Executive Compensation in Japan: How is it Determined and What are the Rules for Fixed Salaries, Bonuses, and Stock Options?

Executive compensation is a cornerstone of corporate governance, serving not only as remuneration for the demanding roles directors undertake but also as a critical mechanism to align management's interests with those of shareholders and the long-term health of the company. In Japan, the Companies Act (会社法 - Kaisha-hō) establishes a distinct framework for determining and regulating the compensation of directors, with a traditional emphasis on shareholder approval to prevent self-dealing, alongside an evolving focus on incentivizing sustainable corporate growth.

This article explores the key principles and procedures governing director remuneration in Japanese companies, particularly those not adopting the "Company with Nominating Committee, etc." structure (where a dedicated Remuneration Committee makes these decisions). We will delve into how fixed salaries, bonuses, traditional retirement benefits, and modern stock options are handled under Japanese law, highlighting the interplay between statutory requirements and prevalent corporate practices.

The General Framework: Shareholder Approval for Director Remuneration

The fundamental rule for director compensation in Japan is set out in Article 361, paragraph 1 of the Companies Act. It stipulates that any "remuneration, bonus, or other financial benefit" (報酬等 - hōshū-tō) received from the company as consideration for the performance of a director's duties must be either:

1. Fixed in the company's articles of incorporation (定款 - teikan); or
2. Approved by a resolution of a shareholders' meeting.

In practice, fixing remuneration in the articles of incorporation is rare due to the cumbersome process of amending them (which typically requires a special shareholder resolution). Therefore, shareholder meeting approval is the standard route.

The term "remuneration, etc." is interpreted broadly to encompass various forms of compensation, including:

• Regular salaries and fixed bonuses.
• Performance-linked bonuses.
• Retirement benefits (退職慰労金 - taishoku irōkin), which have historically been common.
• Stock options (新株予約権 - shinkabu yoyakuken).
• Material benefits, such as the provision of company housing or cars.

The Companies Act requires specific details to be approved by shareholders, depending on the nature of the remuneration:

• For fixed monetary amounts (e.g., a monthly salary): the specific sum.
• For variable monetary amounts (e.g., performance-based bonuses): the specific calculation method or formula (for instance, a percentage of net profit or a metric tied to share price performance).
• For non-monetary benefits: concrete details of the benefit (e.g., terms of a company-provided residence).

The traditional rationale for this shareholder approval requirement has been the prevention of "self-dealing" (お手盛り - otesakari) – situations where directors might unilaterally set their own compensation at excessive levels without regard to their actual contribution or company performance. More recently, legal scholarship and governance guidelines also emphasize that remuneration structures should be designed to provide appropriate incentives for directors to manage the company in a way that enhances corporate value over the medium to long term.

Judicial precedent has affirmed the centrality of shareholder approval. The Supreme Court, in a decision on December 18, 1992 (Minshu Vol. 46, No. 9, p. 3006), held that if remuneration is not duly determined by the articles or a shareholder resolution, directors have no legal claim to it. Conversely, once approved, the terms become part of the director's service agreement with the company. A subsequent Supreme Court ruling on February 15, 2005 (Hanrei Jihō No. 1890, p. 143) indicated that even if remuneration is paid without prior approval, a later, post-facto shareholder resolution can validate these payments, provided there are no "special circumstances" that would negate the spirit of Article 361 (such as clear evidence of bad faith or gross excessiveness).

Fixed Monetary Remuneration (Salaries and Fixed Bonuses)

For fixed monthly salaries and pre-determined bonuses, a widespread practice among Japanese listed companies has been for the shareholders' meeting to approve only an aggregate maximum amount of remuneration for all directors collectively for a given period (typically a year). The board of directors is then delegated the authority to determine the specific remuneration for each individual director within this approved ceiling. This practice allows companies to avoid public disclosure of individual director salaries through shareholder meeting materials, which has been a traditional preference for many Japanese firms.

Once this aggregate cap is established, it is common for companies not to seek a new shareholder resolution on remuneration in subsequent years unless they intend to change this total amount. This means that the foundational shareholder approval for the remuneration cap might have been passed many years, or even decades, prior.

This practice has generally been accepted by Japanese courts and the majority of legal scholars. The Supreme Court, in a judgment on March 26, 1985 (Hanrei Jihō No. 1159, p. 150), supported the legality of delegating individual allocation decisions to the board, provided an aggregate limit is set by shareholders. The reasoning is that the shareholder-approved cap serves as the primary control against overall excessive remuneration, thereby satisfying the core "anti-self-dealing" purpose of Article 361.

However, this approach is not without its critics. Some scholars argue that merely setting an aggregate limit does not adequately ensure that the remuneration allocated to each individual director is appropriate for their specific responsibilities, efforts, and contributions. An overall cap might prevent the total sum from being exorbitant, but it doesn't inherently prevent misallocation within that cap (e.g., an underperforming director receiving too much, or a high-performing director too little, relative to their peers or market rates). If remuneration is also intended to function as an effective incentive, then both overpayment and underpayment relative to performance and responsibility can be problematic.

A further layer of complexity arises when the board, having received delegated authority from shareholders, further re-delegates the task of determining individual remuneration amounts to the representative director (e.g., the President). While some lower court precedents have found this permissible as long as it remains within the shareholder-approved aggregate, a strong counterargument exists that such re-delegation to a single individual can undermine the collective oversight function of the board itself regarding compensation matters.

Retirement Benefits (退職慰労金 - Taishoku Irōkin): A Shifting Landscape

Traditional retirement benefits (taishoku irōkin) have long been a feature of director compensation in Japan. These are typically lump-sum payments made to directors upon their retirement, often calculated based on factors like their final monthly remuneration, years of service, and position held.

The Supreme Court, in a decision dated December 11, 1964 (Minshu Vol. 18, No. 10, p. 2143), established that such retirement benefits, to the extent they represent consideration for services rendered during a director's tenure, fall under the definition of "remuneration, etc." in Article 361 and are therefore subject to its approval requirements.

Historically, a very common practice for these retirement benefits was for the shareholders' meeting to pass a resolution delegating the entire determination of the specific amounts, payment methods, and timing to the board of directors. Often, this delegation was made without even setting an aggregate monetary cap for the retiring directors in that particular instance, primarily to maintain confidentiality around individual payment amounts.

The legality of such broad delegation has been a subject of debate. While many legal scholars argued that, similar to regular remuneration, at least an aggregate limit for the specific retirees should be approved by shareholders, the Supreme Court took a nuanced stance. In a judgment on November 26, 1973 (Hanrei Jihō No. 722, p. 94), the Court stated that while an unconditional delegation of all aspects of retirement benefit decisions to the board would be impermissible, delegation is allowed if the shareholder resolution explicitly or implicitly refers to an established standard for calculating such benefits. This standard typically takes the form of internal company rules or long-standing customs regarding retirement payments, which should be reasonably knowable or ascertainable by the shareholders. If such a standard exists and is referenced, the board can then determine the specifics according to that approved standard.

Reflecting this judicial guidance, the Companies Act Enforcement Rules (Article 82, paragraph 2) now require that if a company (particularly one using written voting for shareholder meetings, which includes most listed companies) proposes a shareholder resolution to delegate the determination of retirement benefits based on certain criteria, those criteria must be described in the reference documents provided to shareholders. An exception exists if "appropriate measures" are taken to enable shareholders to know these criteria (e.g., making the internal rules available for inspection at the company's head office). If the standards are not properly disclosed or made accessible, there's a risk that the shareholder resolution for delegation could be deemed void or subject to cancellation.

The trend in recent years, however, has been for many listed Japanese companies to abolish these traditional, tenure-based retirement benefit systems. This shift has been largely driven by pressure from institutional investors, both domestic and international, who often view such schemes as insufficiently linked to actual performance and potentially encouraging entrenchment rather than value creation. While retirement benefits often contained a merit-based or "功労金 - kōrōkin" (distinguished service payment) component, the perceived lack of transparency in their calculation and the disconnect from measurable performance outcomes led to widespread calls for their reform or elimination in favor of more direct performance-linked incentives.

Stock Options (新株予約権 - Shinkabu Yoyakuken) as Incentive Compensation

Stock options, known in Japan as shinkabu yoyakuken (new share acquisition rights), have gained prominence as a form of incentive compensation designed to align the interests of directors (and often employees) with those of shareholders by giving them a stake in the company's share price appreciation. The basic premise is that if the company's stock price rises above the option's exercise price, the holder can acquire shares at a discount and realize a profit, thus incentivizing efforts to enhance corporate value.

Dual Regulatory Framework

The granting of stock options to directors in Japan is subject to a dual set of regulations:

1. Rules for Issuing New Share Acquisition Rights: As stock options are a type of shinkabu yoyakuken, their issuance must comply with the provisions of the Companies Act governing such rights (Articles 238 et seq.).
2. Remuneration Rules: Since stock options granted to directors are typically in consideration for their services, they also constitute "remuneration, etc." under Article 361 and must comply with its approval requirements.

Issuance as New Share Acquisition Rights

Stock options are often issued to directors for no upfront cash payment (無償発行 - mushō hakkō), with the understanding that the true consideration is the future service the director will render to the company. A key question is whether such an issuance constitutes an "advantageous issuance" (有利発行 - yūri hakkō), which would trigger stricter shareholder approval requirements (a special resolution). The prevailing view is that if the economic value of the services to be provided by the director is reasonably equivalent to the fair value of the stock options granted (calculated using accepted option pricing models like Black-Scholes for listed company shares), then the issuance is not "advantageous," even if no cash is paid for the options themselves. In such non-advantageous cases, public companies can generally issue stock options by a board of directors' resolution, provided the issuance of underlying shares is within the company's authorized capital.

Historically, before the 2005 Companies Act, the concept of granting share-related instruments in exchange for services (a form of "labor contribution" - 労務出資 - rōmu shusshi) was problematic. However, current law generally distinguishes the "payment" for new share acquisition rights (which can be services) from the "payment" for shares upon exercise (which is cash at the exercise price). The risk of overvaluing the services provided in exchange for options is primarily managed through the remuneration approval rules.

Application of Remuneration Rules (Article 361)

Ensuring that the grant of stock options is fair and appropriately linked to director duties and shareholder interests falls under the ambit of Article 361. Two main approaches are seen in practice:

1. Direct Grant Method: The stock options themselves are treated as non-monetary remuneration.
   • For listed companies, the value of these options can be reasonably estimated using financial models.
   • The shareholders' meeting (or articles of incorporation) must approve the "amount" (i.e., the aggregate fair value of the options being granted) and the "specific details" of the options. "Specific details" would include key terms like the number of options, the class and number of underlying shares, the exercise price, the vesting period, and performance conditions, as these are crucial for understanding the incentive structure and value.
   • Furthermore, under Article 361, paragraph 4, directors are required to explain to the shareholders' meeting why granting non-monetary remuneration (in this case, stock options) is considered appropriate.
   • If the value of the options falls within a previously shareholder-approved aggregate remuneration cap for directors, a new shareholder resolution for the "amount" component might not strictly be necessary. However, because the terms and values of options can vary significantly from year to year depending on market conditions and grant specifics, it is often considered best practice (and some argue a legal necessity for the "specific details") to seek shareholder approval for each grant, or at least for the overall plan parameters annually.
2. Offset Method (相殺方式 - sōsai hōshiki) (Common Practice): This is a more administratively common approach.
   • The company, through a shareholder resolution, approves a cash remuneration entitlement for the directors, with the amount set to be equivalent to the fair value of the stock options intended to be granted.
   • Separately, the company "issues" the stock options to the directors, requiring a "payment" for these options equal to their fair value.
   • The directors' claim for the cash remuneration is then immediately offset against their obligation to "pay" for the stock options. The net result is that no cash changes hands for the options from the director's perspective.
   • Legally, this frames the transaction as the provision of cash remuneration (which is then used by the director to "purchase" options). Under this formal construction, the shareholder approval under Article 361 might only strictly need to cover the cash "amount." The "specific details" of the options and the explanation required by Article 361(4) for non-monetary remuneration might not formally be required under the remuneration rules, as the remuneration is nominally cash.
   • However, this approach has been criticized as elevating form over substance, as the economic reality is that the directors are receiving option-based compensation. Recognizing this, many companies, as a matter of best practice and good governance, voluntarily provide shareholders with detailed information about the stock option plan and seek approval of its key terms even when using the offset method.

Disclosure and Shareholder Engagement

Transparency in executive compensation is a growing expectation globally, and Japan is no exception. Disclosure requirements for director remuneration exist, primarily through annual corporate reports and, for higher-earning directors of listed companies, through securities filings (Yukashoken Hokokusho).

Japan's Corporate Governance Code has also played a significant role in shaping practices. The Code encourages companies to:

• Design remuneration policies that provide sound incentives for sustainable growth, linking compensation to medium- to long-term performance and adequately reflecting risk.
• Disclose their policies and procedures for determining director remuneration.
• Consider utilizing mechanisms such as voluntary remuneration committees, with a majority of independent outside directors, to enhance objectivity and transparency in compensation decisions, even for companies not legally mandated to have such a committee (i.e., those not operating under the "Company with Nominating Committee, etc." structure).

Conclusion

The Japanese Companies Act provides a foundational requirement of shareholder involvement in determining director remuneration, primarily aimed at preventing self-dealing and ensuring accountability. While traditional practices involving aggregate caps and board delegation for fixed pay and retirement benefits have been judicially accepted, the landscape is evolving. There is a clear trend towards greater emphasis on performance-linked incentives, such as stock options, and increased transparency in how compensation decisions are made.

Navigating these rules requires careful consideration of the specific type of remuneration, the legal form of its provision (e.g., direct grant vs. offset for options), and the procedural requirements for shareholder approval and disclosure. As institutional investors become more vocal and governance standards continue to align globally, Japanese companies are increasingly expected to demonstrate that their executive compensation practices are fair, transparent, and effectively designed to drive long-term corporate value.