Navigating Director Conflicts of Interest in Japan: What Constitutes a Prohibited Transaction and What Approval is Required?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

The integrity of corporate decision-making hinges on directors acting in the best interests of their company, free from personal conflicts that could sway their judgment. Japanese law, like that of many other jurisdictions, provides a framework to manage situations where a director's personal interests might diverge from those of the corporation they serve. The Japanese Companies Act (会社法 - Kaisha-hō) sets forth specific rules for what are known as "conflict of interest transactions" (利益相反取引 - rieki sōhan torihiki), mandating approval procedures and establishing director liability to protect the company and its shareholders.

Understanding this regime is crucial for directors serving on the boards of Japanese companies, as well as for businesses engaging with them, as it impacts transaction validity, director accountability, and overall corporate governance.

The cornerstone of conflict of interest regulation in Japan is Article 356, paragraph 1 of the Companies Act. This provision identifies two main categories of transactions that require specific approval:

  1. Direct Transactions (直接取引 - chokusetsu torihiki): This occurs when "a director intends to carry out a transaction with the Stock Company for himself/herself or for a third party" (Article 356, paragraph 1, item 2).
  2. Indirect Transactions (間接取引 - kansetsu torihiki): This applies when "a Stock Company intends to guarantee the obligations of a director or otherwise carry out a transaction with a person other than a director, which creates a conflict of interest between the Stock Company and said director" (Article 356, paragraph 1, item 3).

For a director to proceed with either type of transaction, they must first disclose material facts concerning the transaction to the board of directors and obtain its approval (Article 356, paragraph 1). In companies that do not have a board of directors (a common structure for smaller, non-public companies), this approval must generally be sought from a shareholders' meeting (Article 365, paragraph 1).

The legislative intent behind these provisions is to prevent directors from prioritizing their personal interests or those of a connected third party over the interests of the company, thereby averting potential harm to the corporation.

Defining "Direct Transactions": The "For Oneself or a Third Party" Conundrum

A key interpretive challenge in applying Article 356, paragraph 1, item 2 lies in the phrase "for himself/herself or for a third party" (自己又は第三者のために - jiko mata wa daisansha no tame ni). While various scholarly interpretations exist, a prominent view, often referred to as the "nominal theory" (名義説 - meigi-setsu), suggests that this phrase refers to transactions conducted in the name of the director or in the name of a third party whom the director might be representing or acting for.

Under this interpretation, clear examples of direct transactions include:

  • Director as Principal: Director A of Company X enters into a sales contract directly with Company X, where Director A is the other contracting party in their personal capacity.
  • Director Representing a Third Party: Director A of Company X also serves as the representative director of Company Y. Director A, acting on behalf of Company Y, causes Company Y to enter into a loan agreement with Company X. Here, the transaction is between Company X and Company Y (the third party), but Director A is acting "for" Company Y.

This contrasts with the "economic interest theory" (計算説 - keisan-setsu), which would focus more on whose economic benefit the transaction ultimately serves, regardless of the name under which it is formally conducted. The nominal theory provides a more formalistic and arguably clearer line for identifying direct conflicts requiring board scrutiny at the outset.

Unpacking "Indirect Transactions": Substance Over Form

Indirect transactions, as covered by Article 356, paragraph 1, item 3, address situations where the company is transacting with an external party (not the director themselves), yet a conflict still arises between the company's interests and those of one of its directors. The core idea is to capture substantive conflicts of interest that might not fall under the formal definition of a direct transaction but still pose a similar risk of detriment to the company.

The Companies Act itself provides the example of a company guaranteeing a director's debt. Other classic instances that legal scholarship and judicial precedent have recognized include:

  • Company Guaranteeing Director's Personal Debt: Company X guarantees a personal loan taken out by its Director A from a bank. Here, if Company X has to pay under the guarantee, it benefits Director A directly by discharging their debt, creating a clear conflict.
  • Company Guaranteeing Debt of a Director-Affiliated Entity: Company X guarantees a loan taken out by Company Y, where Director A of Company X is also the representative director, a controlling shareholder (e.g., holding 100% or over 50% of the shares), or otherwise in a position to significantly benefit from Company Y's improved financial standing. A notable Supreme Court decision on April 23, 1970 (Minshu Vol. 24, No. 4, p. 364), affirmed that such a guarantee constitutes a conflict of interest transaction requiring approval, even before indirect transactions were explicitly itemized in the statute as they are today. The rationale is that Director A has an incentive to cause Company X to undertake this risk for the benefit of Company Y (and indirectly, themselves).

A nuanced question arises regarding the extent of the conflicted director's involvement in the company's decision to enter into the indirect transaction. For instance, if Director A of Company X is the representative director of Company Y, and Company X guarantees Company Y's debt, does it matter if Director A recuses themselves entirely from Company X's decision-making process for that guarantee, with other directors of Company X making the decision?

  • One perspective (Theory (i) in the source material) suggests that for an indirect transaction to be triggered, the conflicted director should be directly involved in the transaction or in a position to readily influence its terms on behalf of the company.
  • Another, broader perspective (Theory (ii)) argues that the risk of the conflicted director influencing their fellow directors within the company (even informally) to approve a transaction favorable to the director's external interest is sufficient to bring it within the scope of an indirect conflict of interest. This aligns with the spirit of the law, which seeks to address potential, not just actual, abuse of position.

The prevailing trend seems to favor a substantive assessment of whether a director's external interests could plausibly impair their independent judgment concerning the transaction's benefits to the company.

The Approval Process: A Necessary Safeguard

When a transaction falls under Article 356, paragraph 1, the director seeking to engage in it, or the director whose interests conflict with the company's in an indirect transaction, has a duty to disclose all material facts concerning the proposed transaction to the board of directors (or shareholders' meeting, if applicable). This disclosure is critical for the approving body to make an informed decision.

Furthermore, a director who has a special interest in a board resolution cannot participate in the vote on that resolution (Article 369, paragraph 2). This rule naturally applies to a director whose own conflict of interest transaction is being considered for approval; they must abstain from voting to ensure the decision is made by disinterested directors. The approval itself must be by a majority of the attending directors who are entitled to vote.

Consequences of Non-Compliance and Director Liability

Failure to comply with the approval requirements for conflict of interest transactions, or engaging in such transactions in a manner that harms the company even if formally approved, can lead to significant legal consequences, primarily in the form of director liability.

Transaction Validity with Third Parties

It's important to note that a conflict of interest transaction entered into by a company without the requisite internal approval is not automatically void vis-à-vis the third party to the transaction. Generally, such a transaction remains valid unless the third party knew or was grossly negligent in not knowing about the director's breach of procedure (i.e., the lack of approval). However, the primary focus of the Companies Act in this area is the accountability of the directors to the company.

Director's Liability to the Company (Article 423)

Directors who breach their duties to the company, including those related to conflict of interest transactions, are liable for any damages suffered by the company as a result (Article 423, paragraph 1). The Companies Act includes specific provisions that ease the burden of proof for the company (or shareholders in a derivative suit) in these situations:

  1. Presumption of Breach of Duty (Article 423, paragraph 3): If a company suffers damage as a result of a transaction falling under Article 356, paragraph 1 (i.e., a conflict of interest transaction, whether it was approved or not), certain directors are presumed to have been negligent in the performance of their duties. This presumption applies to:
    • The director who engaged in the direct transaction or whose interests conflicted in an indirect transaction.
    • Any director who made the decision for the company to engage in the transaction.
    • Any director who voted in favor of the board resolution approving the transaction.
      These directors then bear the burden of proving that they were not, in fact, negligent (i.e., that they acted with the due care of a prudent manager) to avoid liability. This evidentiary rule underscores the heightened scrutiny applied to such transactions.
  2. Special (Stricter) Liability for Direct Transactions "For Oneself" (Article 428, paragraph 1): The Companies Act imposes an even stricter form of liability on a director who carries out a direct transaction "for himself/herself" (自己のために - jiko no tame ni) with the company. If the company suffers damages from such a transaction, that director cannot be exempted from liability by proving that they were not negligent with respect to the occurrence of the damages.
    • Meaning of "For Oneself": While the scope of direct transactions under Article 356(1)(ii) is often interpreted based on the "nominal theory" (in whose name), "for oneself" in Article 428(1) is generally understood to refer to transactions where the director personally stands to gain economically. If a director engages in a transaction in their own name but purely for the economic benefit of an unrelated third party, Article 428(1) might not directly apply, though other liability provisions could. Scholarly discussion suggests that Article 428(1) might be applied by analogy even in cases where the transaction is formally in a third party's name if the director is the substantive economic beneficiary (e.g., the director is the 100% shareholder of the third-party company).
    • Rationale: The policy behind this stricter liability is that if a director personally benefits from a transaction that harms the company, there is little justification for allowing the director to retain that benefit, even if they can argue they weren't technically negligent in how the damage arose. It aims to ensure that any such gains are disgorged to compensate the company.
    • Application Context: This provision is particularly relevant even if the transaction was formally approved by the board. The approval might protect against procedural claims but doesn't shield the director from this stricter liability if they transacted "for themselves" and caused damage. If the transaction was unapproved, the lack of approval itself is a breach of duty, and Article 428(1) further strengthens the company's position to recover damages from the self-dealing director.

Unapproved Transactions

If a director causes the company to enter into a conflict of interest transaction without obtaining the necessary board or shareholder approval, this failure to follow mandatory procedures is, in itself, typically considered a breach of their duties. The directors responsible for this procedural lapse can be held liable for ensuing damages.

Despite the statutory framework, grey areas persist, particularly in determining the outer boundaries of "indirect transactions" where the conflict is not immediately obvious. A director's involvement with multiple entities, complex shareholding structures, or close personal relationships can create scenarios where a potential conflict requires careful assessment.

To mitigate risks, companies are well-advised to:

  • Establish robust internal policies and guidelines for identifying and managing potential conflicts of interest.
  • Foster a corporate culture that encourages directors to proactively disclose any actual or potential conflicts.
  • Utilize independent directors, audit committees, or special committees of disinterested directors to scrutinize and approve conflict of interest transactions, thereby adding a layer of objective review.
  • Maintain thorough records of disclosures made and approvals granted.

Conclusion

The Japanese Companies Act provides a structured approach to addressing director conflicts of interest, balancing the need for companies to engage in legitimate transactions with the imperative to protect corporate assets and shareholder interests from directorial self-dealing. The distinction between direct and indirect transactions, coupled with mandatory approval processes and specific liability rules (including a stricter liability standard for direct self-dealing), forms the core of this regulatory regime.

For directors, a keen awareness of these rules and a commitment to transparency are paramount. For companies, implementing strong internal controls and seeking disinterested approval for such transactions are key to navigating this complex area and upholding high standards of corporate governance. While the legal provisions offer a framework, sound ethical judgment and transparent processes remain the most effective tools in managing the inherent challenges posed by directors' conflicts of interest.