Fictitious Share Payments in Japan: What are the Legal Consequences for Subscribers and Directors under the Amended Companies Act?

The integrity of a company's capital base is a cornerstone of corporate law. When shares are issued, the expectation is that the company receives genuine economic value in return. However, practices involving "fictitious payments" (仮装払込み - kasō haraikomi) for shares—where the appearance of payment is created without a lasting contribution of capital—undermine this fundamental principle. Such actions can mislead stakeholders, dilute legitimate shareholder interests, and, in some cases, facilitate market abuse.

In response to concerns, particularly highlighted by certain "unfair finance" schemes involving listed companies, Japan amended its Companies Act (会社法 - Kaisha-hō) in 2014 to specifically address fictitious payments. This article explores what constitutes a fictitious payment under Japanese law, details the legal consequences for share subscribers and involved directors under these amended provisions, and discusses the ongoing legal complexities, particularly concerning the validity of shares issued through such means. While these rules apply broadly (including at incorporation and for new share acquisition rights), our focus here will be on fictitious payments in the context of subsequent issuances of shares for subscription (募集株式 - boshū kabushiki).

What Constitutes Fictitious Payment for Shares in Japan?

A fictitious payment essentially involves creating the outward illusion that a subscriber has duly paid for newly issued shares, when in reality, the company does not receive, or does not retain, the substantive economic benefit of that payment. The core of the concept, as indicated by long-standing judicial precedent (e.g., Supreme Court, December 6, 1963, regarding payments at the time of company incorporation), is an act that is "merely feigning the appearance of payment without any real intention to make it part of the company's capital."

Common scenarios recognized under Japanese law and practice include:

1. "Show Money" (Misekin - 見せ金): This is a classic form of fictitious payment. Typically, a share subscriber (who might also be an insider like a director or promoter) borrows funds from an unrelated third party. These borrowed funds are then temporarily deposited into the designated bank account for the share payment, creating a record of payment. Shortly after the shares are formally issued (or the company is established, in an incorporation context), the same amount of money is withdrawn from the company's account (or routed through other means) and used to repay the original lender. The net effect is that the company's capital is not actually augmented by the supposed payment.
2. "Collusive Deposit" (Azariai - 預合い): This scheme involves collusion between the share subscriber and the financial institution handling the payment. It can manifest in a couple of ways:
   • Type A (Circular Movement): The subscriber borrows funds directly from the financial institution where the share payment is to be made. The borrowed sum is formally paid in for the shares, but almost immediately, these funds are withdrawn from the company's account (or an account effectively controlled by the subscriber through the company) and used to repay the loan to the same financial institution. The funds merely make a round trip.
   • Type B (Restricted Funds): The subscriber borrows from the financial institution and makes the share payment. However, there is an explicit or implicit agreement between the subscriber, the company (often influenced by the subscriber), and the bank that the company will not be able to freely withdraw or use these "paid-in" funds until the subscriber has repaid their personal loan to the bank. This is sometimes referred to as a "non-withdrawal agreement" (不返還の合意 - fuhenkan no gōi). If this restriction on the company's access to the funds is significant in duration or scope, it effectively means the capital has not genuinely been made available for the company's use.

Japanese courts, when determining whether a payment is fictitious, typically consider factors such as:

• The length of time the paid-in funds actually remained at the company's free disposal.
• Whether the funds were genuinely used for the company's business operations.
• The overall financial impact on the company resulting from the series of transactions (e.g., whether the company was left without the substantive assets it was supposed to have received).

Essentially, if the arrangement ensures that the company never truly benefits from the subscribed capital as an operational asset, the payment is likely to be deemed fictitious.

The 2014 Companies Act Amendments: Addressing Fictitious Payments

While the concept of fictitious payments was recognized previously, the 2014 amendments to the Companies Act introduced specific statutory provisions to clarify the consequences and provide more direct remedies. The primary goals were to enhance legal certainty and address the harm caused by such practices, rather than merely to act as a deterrent for specific "unfair finance" schemes.

The key provisions relevant to fictitious payments for shares issued for subscription are:

1. Liability of Subscribers and Directors (Articles 213-2, 213-3)

• Liability of the Subscriber:
  • If a subscriber makes a fictitious monetary payment for shares, they remain liable to pay the company the full amount that was fictitiously paid (Article 213-2, paragraph 1, item 1).
  • If a subscriber makes a fictitious contribution in kind (i.e., feigns the delivery of non-cash assets), they are liable either to actually make the contribution of the promised assets or, if the company so demands, to pay the monetary value of those assets (Article 213-2, paragraph 1, item 2).
• Liability of Involved Directors and Executive Officers:
  • Directors and executive officers who were involved in (e.g., planned, executed, or knowingly permitted) the fictitious monetary payment or fictitious in-kind contribution are jointly and severally liable with the subscriber to pay the relevant amount (or monetary value of in-kind assets) to the company (Article 213-3, paragraph 1, main sentence).
  • Defense for Directors/Officers: These directors and officers can avoid this liability if they can prove that they were not negligent in the performance of their duties concerning the transaction (i.e., they exercised due care and were unaware of, or reasonably unable to prevent, the fictitious act) (Article 213-3, paragraph 1, proviso).
• Enforcement: These payment liabilities, owed by both the subscriber and culpable directors/officers, can be enforced by the company directly or through a shareholder derivative lawsuit (Article 847, paragraph 1), providing a mechanism for shareholder action if the company itself fails to pursue recovery.
• Consequences of Payment by Directors/Officers: If a director or officer fulfills this payment obligation to the company, the shares themselves still legally belong to the original subscriber or their transferee. The paying director/officer generally obtains a right of reimbursement against the defaulting subscriber under principles of subrogation or joint tortfeasor contribution (Civil Code Articles 500, 501).

2. Restriction on Exercise of Shareholder Rights (Article 209, paragraphs 2 and 3)

Recognizing that a shareholder who has not genuinely contributed capital should not enjoy full shareholder privileges, the Act imposes restrictions:

• Restriction on Subscriber: Until the subscriber (or involved directors/officers) fulfills the payment obligation arising from the fictitious transaction, the subscriber who made the fictitious payment cannot exercise shareholder rights with respect to those shares. This includes rights such as voting at shareholder meetings or receiving dividends (Article 209, paragraph 2).
• Restriction on Certain Transferees: This restriction on exercising rights also extends to subsequent transferees of these "tainted" shares if they acquired the shares with knowledge (in bad faith) of the fictitious payment or were grossly negligent in not knowing about it.
• Protection for Good Faith Transferees: Crucially, to maintain the fluidity and safety of share transactions in the broader market, a transferee who acquired shares (that were originally subscribed for via a fictitious payment) in good faith and without gross negligence regarding the fictitious payment can exercise full shareholder rights, even if the underlying payment deficiency owed by the original subscriber has not yet been rectified (Article 209, paragraph 3). This provision is vital for protecting innocent purchasers in the secondary market.

The Lingering Question: Are Shares Issued via Fictitious Payment Valid?

Despite the 2014 amendments clarifying liabilities and rights restrictions, the Companies Act does not explicitly state whether the shares issued through a fictitious payment are (a) valid from the outset, (b) completely non-existent as a matter of law, or (c) initially valid but subject to nullification by a court. This fundamental question about the legal status of the shares themselves remains a subject of significant academic debate in Japan.

The Nature of Fictitious "Payment"

Most legal scholars and prior case law (like the aforementioned 1963 Supreme Court decision) agree that a fictitious "payment" is legally ineffective as a payment that actually discharges the subscriber's obligation to pay the subscription price. It's a sham.

Impact on Share Validity – Three Main Theories

Given that the "payment" is a sham, what is the status of the shares purportedly issued against it?

1. Shares are Non-Existent (Fusonjai - 不存在 or Miseiritsu - 未成立): This theory holds that because a fundamental condition for share issuance (genuine payment/contribution) is missing in substance, the shares never legally come into existence. They are void ab initio.
   • Challenges for this theory: It creates significant difficulty in harmonizing with Article 209, paragraph 3, which expressly allows a good faith transferee to exercise shareholder rights. How can one exercise rights attached to shares that legally do not exist? Proponents might argue that Article 209(3) has a unique right-creating effect for such transferees, or that it creates a form of statutory estoppel against the company. Also, explaining why the original subscriber can subsequently gain rights upon fulfilling the payment (as implied by Art. 209(2)) becomes complex – perhaps they acquire a form of statutory option to perfect the shares.
2. Shares are Valid but Nullifiable: This theory posits that the shares are considered to have been validly issued, at least provisionally. However, the fictitious nature of the payment constitutes a serious defect in the issuance process, providing grounds for a court to nullify the share issuance if challenged in a lawsuit by the company or other shareholders. Such a lawsuit would typically need to be brought within a statutory period (one year for non-public companies, six months for public companies, from the date of issuance, under Article 828, paragraph 1, item 2).
   • Strengths of this theory: It more easily accommodates Article 209(3), as the shares exist (until nullified), allowing good faith transferees to acquire and exercise rights. The restriction on the original subscriber's rights is then seen as a temporary measure pending either rectification (payment) or nullification.
3. Shares are Fully Valid (No Nullity Ground): This theory argues that the shares are validly issued despite the fictitious payment, and the Companies Act's remedies are confined to the personal payment liabilities of the subscriber and involved directors (under Articles 213-2 and 213-3) and the temporary restriction on the subscriber's rights (under Article 209(2)). The shares themselves cannot be nullified solely on the basis of fictitious payment.
   • Strengths of this theory: It strongly prioritizes transactional stability and the status of issued shares, especially once they might have entered the market. Weakness: It may provide insufficient redress to the company and legitimate shareholders if the personal payment liabilities are uncollectible (e.g., due to insolvency of the liable parties), as the "phantom" shares would remain permanently in circulation.

The choice among these theories has significant practical implications for the scope and effectiveness of remedies, particularly the ability to definitively eliminate shares that were not genuinely paid for if the default persists. Scholarly debate continues, often weighing the need for robust shareholder/company protection against the desire for legal certainty and the protection of innocent third-party acquirers. Interpretive consistency with the new statutory provisions, especially Article 209(3) protecting good faith transferees, is a key consideration.

Why Fictitious Payments Undermine Corporate Finance

Fictitious payments for shares are not mere technical infractions; they strike at the heart of corporate financial integrity:

• Erosion of Capital Base: The company is deprived of the real economic resources that it is supposed to receive in exchange for issuing equity. This weakens its financial foundation, reduces its capacity for investment and operations, and diminishes its ability to absorb losses.
• Misleading Financial Statements: If the fictitious payment is not properly accounted for (which is often the intent of the scheme), the company's balance sheet will misleadingly show a higher level of paid-in capital and assets than actually exists. This can deceive creditors, potential investors, and other stakeholders about the company's true financial health and solvency.
• Unfair Dilution of Legitimate Shareholders: If shares issued against fictitious payments are treated as valid and their holders are allowed to exercise rights (especially after transfer to good faith third parties who are protected), the proportionate ownership and economic claims of legitimate shareholders who did contribute real capital are unfairly diluted without any corresponding increase in the company's actual assets.
• Market Integrity Concerns (for listed companies): Fictitious payment schemes involving listed companies can be part of broader efforts to manipulate stock prices, facilitate insider trading, or allow promoters to extract value from the company illicitly by selling unpaid-for shares into the market.

Conclusion

Fictitious payments for shares represent a serious threat to corporate financial probity and stakeholder trust in Japan. The 2014 amendments to the Companies Act have provided much-needed clarity by establishing direct personal liabilities for subscribers and culpable directors to make good on the feigned contributions, and by restricting shareholder rights associated with such shares until this deficiency is rectified. The protection afforded to good faith transferees is also a critical element for market stability.

However, the ultimate legal status of shares issued through fictitious payments—whether they are non-existent, voidable, or fully valid subject only to personal claims—continues to be a complex area of legal interpretation. A nuanced understanding of these rules, the underlying policy considerations, and the associated risks is essential for directors, subscribers, investors, and legal advisors involved with share subscriptions in Japanese companies to ensure compliance, maintain sound corporate governance, and protect the legitimate interests of all stakeholders.