How is the Business Judgment Rule Applied to Directors in Japan?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

Directors of Japanese corporations (kabushiki kaisha) operate under significant legal duties, primarily the duty of care (善管注意義務 - zenkan chūi gimu, the duty of a good manager) owed to the company, as stipulated by Article 330 of the Companies Act (会社法 - Kaishahō), which incorporates Article 644 of the Civil Code. They also owe a duty of loyalty (忠実義務 - chūjitsu gimu) under Article 355 of the Companies Act. A breach of these duties that causes damage to the company can lead to personal liability for the directors under Article 423 of the Companies Act.

Given that business inherently involves risk and that decisions made with sound judgment at the time can appear flawed in hindsight, a strict application of liability could make directors overly cautious, stifling innovation and enterprise. To counteract this, Japanese courts have developed and apply a doctrine akin to the Business Judgment Rule (BJR) (経営判断の原則 - keiei handan no gensoku). This rule provides a degree of deference to directors' business decisions, shielding them from liability if certain conditions regarding their decision-making process and motivations are met.

The Rationale and Judicial Development of the BJR in Japan

The core purpose of the Business Judgment Rule in Japan is to encourage directors to undertake reasonable business risks for the benefit of the corporation without the constant fear of personal liability should those risks not materialize as hoped. It recognizes that courts are generally not business experts and should refrain from second-guessing legitimate business decisions made by informed and disinterested directors.

Unlike in some jurisdictions where the BJR might have a more explicit statutory basis or a very strong presumptive force, in Japan, it is primarily a judicially crafted doctrine. It has evolved through case law as courts interpret the scope of the director's duty of care. While earlier cases grappled with the standard of directoral scrutiny, a pivotal Supreme Court judgment on July 15, 2010 (Heisei 22) provided significant clarification. This ruling (in the context of a company's decision regarding a business restructuring plan) effectively endorsed a BJR-like approach by stating that directors will not be found in breach of their duty of care as long as their decision-making process and the content of their decision are not "grossly unreasonable" (著しく不合理 - ichijirushiku fugōri).

Another important Supreme Court case, dated January 28, 2008 (Heisei 20), involved a bank's lending decisions. While it found some directors liable for losses on a major loan, the court did so by focusing on severe deficiencies in the information gathering and deliberation process concerning that loan, rather than by explicitly rejecting the BJR as a concept. This highlights the judicial emphasis on the diligence of the decision-making process.

Core Elements for BJR Protection in Japan

For directors' decisions to receive the deference afforded by the BJR in Japan, several conditions must typically be met. These align with the general principles underlying the BJR internationally:

  1. Absence of Personal Interest / Good Faith: The directors must have made the decision without being tainted by self-interest, conflicts of interest, or bad faith. If a director stands to gain personally from a decision in a way that is separate from the company's interests, the BJR's protection is unlikely to apply, and the transaction might be subject to stricter scrutiny under conflict-of-interest rules.
  2. Informed Basis (情報の収集・分析の相当性 - Jōhō no Shūshū・Bunseki no Sōtōsei): Directors must have made reasonable efforts to gather and consider material information relevant to the business decision. This involves:
    • Actively seeking out necessary data.
    • Critically evaluating the information received.
    • Seeking expert advice (legal, financial, technical) when appropriate.
    • Allowing sufficient time for deliberation.
      A failure to become reasonably informed before making a decision is a key area where courts may find a breach of the duty of care, thereby negating BJR protection.
  3. Rational Belief / Rational Business Purpose (判断内容の合理性 - Handan Naiyō no Gōrisei): The decision itself must have a rational business purpose and not be so egregious or one-sided that no business person of ordinary, sound judgment would believe that the corporation has thereby attained some consideration of equivalent value or that it serves a legitimate corporate objective. The standard here is typically one of gross unreasonableness; courts will not simply substitute their own business judgment for that of the directors.

Judicial Scrutiny: The Bifurcated Approach to Process and Substance

Japanese courts, particularly in influential lower court decisions that have shaped the understanding of BJR, often adopt a bifurcated approach when reviewing director conduct:

  1. Scrutiny of the Decision-Making Process (意思決定の前提・過程 - Ishi Kettei no Zentei・Katei): This aspect receives more rigorous judicial attention. Courts will examine:If the decision-making process is found to be substantially flawed (e.g., based on demonstrably incorrect information that diligent inquiry would have revealed, or made with undue haste and insufficient deliberation), the BJR is unlikely to shield the directors.
    • Fact Recognition (事実の認識 - Jijitsu no Ninshiki): Were the facts upon which the decision was based accurately perceived? Did the directors overlook critical information or rely on flawed data without adequate verification? The PDF's commentary on Problem 41 notes that some lower court precedents apply a relatively strict standard when assessing the directors' diligence in recognizing the factual basis for their decisions.
    • Deliberation and Analysis: Was there sufficient discussion and analysis by the board? Were alternative courses of action considered? Was expert advice, if needed, appropriately obtained and evaluated?
  2. Scrutiny of the Substance of the Decision (意思決定の内容 - Ishi Kettei no Naiyō): Provided the decision-making process was sound and the directors were disinterested and acting in good faith, courts are generally highly deferential to the actual business merits of the decision. As affirmed by the Supreme Court judgment of July 15, 2010, the substance of the decision will typically only lead to liability if it is found to be "grossly unreasonable" (ichijirushiku fugōri). This means the decision must be so far afield of rational business judgment that it cannot be attributed to a mere error in judgment but rather to a reckless disregard or an inexplicable failure.

Illustrative Application: A Case Study of Banking Decisions (Problem 41)

The PDF's Problem 41 presents a scenario involving a bank ("A Bank") making two substantial loans to a company ("B Company") for a resort development project, which ultimately fails, leading to large unrecoverable debts for A Bank. A shareholder derivative suit is filed against A Bank's directors: Y₁ (President), Y₂ (Director of Deposit Operations), and Y₃ (Outside Director).

The First Loan (20 Billion Yen)

  • Context: B Company was performing well, its stock price was high. A Bank saw opportunities for its own business expansion through the relationship.
  • Information Presented to A Bank's Board:
    • Positive aspects: B Company's sales and profit growth, high stock price, A Bank's perceived ability to guide B Company, regional business development for A Bank.
  • Information Not Adequately Considered or Flaws in Process:
    • The risk that if B Company's stock (taken as collateral) had to be sold off en masse, its price could plummet.
    • Lack of concrete strategies to mitigate this collateral risk.
  • BJR Application:
    • Process: Was the board's information gathering sufficiently diligent regarding the risks associated with the collateral and B Company's reliance on a single large project? Did Y₁ present a balanced view, or was it overly optimistic? Y₂'s role in assessing B Company's overall financial stability (beyond deposits) might be questioned. Y₃, as an outside director, would be expected to ask probing questions about risk assessment. If the board's review of these risks was superficial, the "informed basis" prong of the BJR might be challenged.
    • Substance: At the time, given B Company's apparent strength, the decision to lend might not have been "grossly unreasonable" if the process deficiencies were not too severe. However, a significant failure in risk assessment during the process could undermine BJR protection.

The Second Loan (40 Billion Yen, 1.5 Years Later)

  • Context: B Company's stock price had fallen, collateral value was impaired, and B Company was projected to face a 90 billion yen capital deficit within two years. The resort project was struggling.
  • Information Presented to A Bank's Board:
    • Reasons for further lending: A Bank's deep involvement and perceived responsibility to see the project through, need to avoid chain bankruptcies in the region (A Bank as a leading regional bank), a new forecast that the resort could be profitable in 10 years.
  • Information Not Adequately Considered or Flaws in Process:
    • Lack of concrete, detailed analysis of the resort's future hotel occupancy rates and revenue projections. The 10-year profitability forecast appears to have been accepted without rigorous scrutiny.
    • The decision was framed as providing "minimum necessary funds" for B Company's "life support" until the hotel opened, suggesting a high-risk, defensive loan.
  • BJR Application:
    • Process: The information gathering seems even more critical here. Was the 10-year profitability forecast credible and based on robust assumptions, or was it a hopeful projection accepted without due diligence? Did the board fully explore alternatives to further massive lending, such as immediate workout procedures or a more limited form of support? The pressure to avoid regional economic fallout is a factor, but it doesn't excuse a lack of diligent inquiry into the viability of the new loan.
    • Substance: Lending an additional 40 billion yen to a company already known to be in severe financial distress and facing a massive capital deficit requires exceptionally strong justification. If the board approved this loan based on poorly substantiated recovery plans, the decision itself could be challenged as "grossly unreasonable," even if some altruistic motives (like preventing wider economic harm) were present. The primary duty is to A Bank itself.

For directors like Y₂ (deposit operations) and Y₃ (outside director), their liability would depend on their specific involvement, access to information, and actions (or inactions) during the board deliberations for both loans. Outside directors, while not involved in day-to-day management, are still expected to exercise due care in reviewing major decisions, asking critical questions, and, if necessary, opposing imprudent actions.

The BJR in Specific Contexts

Financial Institutions' Lending Decisions

There has been considerable debate in Japan about whether directors of financial institutions should be held to a higher or different standard of care when making lending decisions, given the public nature of banking and the potential systemic impact of bank failures. The PDF's commentary on Problem 41 notes this discussion. While the BJR as a general principle applies, the application of the "informed basis" and "rational belief" prongs might implicitly require a more rigorous approach to risk assessment and due diligence for bank directors compared to directors in some other industries, due to the nature of their business. Courts may scrutinize the quality of credit analysis and risk management processes more intensely.

Scope of BJR Protection

It's important to remember that the BJR generally does not protect directors from liability for:

  • Decisions tainted by fraud, illegality, or self-dealing (conflicts of interest).
  • A complete failure to exercise any business judgment (e.g., abdicating responsibility).
  • Gross negligence in oversight leading to sustained illegal activity by the company (though the BJR might protect specific decisions made to address such a crisis if those decisions meet BJR criteria).

Comparing the Japanese and U.S. Business Judgment Rules

The Japanese BJR shares fundamental similarities with its U.S. counterpart:

  • Core Purpose: Both aim to protect directors from liability for honest errors in judgment, encourage informed risk-taking, and prevent judicial second-guessing of business decisions.
  • Key Conditions: Both require directors to act in good faith, on an informed basis, and without disabling conflicts of interest.

Potential differences can lie in:

  • Presumption: The U.S. BJR is often described as creating a strong presumption that directors have acted properly. While Japanese courts are deferential, the "presumption" might not be as formally articulated or as difficult for plaintiffs to overcome in all circumstances, especially if process flaws are evident.
  • Standard for Rebuttal/Substantive Review: The "grossly unreasonable" standard in Japan for the substance of a decision is comparable to the "rational basis" or "waste" standards in some U.S. formulations, all of which are highly deferential.
  • Emphasis on Process: Japanese courts, particularly following the influential lower court trend and the nuance in Supreme Court cases, seem to place a very strong, perhaps even primary, emphasis on the adequacy of the decision-making process. A flaw in the process of becoming informed can more readily remove BJR protection than in some U.S. analyses where a substantively sound decision might sometimes overcome minor process glitches.

Conclusion

The Business Judgment Rule, as applied by Japanese courts, provides crucial protection for corporate directors, allowing them to navigate complex business environments and make difficult decisions without undue fear of personal liability for outcomes that are unfavorable in hindsight. However, this protection is not absolute. It is contingent upon directors diligently fulfilling their duties to act in good faith, to make decisions on a reasonably informed basis after adequate investigation and deliberation, and to ensure their decisions have a rational business purpose. The emphasis on a sound decision-making process is particularly notable in Japanese jurisprudence. While courts will generally defer to the substance of a business decision made under these conditions, a failure to meet these procedural and ethical prerequisites can expose directors to liability for resulting corporate losses.