How Are Conflicts of Interest and Related-Party Transactions Managed in Japanese Corporate Law?

Japanese Attorney at Law - Bengoshi L.L.

• 9 min read

Conflicts of interest and related-party transactions are inherent challenges in corporate governance globally. In Japan, a framework rooted in the Companies Act (会社法 - Kaisha-hō), augmented by securities regulations and the principles of the Corporate Governance Code (CG Code), aims to manage these situations to protect the interests of the company and its shareholders, particularly minority shareholders. For US corporate legal professionals and business people engaging with Japanese entities, understanding this framework is crucial for navigating potential complexities and ensuring sound governance.

The Companies Act lays down specific rules governing situations where a director's personal interests might diverge from those of the company. These rules are built upon the fundamental fiduciary duties of directors.

A. Director's Duty of Loyalty (忠実義務 - Chūjitsu Gimu) (Article 355)
This overarching duty requires directors to act faithfully for the benefit of the company. It forms the bedrock for regulating specific conflict situations, compelling directors to prioritize corporate interests over personal gain.

B. Specific Regulations for Conflict-of-Interest Transactions (利益相反取引 - Rieki Sōhan Torihiki)
Article 356, paragraph 1 of the Companies Act specifically addresses two main categories of transactions where a director might have a conflict of interest:

  1. Competitive Transactions (競業取引 - Kyōgyō Torihiki) (Article 356, para. 1, item 1):
    • Definition: This occurs when a director intends to engage in a transaction that falls within the scope of the company's business, either for their own account or for the account of a third party. For example, a director of Company A setting up or working for Company B, which competes directly with Company A.
    • Requirement for Disclosure and Approval: Before undertaking such a transaction, the director must disclose all material facts about the proposed competitive transaction to the board of directors (or to the shareholders' meeting if the company does not have a board) and obtain its approval.
    • Post-Transaction Reporting: If the transaction is approved and undertaken, the director who conducted it must report the important facts concerning the transaction to the board of directors without delay (Article 365, para. 2, for companies with a board).
    • Liability for Damages: If a director engages in a competitive transaction without the required approval and causes damage to the company, they are liable for such damages. Furthermore, any profit earned by the director (or the third party for whom they acted) from an unapproved competitive transaction is presumed to be the amount of damage suffered by the company (Article 423, para. 2).
  2. Self-Dealing Transactions (自己取引 - Jiko Torihiki) (Article 356, para. 1, items 2 & 3):
    These are transactions where a director is on both sides of the deal, or where their personal interests are directly pitted against the company's. The Companies Act distinguishes between:
    • Direct Self-Dealing (直接取引 - Chokusetsu Torihiki) (Item 2): When a director intends to enter into a transaction directly with the company for their own account or for the account of a third party. Examples include a director selling their personal property to the company, the company lending money to a director, or a director purchasing assets from the company.
    • Indirect Self-Dealing (間接取引 - Kansetsu Torihiki) (Item 3): When the company engages in a transaction with a third party, but the transaction creates a conflict of interest with one of its directors. Common examples include the company guaranteeing a director's personal debt to a third party, or the company taking on a director's debt.
    • Requirement for Disclosure and Board Approval: Similar to competitive transactions, the director must disclose all material facts about the proposed self-dealing transaction to the board of directors (or shareholders' meeting) and obtain its approval. The interested director is excluded from participating in the vote on the approval (Article 369, para. 2).
    • Consequences of Non-Approval: A transaction entered into without the requisite approval may be voidable by the company against the director or a third party who was aware (or should have been aware) of the lack of approval.
    • Director's Liability (Article 423, para. 3): If a director engages in a self-dealing transaction (even one approved by the board under Article 356), and the company suffers damages as a result, the director who engaged in the transaction is liable for those damages. Furthermore, any directors who approved the transaction are also presumed to have been negligent in their duties unless they can prove they acted with due care. This presumption of negligence for approving directors is a significant feature aimed at ensuring careful scrutiny by the board. The transacting director's liability under this provision is strict in many interpretations if damage occurs, meaning they are liable even if they were not negligent, unless specific conditions for exemption are met.

It is crucial to note that the scope of "third party" for whose benefit a director might act in these conflict situations is interpreted broadly and can include entities controlled by the director or their close relatives.

While Article 356 focuses on specific conflict-of-interest transactions involving directors, the broader concept of "related-party transactions" encompasses a wider range of dealings that require careful management and disclosure.

  • Definition: Related-party transactions are those between a company and its related parties. Related parties can include:
    • Directors and their close family members.
    • Major shareholders (those holding a significant percentage of voting rights, often 10% or more).
    • The parent company, subsidiaries, and fellow subsidiaries (affiliates).
    • Key management personnel.
    • Entities significantly influenced by any of the above.
  • Governance Concerns: The primary concern with related-party transactions is that they may not be conducted on an arm's-length basis, potentially leading to the transfer of value away from the company or its minority shareholders to the related party. Such transactions can also obscure the true financial position and performance of the company if not properly disclosed.

III. The Role of the Corporate Governance Code (CG Code)

Japan's Corporate Governance Code places significant emphasis on the proper management of conflicts of interest and related-party transactions.

  • Principle 1-7 (Related Party Transactions): The 2021 revised CG Code states: "When conducting transactions with related parties, the company should, in order to ensure that such transactions do not harm the interests of the company or its common shareholders and to prevent any concerns in this regard, establish and disclose procedures for their approval by the board of directors, including ensuring the involvement of independent outside directors in supervising these transactions."
  • Key Expectations from the CG Code:
    • Establishment of Procedures: Companies should have clear internal procedures for identifying, reviewing, approving, and monitoring related-party transactions.
    • Board Oversight: The board of directors is ultimately responsible for overseeing these transactions.
    • Involvement of Independent Elements: The Code stresses the importance of independent outside directors in the supervision and approval process. This might involve requiring their affirmative vote or review by a committee composed mainly of independent directors.
    • Ensuring Fairness and Rationality: The underlying goal is to ensure that all related-party transactions are conducted on terms that are fair to the company and are commercially reasonable.
    • Transparency: Appropriate disclosure of these procedures and material transactions is crucial.

Japanese companies employ various mechanisms, combining legal requirements with governance best practices, to manage these sensitive transactions:

  • Robust Board Approval Processes:
    • Full Disclosure to the Board: The interested director (or management proposing the transaction) must provide comprehensive information to the board regarding all material aspects of the proposed transaction, including its terms, purpose, necessity, and potential risks and benefits to the company.
    • Exclusion of Interested Directors: As mandated by the Companies Act (Article 369, para. 2), any director who has a special interest in a proposed board resolution (which would include a director involved in a conflict-of-interest transaction) cannot participate in the vote on that resolution. They may also be asked to leave the room during deliberations to ensure open discussion.
    • Substantive Review: The board (particularly its independent members) is expected to critically assess the transaction for its fairness to the company, whether it is on arm's-length terms, and whether it serves a legitimate corporate purpose.
  • Enhanced Role of Independent Outside Directors: Independent outside directors are seen as key guardians against abusive related-party transactions. Their objectivity and independence from management and controlling shareholders allow them to provide critical scrutiny. They are often expected to take a leading role in questioning and evaluating such transactions.
  • Oversight by Statutory Auditors or Committees:
    • Statutory Auditors (Kansayaku): In companies with a statutory auditor system, auditors oversee the legality of directors' actions, which includes compliance with procedures for approving conflict-of-interest transactions. They can investigate suspicious transactions and report findings to shareholders.
    • Audit Committee / Audit & Supervisory Committee: In companies with committee-based governance, these committees (typically with a majority of independent outside directors) play a significant role in overseeing internal controls related to financial reporting, which includes the proper accounting and disclosure of related-party transactions. They may also be involved in reviewing the appropriateness of such transactions.
  • Voluntary Establishment of Special Committees: To further enhance objectivity, some companies, especially those with a controlling shareholder or a high volume of material related-party transactions, voluntarily establish special committees composed primarily or exclusively of independent outside directors. These committees are tasked with reviewing and opining on proposed related-party transactions before they go to the full board for approval.
  • Obtaining Third-Party Valuations or Fairness Opinions: For significant transactions, especially those involving assets with subjective valuations or complex terms, companies may obtain valuations or fairness opinions from independent third-party experts (e.g., investment banks, accounting firms). This provides the board with an objective benchmark for assessing the fairness of the transaction terms.
  • Clear Internal Rules and Procedures: Many companies develop and implement detailed internal rules and codes of conduct regarding the identification, approval, monitoring, and disclosure of conflicts of interest and related-party transactions. These rules often define materiality thresholds for requiring board review and specify the information to be provided.

V. Disclosure Requirements

Transparency is a cornerstone of managing related-party transactions. Key disclosure requirements include:

  • Companies Act (Business Report - 事業報告 - Jigyō Hōkoku): The annual business report, which is part of the materials for the shareholders' meeting, must disclose certain significant transactions between the company and its directors (e.g., Article 356 transactions that were approved).
  • Financial Instruments and Exchange Act (FIEA) (Annual Securities Report - 有価証券報告書 - Yūka Shōken Hōkokusho): For listed companies, the FIEA and related cabinet office ordinances mandate detailed disclosure of related-party transactions in the notes to the financial statements. This includes:
    • The nature of the related-party relationship.
    • A description of the transaction.
    • The transaction amounts.
    • Outstanding balances at the period end.
    • Terms and conditions of the transaction, including whether it was at arm's length.
    • Allowances for doubtful accounts related to balances with related parties.
      The scope of "related parties" for these disclosure purposes is broad and defined by accounting standards.
  • Corporate Governance Report: As per the CG Code, companies should disclose their policies and procedures for managing related-party transactions. This includes explaining how they ensure the fairness and appropriateness of such dealings and the role of independent directors or committees.
  • Stock Exchange Rules: The Tokyo Stock Exchange and other exchanges also have rules requiring timely disclosure of certain material related-party transactions.

VI. Specific Challenges and Considerations

  • Transactions with Controlling Shareholders: These transactions carry a heightened risk of abuse of minority shareholders. The CG Code specifically advises companies with controlling shareholders to take measures to protect minority interests, such as ensuring a sufficient number of independent directors (e.g., a majority, or at least one-third under certain conditions for Prime Market companies) or establishing a special committee composed of independent persons to review material transactions with the controlling shareholder.
  • Intra-Group Transactions: In complex corporate groups with numerous subsidiaries and affiliates, managing transactions between group companies to ensure fairness to each entity (and its respective minority shareholders, if any) can be challenging. Robust group governance policies are essential.
  • Defining "Materiality" and "Conflict": Determining precisely what constitutes a "material" transaction requiring specific approval or disclosure, or what constitutes a "conflict of interest" that could impair a director's judgment, can sometimes involve complex factual and legal assessments. Companies often establish internal thresholds and seek legal advice.
  • Substance over Form: The focus is increasingly on the substance of transactions rather than just formal compliance. Even if a transaction does not fall squarely within the legal definition requiring board approval under Article 356, if it substantively creates a conflict or poses risks to minority shareholders, good governance would dictate careful review and appropriate oversight.

VII. Enforcement and Consequences of Improper Management

Failure to properly manage conflicts of interest and related-party transactions can lead to various adverse consequences:

  • Director Liability: As discussed, directors can be held liable to the company for damages resulting from breaches of their duty of care or loyalty, including those arising from improperly approved or unfair conflict-of-interest transactions (Article 423).
  • Nullification of Transactions: Transactions conducted in severe violation of approval procedures, or those that are manifestly unfair to the company, may be subject to legal challenge and potentially nullified.
  • Reputational Damage: Scandals involving self-dealing or unfair related-party transactions can severely damage the reputation of the company and its management, eroding investor and public trust.
  • Regulatory and Stock Exchange Scrutiny: Regulators (like the Financial Services Agency or the Securities and Exchange Surveillance Commission) and stock exchanges monitor related-party disclosures and can impose sanctions or penalties for non-compliance or misleading disclosures.
  • Shareholder Activism: Improperly managed related-party transactions are often a target for shareholder activists, who may launch campaigns demanding governance improvements, board changes, or even legal action.

Conclusion

Japanese corporate law and governance principles provide a multi-layered framework for managing conflicts of interest and related-party transactions. This framework combines specific legal prohibitions and approval requirements under the Companies Act with broader principles of transparency, board oversight, and independent scrutiny promoted by the Corporate Governance Code. The overarching goal is to ensure that directors act in the best interests of the company, that transactions are conducted on fair and reasonable terms, and that the interests of all shareholders are adequately protected. While legal compliance forms the baseline, a proactive and robust approach to identifying, evaluating, approving, and disclosing these sensitive transactions is increasingly viewed as a hallmark of strong corporate governance in Japan.