How Does Japanese Law Regulate Director Conflict-of-Interest Transactions?

Directors of Japanese corporations (kabushiki kaisha) are bound by a duty of loyalty (忠実義務 - chūjitsu gimu), requiring them to act in the best interests of the company. A critical area where this duty comes into sharp focus is in transactions where a director's personal interests may conflict, or appear to conflict, with those of the company. Such conflict-of-interest transactions (利益相反取引 - rieki sōhan torihiki) are subject to specific regulations under the Japanese Companies Act (会社法 - Kaishahō) to protect the company and its shareholders from potential abuse and director self-dealing.

This article examines the legal framework in Japan for identifying, approving, and dealing with the consequences of director conflict-of-interest transactions.

The Statutory Framework: Companies Act Articles 356 and 365

The core provisions governing these transactions are found in Articles 356 and 365 of the Companies Act.

Article 356, Paragraph 1 outlines the types of transactions that trigger these regulations. A director must seek approval from the board of directors (or shareholders' meeting if the company does not have a board) for the following:

• Item 1: Competitive Transactions: When a director intends to carry out, for their own account or for the account of a third party, a transaction that falls within the company's line of business (discussed in a separate article).
• Item 2: Direct Conflict-of-Interest Transactions (自己取引 - Jiko Torihiki): When a director intends to carry out a transaction with the company for their own account or for the account of a third party. This is often referred to as "self-dealing."
• Item 3: Indirect Conflict-of-Interest Transactions (間接取引 - Kansetsu Torihiki): When the company intends to carry out a transaction with a third party, where the interests of the company and the director conflict. This typically covers situations where the company guarantees a director's debt, or engages in transactions with another entity in which the director has a significant personal or financial interest (e.g., a company controlled by the director or their close relatives).

Article 365, Paragraph 1 mandates that a director may only engage in transactions falling under Article 356, Paragraph 1, Items 1, 2, or 3 if they have disclosed "material facts" (重要な事実 - jūyō na jijitsu) concerning the proposed transaction to the board of directors and have obtained its approval.

Furthermore, Article 365, Paragraph 2 requires a director who has engaged in such a transaction (after obtaining approval) to report the material facts of that transaction to the board of directors without delay.

Identifying Conflict-of-Interest Transactions

Distinguishing between the types of transactions is crucial for understanding the application of these rules.

Direct Conflict-of-Interest Transactions (Article 356, Paragraph 1, Item 2)

These are transactions where the company is on one side and the director (or a third party for whom the director is acting) is on the other. Examples include:

• A director selling property to, or buying property from, the company.
• A director obtaining a loan from the company.
• A director, acting as an agent or representative for a third party, causes that third party to contract with the company.

The scenario in Problem 36 from the provided PDF offers a clear example. A1, the representative director of X社, orchestrates the sale of X社's land (本件土地) to B社. A2, another director of X社, is the representative director of B社. In this transaction, A2 is acting "for the account of a third party" (B社) in a transaction with X社. This squarely falls under Article 356, Paragraph 1, Item 2. The motive (A1's self-preservation - 保身目的 hoshin mokuteki) further underscores the conflict, although the rule applies regardless of benign intent if the structural conflict exists.

Scholarly interpretation generally holds that the "for oneself or a third party" criterion in direct transactions refers to the nominal party to the contract. If the director is the named counterparty, or is explicitly representing the counterparty, Item 2 applies.

Indirect Conflict-of-Interest Transactions (Article 356, Paragraph 1, Item 3)

These involve transactions between the company and an external third party, but where a director's personal interests are intertwined in such a way that they might improperly influence the company's decision-making. Common examples include:

• The company guaranteeing a director's personal loan from a bank.
• The company entering into a significant contract with another corporation in which one of its directors is a controlling shareholder or holds a key executive position (and is not merely acting as the nominal representative of that other corporation in the transaction itself, which might push it into Item 2 territory).

The key here is that the director's interest creates a situation where their duty of loyalty to the company could be compromised by their personal stake in the transaction's outcome, even if they are not a direct party to the contract.

The Board Approval Process: Disclosure and Resolution

To legitimize a transaction falling under Article 356, Paragraph 1, specific procedural safeguards must be met:

1. Disclosure of Material Facts: The concerned director (or directors proposing the transaction) must disclose all "material facts" regarding the transaction to the board. This is a critical step. While "material facts" are not exhaustively defined in the statute, they generally include:
   • The nature and terms of the proposed transaction.
   • The identity of all parties involved.
   • The extent of the director's personal interest (direct or indirect).
   • Any potential benefits or risks the transaction poses to the company.
   • Any information a reasonable director would consider important in deciding whether to approve the transaction.
     The disclosure must be sufficiently comprehensive and accurate to allow the other directors to make a fully informed judgment.
2. Board of Directors' Approval: The transaction must be approved by a resolution of the board of directors.
   • Voting Standard: Typically, an ordinary resolution is required, meaning a majority vote of the directors present at a meeting where a quorum is established (Article 369, Paragraph 1).
   • Exclusion of Interested Directors: Crucially, under Article 369, Paragraph 2, any director who has a "special interest" (特別の利害関係 - tokubetsu no rigai kankei) in the proposed resolution cannot participate in the vote. The director whose conflict is being considered is invariably deemed to have such a special interest. This rule is designed to ensure that the decision is made by disinterested directors. The non-participating interested director is not counted for quorum purposes regarding that specific resolution.

Failure to obtain this informed, disinterested board approval renders the transaction unauthorized and exposes both the involved director(s) and the transaction itself to legal challenge.

Consequences of Transactions Lacking Board Approval

The lack of proper board approval for a conflict-of-interest transaction has significant internal and external ramifications.

Internal Effect: Director's Liability to the Company

1. Breach of Duty of Loyalty and Care: Engaging in an unapproved conflict-of-interest transaction is a clear breach of the director's duty of loyalty (Article 355) and potentially the duty of care (Article 330, referencing Civil Code Article 644).
2. Liability for Damages (Article 423, Paragraph 1): The director(s) involved are liable to the company for any damages it suffers as a result of the unauthorized and potentially unfair transaction.
3. Presumption of Negligence (Article 423, Paragraph 3): For transactions falling under Article 356, Paragraph 1, Items 2 (direct conflicts) and 3 (indirect conflicts), as well as competitive transactions (Item 1), there's a statutory presumption of negligence. This means if the company incurs damages from such a transaction that lacked proper approval, the directors who engaged in or approved the transaction are presumed to have breached their duties. The burden shifts to them to prove they were not negligent.
4. Specific Liability for Direct Self-Dealing (Article 428): If a director enters into a direct transaction with the company for their own personal account (as opposed to acting for a third party, as A2 did in Problem 36 when acting for B社), Article 428 imposes a stricter form of liability. In such cases, if the company suffers damages, the director is liable unless they can prove that the transaction did not harm the company (e.g., it was on terms entirely fair to the company or that the company would have suffered the loss anyway). This provision establishes a near-strict liability standard for direct personal dealings that are unapproved or harmful. In Problem 36, since A2 was acting as representative director of B社 (a third party), this stricter Article 428 would not directly apply to A2's liability, though Article 423, Paragraph 3 would.

External Effect: Validity of the Transaction

The more complex issue concerns the validity of the unapproved conflict-of-interest transaction with the external party. Japanese law, guided by significant Supreme Court precedent, adopts a position of "relative invalidity" (相対的無効説 - sōtaiteki mukō-setsu).

This means an unapproved conflict-of-interest transaction is not automatically void ab initio (from the beginning) as against all parties. Instead:

• The Company's Position: The company can generally choose to either ratify the transaction (making it fully valid) or assert its invalidity.
• Against the Director and Knowing/Negligent Third Parties: The company can typically assert the invalidity of the transaction against the director involved and against any third party who was a party to the transaction if that third party knew (悪意 - akui) or was negligent in not knowing (有過失 - yukashitsu) about the lack of board approval or the conflicted nature of the deal. The Supreme Court judgment of October 13, 1971 (Showa 46), dealing with a promissory note issued by a company to its director without board approval, is a landmark case supporting this. While initially concerning a direct transaction, Justice Osumi's influential supplementary opinion in that case suggested extending the principle of protecting bona fide parties to general conflict-of-interest transactions involving third parties.
• Protection of Bona Fide Third-Party Transferees: If the property or rights involved in the unapproved transaction are subsequently transferred to a further third party (a transferee), that transferee is generally protected if they acquired the property in good faith and without gross negligence (善意無重過失 - zen'i mūjukashitsu). The exact standard (simple negligence vs. gross negligence) for the initial third party and subsequent transferees can sometimes be debated, but the underlying principle is to protect those who transact innocently and for value.

Applying to Problem 36:

• X社 vs. B社 (Initial Transaction): X社 sold its land to B社 (represented by X社's director A2) for half its market value, without X社 board approval, and for an improper motive on A1's part. B社, being represented by A2 (a director of X社), would almost certainly be deemed to have known, or at least been negligent in not knowing, about the lack of proper X社 board approval and the grossly unfavorable terms for X社. Therefore, X社 would likely be able to assert the invalidity of this land sale against B社.
• X社 vs. Y社 (Subsequent Transferee): B社 then sold the land to Y社 at market value. X社's ability to recover the land from Y社 depends on Y社's status.
  • If Y社 was a bona fide purchaser for value without knowledge or gross negligence regarding the defect in the X社-B社 transaction, Y社 would likely be protected, and X社 would be unable to recover the land from Y社. X社's recourse would be damages against its former directors A1 and A2.
  • However, the facts in Problem 36 state that A2 (director of X社 and representative of B社) and the representative director of Y社 are members of the same "secret society" (秘密結社). This strongly implies collusion or, at a minimum, that Y社 was not a bona fide purchaser without notice. If X社 can prove Y社's bad faith or gross negligence (i.e., that Y社 knew or should have known about the impropriety of the initial X社-B社 sale), then X社 could potentially assert the invalidity of the initial sale and seek the return of the land even from Y社. The fact that Y社 paid market value to B社 would not necessarily shield Y社 if it was not acting in good faith regarding the provenance of B社's title.

The ability of the company (X社) to assert invalidity is generally limited to the company itself. A third party (like Y社, if it were arguing that the X社-B社 transfer was invalid for some reason beneficial to Y社) usually cannot invoke the company's internal approval defect to challenge the transaction. The protection is for the company.

Comparison with U.S. Corporate Law

U.S. corporate law, particularly under statutes like Delaware General Corporation Law §144, also heavily regulates director conflict-of-interest transactions. There are parallels and differences:

• Disclosure and Approval: Both systems emphasize full disclosure of the conflict and approval by disinterested decision-makers. In the U.S., this often involves approval by a majority of disinterested directors or, alternatively, by a shareholder vote.
• Safe Harbors: U.S. law often provides "safe harbors": if a conflicted transaction is approved by fully informed, disinterested directors, or ratified by fully informed shareholders, or proven to be entirely fair to the corporation, it will generally be upheld. Japan's system focuses primarily on board approval by disinterested directors (after excluding the interested one from the vote). While shareholder ratification might be possible, it's not the primary statutory route for validating such a transaction initially.
• Fairness Standard: In the U.S., if a transaction is not cleansed by a safe harbor, it is typically subject to an "entire fairness" review by the courts, where the burden is on the conflicted director to prove both fair dealing (process) and fair price (substance). While fairness is implicitly a concern in Japan (e.g., an egregiously unfair transaction might lead to director liability even if formally approved, or make it easier to show a third party should have known of the defect), the statutory emphasis is more on the procedural approval.
• Remedies: Both systems provide for damages against the breaching director. The concept of voidability against knowing third parties also exists in U.S. law, though the specifics can vary by state.

Practical Implications

For companies operating in Japan and their directors:

1. Robust Internal Policies: Implement clear policies and procedures for identifying, disclosing, reviewing, and approving potential conflict-of-interest transactions.
2. Thorough Board Deliberations: Ensure that the board receives complete information about any proposed conflicted transaction and that discussions and decisions are meticulously documented in the minutes. Interested directors must be clearly identified and recused from voting.
3. Regular Training: Directors should be educated about their duty of loyalty and the rules surrounding conflict-of-interest transactions.
4. Third-Party Due Diligence: When a company is a third party transacting with another company where a conflict might exist (e.g., dealing with a company whose director is also on your board, or is substantially controlled by one of your directors), it's prudent to ensure that the counterparty has obtained proper internal approvals. This can mitigate the risk of the transaction being challenged later.

Conclusion

Japanese law provides a structured approach to regulating director conflict-of-interest transactions, centering on mandatory disclosure to the board of directors and approval by disinterested members of that board. While not rendering unapproved transactions automatically void, the law makes them vulnerable to challenge by the company, particularly against the conflicted director and third parties who were not acting in good faith. Directors who fail to adhere to these rules face significant personal liability for any resulting damages to the company. The overarching goal is to ensure that directors prioritize the company's interests above their own, thereby maintaining the integrity of corporate governance.