards for Breach of Duty of Care and the Business Judgment Rule?

Directors of Japanese corporations operate under a legal framework that imposes significant duties, the breach of which can lead to personal liability for damages suffered by the company. Central to this framework is the "duty of due care," a standard requiring directors to manage the company's affairs with the diligence of a prudent manager. Understanding how Japanese law defines this duty, what constitutes a breach, and the defenses available—particularly the Business Judgment Rule—is critical for anyone serving on or advising the board of a Japanese entity.

This article examines the scope of director's liability to the company under Japan's Companies Act (会社法 - Kaisha-hō), focusing on the standards for determining a breach of the duty of due care, the application of the Business Judgment Rule, and specific areas of concern such as supervisory responsibilities and internal controls.

The Foundation: Director's Duty of Care and Liability for Breach

Under Article 423, paragraph 1 of the Companies Act, a director is liable to the company for any damages caused by their neglect in performing their duties (任務懈怠 - ninmu keitai). This liability is generally understood as arising from a breach of the director's service agreement with the company, which is characterized as a mandate (委任 - inin) relationship (Article 330, Companies Act). Consequently, directors are obliged to discharge their duties with the "care of a good manager" (善良なる管理者の注意 - zenryō naru kanrisha no chūi), a standard akin to the duty of due care found in many legal systems (derived from Article 644 of the Civil Code, applied to directors via the Companies Act).

A failure to meet this standard of care—a breach of the duty of due care (zenkan chūi gimu ihan)—constitutes a neglect of duties and can trigger liability. To establish such liability, several elements generally need to be present:

1. A breach of duty by the director.
2. Culpability on the part of the director (intent or negligence - 過失 - kashitsu).
3. The occurrence of damages to the company.
4. A causal link between the breach of duty and the damages.

Typically, the burden of proving the breach of duty, damages, and causation falls on the plaintiff (the company or shareholders in a derivative action). The director, in turn, bears the burden of proving the absence of culpability (intent or negligence) if they wish to avoid liability once a prima facie case of breach causing damage is established. It's noteworthy that "negligence" in this context is usually interpreted as objective negligence, meaning a failure to take reasonable steps to avoid foreseeable harm. This often overlaps significantly with the concept of breaching the duty of due care itself; if a breach of the duty of care is proven, it is rare for a director to successfully argue they were not negligent.

A point of legal debate in Japan has been whether a "neglect of duty" is limited only to breaches of the general duty of due care (the "unitary theory" - 一元説 - ichigen-setsu), or if it also directly encompasses violations of specific statutory provisions, even if those violations don't independently amount to a lack of due care (the "dual theory" - 二元説 - nigen-setsu). The practical significance of this debate often lies in the allocation of the burden of proof. If a director violates a specific statute (e.g., an environmental regulation or a labor law), under the dual theory, the plaintiff might only need to prove the statutory violation itself to establish a "neglect of duty." The burden would then shift to the director to prove they were not culpable (e.g., the violation occurred despite them taking all reasonable measures). The unitary theory might require the plaintiff to go further and demonstrate that the statutory violation also constituted a failure to exercise the care of a good manager in the circumstances. Many commentators favor the dual theory for its practical effect of holding directors accountable for clear statutory breaches unless they can demonstrate blamelessness.

Key Areas of Potential Breach and Applicable Standards

Assuming a framework where neglect of duty can encompass both general failures of care and specific statutory violations, we can explore several key areas where director liability often arises:

A. Violations of Specific Statutes

Directors are expected to ensure the company complies with all applicable laws and regulations. This is not limited to the Companies Act itself but extends to criminal laws, industry-specific regulations, environmental laws, labor laws, and even foreign laws if the company's operations have an international dimension (as affirmed by the Supreme Court on July 7, 2000, Minshu Vol. 54, No. 6, p. 1767, in a case involving foreign anti-bribery laws).

If a director's actions or omissions lead to the company violating a statute, and this causes damage to the company (e.g., fines, legal costs, reputational harm), the director may be held liable. However, a director might be excused if they can demonstrate an absence of culpability. This could involve showing, for instance, that:

• At the time of the action, the illegality of the conduct was not recognized even among legal experts, and advice from counsel would not have revealed the risk (i.e., the harm was unforeseeable).
• While a risk of illegality was recognized, a thorough and reasonable cost-benefit analysis, undertaken in good faith for the company's best interests, indicated that the potential benefits of the action outweighed the low probability or minor consequences of the violation. This is a high bar to meet and requires robust evidence of a diligent decision-making process.

B. Errors in Business Judgment and the Business Judgment Rule (BJR)

One of the primary functions of directors is to make business judgments, often in uncertain environments with incomplete information. Recognizing that not all business decisions will yield positive outcomes, Japanese courts have developed and apply the Business Judgment Rule (経営判断原則 - keiei handan gensoku) to shield directors from liability for honest errors of judgment, provided their decision-making process and the decision itself meet certain standards.

The Supreme Court of Japan, in a significant ruling on July 15, 2010 (often referred to as the Acom case regarding its investment in Appaman Shop), articulated a widely cited formulation of the BJR. It stated that for matters entrusted to the specialized business judgment of directors, a decision made by them does not constitute a breach of the duty of due care unless there were "grossly unreasonable" points (著しく不合理 - ichijirushiku fugōri) in the decision-making process or the content of the decision itself.

Key aspects of the BJR as applied in Japan include:

• Focus on Process and Substance: The inquiry looks at both how the decision was made (e.g., did directors inform themselves adequately, deliberate sufficiently?) and the substance of the decision (was it so irrational that no reasonable business person would have made it?).
• Contemporaneous Assessment: The reasonableness of the decision is judged based on the facts and circumstances known or reasonably knowable to the directors at the time the decision was made, not with the benefit of hindsight. This is crucial to avoid penalizing directors for outcomes that were unforeseeable.
• Deference to Business Expertise: Courts generally defer to the business expertise of directors and are reluctant to substitute their own judgment for that of the board, unless the "grossly unreasonable" threshold is met.
• Rationale: The BJR aims to encourage directors to engage in prudent risk-taking and innovation, which are essential for corporate growth, without the chilling effect of potential liability for decisions that turn out badly despite being made in good faith and with due care.

Scope and Limitations of the BJR:
The protection of the BJR is not absolute. Its application can be limited or modified in certain circumstances:

• Conflicts of Interest: If a director making a business decision has a significant personal interest that conflicts with the interests of the company (even if it doesn't meet the formal definition of a conflict of interest transaction requiring board approval under Article 356 of the Companies Act but still taints their independent judgment), the full deference of the BJR may not apply. In such cases, courts might apply a stricter standard of "reasonableness" rather than "gross unreasonableness," taking into account the nature and materiality of the conflict. The director would have a heavier burden to show the fairness of the decision to the company.
• Illegality: The BJR generally does not protect decisions that are illegal or that direct the company to engage in illegal activities.
• Lack of Good Faith or Rational Basis: Decisions made in bad faith, for an improper purpose, or without any discernible rational business basis are unlikely to receive BJR protection.

C. Breach of Supervisory Duty (監視義務違反 - Kanshi Gimu Ihan)

Directors, particularly members of the board, have a duty to supervise the conduct of their fellow directors, especially those entrusted with executive responsibilities like representative directors and other executive officers. This is not a separate, standalone duty but rather an integral aspect of their overall duty of due care in managing the company's affairs. A breach of this supervisory duty can occur in several ways:

1. Knowing Inaction: If a director becomes aware of illegal acts or serious misconduct by other directors or employees that is harming or is likely to harm the company, they have a duty to take reasonable steps to prevent or mitigate the harm. This typically involves raising the issue at the board level and advocating for appropriate corrective measures (which could include internal investigations, disciplinary actions, or even seeking the removal of the wrongdoing individuals). Failure to act appropriately in the face of known wrongdoing can constitute a breach of supervisory duty.
2. Ignoring "Red Flags": Even if a director does not have direct knowledge of misconduct, if they are aware of circumstances that should reasonably arouse suspicion or indicate potential problems (i.e., "red flags"), they have a duty to make reasonable inquiries or ensure that such inquiries are made. Willful blindness or a failure to follow up on credible warning signs can lead to liability.
3. Systemic Failure due to Dereliction of Basic Duties: A director cannot escape supervisory liability by remaining ignorant if that ignorance results from their own failure to fulfill fundamental directorial responsibilities. For example, consistently failing to attend board meetings, not reading board materials, or generally neglecting to engage with the company's affairs and its internal control environment could lead to a situation where misconduct goes undetected. In such cases, the failure to fulfill these basic duties can itself be the basis for a breach of the broader supervisory obligation.

The "principle of reliance" (信頼の原則 - shinrai no gensoku) is sometimes invoked, suggesting that directors are generally entitled to rely on the competence and integrity of their fellow directors and company officers, as well as on information provided by them. However, this reliance must be reasonable. It does not absolve directors of their duty to be attentive, ask critical questions when warranted, and act upon information that suggests problems.

A point of discussion in Japanese corporate law has been the extent of an individual director's power to investigate company affairs, especially if they are a minority voice on the board. While the board as a collective has clear oversight and investigative powers, the majority scholarly view is that individual directors in companies without specialized committee structures (like Nominating or Audit & Supervisory Committees) do not possess broad, independent rights to demand information or conduct investigations beyond what is necessary to participate in board deliberations or by requesting the board itself to act. This can create challenges for proactive supervision by non-executive or minority directors, although they retain the duty to escalate concerns within the board structure.

D. Failure in Relation to Internal Control Systems (内部統制システム - Naibu Tōsei Shisutemu)

The Companies Act explicitly requires the board of directors of large companies and companies with committee-based governance structures (and directors in companies without a board) to make decisions regarding the establishment and maintenance of "systems to ensure the propriety of business operations," commonly referred to as internal control systems (Article 348(4), 362(4)(vi) & (5), 399-13(1)(i)(b)&(c), 416(1)(i)(e) & (2)). These systems are expected to cover areas such as:

• Compliance with laws and regulations.
• Preservation and management of information related to the execution of directors' duties.
• Risk management policies and procedures.
• Ensuring the efficient execution of directors' duties.

Director liability in relation to internal controls can arise in several contexts:

1. Decision on System Design: The board's decision on what kind of internal control system to establish (or even a decision not to implement certain aspects, if reasonably justified) is itself a business judgment. Therefore, liability for a flawed system design would typically be assessed under the BJR – was the board's decision grossly unreasonable at the time it was made?
2. Implementation Failures: Once the board decides on the framework of the internal control system, the executive directors (particularly representative directors) are responsible for its implementation. A failure to implement the system diligently and effectively could lead to liability, again likely assessed under the BJR concerning their implementation decisions and actions.
3. Monitoring and Oversight Failures: All directors have an ongoing duty to reasonably oversee the functioning of the internal control system. This includes being attentive to reports on its effectiveness, inquiring into deficiencies or "red flags" that come to their attention, and taking appropriate action to ensure that known weaknesses are remediated. A passive approach where directors ignore systemic failures can constitute a breach of their supervisory duty.

It is generally understood that the duty regarding internal controls does not require directors to personally guarantee that no misconduct will ever occur within the company. Rather, it requires them to exercise due care in establishing and overseeing systems reasonably designed to promote compliance and manage risks.

Causation and Damages: The Practical Challenges

For a director to be held liable, the plaintiff must demonstrate not only a breach of duty and culpability but also that the company suffered damages and that these damages were legally caused by the director's breach. The usual approach to quantifying damages is the "difference theory" (sagaku-setsu): comparing the company's actual net asset position with the hypothetical net asset position it would have been in had the director fulfilled their duties.

Proving causation can be particularly challenging in cases involving breaches of supervisory duty. For example, if a director failed to adequately supervise a representative director who subsequently engaged in fraudulent activity causing financial loss to the company, the plaintiff must essentially show that if the supervising director had acted properly, the loss would have been prevented or mitigated. This can be difficult:

• Would proper supervision have actually detected the fraud in time?
• Even if detected, could the supervising director have effectively intervened to stop it, especially if they were a minority voice on the board?
• Had the damage already irreversibly occurred by the time the supervisory lapse became critical?

While the plaintiff traditionally bears this burden, there is a notable trend in some Japanese judicial opinions and influential academic commentary suggesting that once a clear breach of supervisory duty is established and damages from underlying misconduct are evident, a factual presumption of causation may arise. This would effectively shift the burden to the delinquent supervising director to prove that the damage would have occurred even if they had properly fulfilled their supervisory duties. This approach aims to provide more effective redress in situations where proving the counterfactual (what would have happened) is inherently difficult for plaintiffs.

Conclusion

The liability of directors to their company under the Japanese Companies Act is a critical mechanism for ensuring accountability and prudent management. While the overarching standard is the "duty of due care," its application varies depending on the context—whether it involves specific statutory compliance, complex business judgments, supervisory functions, or the establishment of internal controls. The Business Judgment Rule provides significant, though not absolute, protection for directors making good-faith business decisions, encouraging them to take calculated risks for corporate growth. However, this protection recedes in cases of gross unreasonableness, conflicts of interest, or clear dereliction of fundamental duties.

For directors operating in Japan, a thorough understanding of these duties, the standards by which their conduct will be judged, and the importance of a diligent and well-documented decision-making process is essential for both effective governance and personal liability mitigation.