What Constitutes a Breach of a Director's Duty of Non-Competition in Japan?

Directors of Japanese corporations (kabushiki kaisha) stand in a fiduciary relationship with their company. This relationship imposes several key duties, paramount among them being the duty of loyalty (忠実義務 - chūjitsu gimu) and the duty of care (善管注意義務 - zenkan chūi gimu). A specific and critical manifestation of these broader duties is the director's duty of non-competition. This duty is designed to prevent directors from leveraging their position, knowledge, or corporate resources to engage in activities that compete with the company, thereby potentially harming the company's business interests.

Understanding the scope, procedural requirements, and consequences associated with this duty is vital for directors, the companies they serve, and any entities that might engage with directors in their personal capacities. This article delves into the Japanese legal framework governing a director's duty of non-competition.

The Statutory Framework: Companies Act Articles 356 and 365

The primary statutory provisions governing a director's duty of non-competition in Japan are found in the Companies Act (会社法 - Kaishahō).

Article 356, Paragraph 1, Item 1 sets the stage by identifying a "competitive transaction." It stipulates that a director must disclose material facts to the board of directors and obtain its approval if the 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" (株式会社の事業の部類に属する取引 - kabushiki kaisha no jigyō no burui ni zokusuru torihiki).

Article 365, Paragraph 1 reinforces this, stating that a director may engage in such a transaction (as described in Article 356, Paragraph 1, Item 1) only if they have disclosed material facts concerning said transaction to the board of directors and have obtained its approval. This approval typically requires an ordinary resolution of the board.

Furthermore, Article 365, Paragraph 2 imposes a post-transaction obligation: a director who has engaged in an approved competitive transaction must report the material facts of that transaction to the board of directors without delay.

These provisions collectively aim to ensure transparency and allow the company, through its board, to assess and manage potential conflicts arising from a director's competitive activities.

Defining a "Competitive Transaction"

The application of the non-competition duty hinges on what constitutes a "competitive transaction." This involves interpreting two key phrases: "company's line of business" and "for oneself or a third party."

"Company's Line of Business" (会社の事業の部類に属する取引)

This phrase is crucial in determining whether a director's proposed transaction requires board approval. Courts interpret "company's line of business" by considering:

1. Actual Business Activities: The most straightforward interpretation includes the business activities the company is currently engaged in.
2. Stated Business Purposes: The company's objects or business purposes as stated in its articles of incorporation (定款 - teikan) are relevant, though not solely determinative. A company may not be actively pursuing all its stated objects.
3. Planned Business Expansion: This is a more nuanced area. If a company has concrete plans to expand into a new product line, service, or geographical market, a director's transaction in that area could be deemed competitive. The mere abstract possibility of future expansion is usually insufficient; there must be some tangible evidence of planning or preparation. For example, a Tokyo District Court judgment on March 26, 1981 (Showa 56), indicated that if a company has progressed to the stage of market research for entry into a specific region, a director setting up a similar business in that same region could be considered engaging in a competitive transaction.
4. Nature of Goods/Services and Market: Competition is assessed based on whether the director's transaction involves goods or services that are the same as, or substitutable for, those offered by the company, and whether they target the same or overlapping customer base or market segment.

Consider the scenario outlined in the PDF's Problem 34: Y is the representative director of X社, a company manufacturing and selling snack foods primarily in the Kansai region. X社 is conducting market research to expand into the Tokai region. Y, without X社 board approval, establishes A社, which Y wholly owns (his wife is the representative director). A社 then acquires land in Hamamatsu (Tokai region), using information Y likely obtained through X社, and begins manufacturing and selling fried rice crackers, a type of snack food, in the Tokai region.

In this case, A社's business (fried rice crackers in Tokai) would likely be considered within X社's "line of business." Even if X社 isn't currently selling fried rice crackers or operating in Tokai, its existing snack food business and its concrete market research for Tokai expansion make A社's activities directly competitive. The specific type of snack might differ slightly, but they would likely appeal to similar consumer segments and distribution channels.

"For Oneself or a Third Party" (自己又は第三者のために)

This element addresses whose interests the director is serving through the competitive transaction.

• For Oneself (自己のために - Jiko no tame ni): This is when the director personally engages in the competitive business or is the direct beneficiary of the transaction.
• For a Third Party (第三者のために - Daisansha no tame ni): This occurs when the director facilitates or engages in a competitive transaction that benefits another individual or entity. This often involves situations where the director has a significant interest in the third party, such as being a major shareholder, director, or having close family ties to its management.

In Problem 34, Y establishes A社. Although Y is not the representative director of A社 (his wife is), Y wholly owns A社 and effectively controls it. Japanese courts and scholars often apply a "substantial interest" or "calculation" test (実質説 - jisshitsu-setsu, or 誰の計算において - dare no keisan ni oite, meaning "on whose account"). If the transaction is, in substance, conducted for the director's economic benefit, even if formally through a third party like a spouse's company or a director's own separate entity, it falls under this prong. Thus, Y's actions in establishing and operating A社 would be considered "for oneself" due to his 100% ownership and effective control, making A社's competitive activities subject to Article 356.

The Board Approval Process

When a director proposes to engage in a competitive transaction, they must:

1. Disclose Material Facts: The director must provide the board of directors with all "material facts" (重要な事実 - jūyō na jijitsu) concerning the proposed transaction. This includes the nature of the transaction, its scope, the parties involved, the director's interest in it, and any potential impact on the company. The disclosure must be sufficiently detailed to enable the board to make an informed decision.
2. Obtain Board Approval: The transaction must be approved by a resolution of the board of directors. This is typically an ordinary resolution (requiring a majority of attending directors, who themselves constitute a quorum, to vote in favor – Article 369, Paragraph 1).
3. Exclusion of Interested Directors: Under Article 369, Paragraph 2, a director who has a "special interest" (特別の利害関係 - tokubetsu no rigai kankei) in a resolution cannot participate in the vote on that resolution. A director seeking approval for their own competitive transaction would almost certainly be considered to have a special interest and thus be barred from voting on the approval.

Failure to follow this approval process renders the competitive transaction unauthorized.

Consequences of an Unauthorized Competitive Transaction

If a director engages in a competitive transaction without the required board approval, several consequences can follow:

1. Director's Liability for Damages (Article 423, Paragraph 1)

The primary remedy for the company is to hold the director liable for any damages it suffers as a result of the unauthorized competitive transaction. This falls under the general director's liability provision, Article 423, Paragraph 1 of the Companies Act. The company would need to prove the director's breach of duty (engaging in competition without approval), the damages suffered, and the causal link.

2. Presumption of Damages – The "Right of Intervention" Effect (Article 423, Paragraph 2)

A significant provision in this context is Article 423, Paragraph 2. It states that if a director, in breach of Article 356, Paragraph 1 (which includes the non-competition rule), carries out a transaction for their own account or for the account of a third party, the amount of profit gained by the director or the third party through that transaction is presumed to be the amount of damage suffered by the company.

This provision is often referred to as having an effect similar to a "right of intervention" (介入権 - kainyūken), although it's technically a rule for presuming damages. It allows the company to effectively claim or "disgorge" the profits made by the director (or a third party for whom the director acted) from the unauthorized competitive activity.

• How the Presumption Works: The company needs to establish the breach of the non-competition duty and the amount of profit earned from the competitive transaction. Once these are shown, the profit is presumed to be the company's damage. The burden then shifts to the director to rebut this presumption, for example, by proving that the company would not have made those profits even if the director had not competed, or that the actual damage was less.
• Calculating "Profit": Determining the "profit" can be complex. It generally refers to the net profit after deducting relevant expenses. However, courts may look beyond formally reported profits. For instance, if the competing entity (like A社 in Problem 34) is structured to show little or no profit, but the director (or closely related parties) extracts value in other ways (e.g., excessive salaries, personal expenses paid by the competing entity), these amounts might be considered part of the "profit" subject to the presumption. The PDF commentary for Problem 34 alludes to a Nagoya High Court judgment of April 17, 2008 (Heisei 20), where even if the competing company itself was unprofitable, remuneration paid to its representative (who was the wife of the breaching director) could be considered part of the profit attributable to the director's breach.

In Problem 34, if Y engaged in competition through A社 without X社's board approval, X社 could sue Y for damages. The profits earned by A社 (or by Y through A社, including potentially the excessive remuneration to his wife as A社's representative director if A社 itself was not profitable) would be presumed to be X社's damages.

3. Injunctive Relief (差止請求 - Sashitome Seikyū)

While the Companies Act does not provide a specific statutory right for the company or shareholders to seek an injunction solely based on a breach of Article 356/365, such relief might be obtainable under general principles. If a director is actively engaging in unauthorized competition, the company could potentially seek a court order to compel the director to cease the competing activity based on their overarching duty of loyalty. Shareholders might pursue this through a derivative suit, demanding the company enforce its rights against the director.

4. Dismissal of the Director

A breach of the duty of non-competition is a serious breach of a director's fiduciary duties and can constitute "just cause" for their dismissal by a resolution of the shareholders' meeting (Article 339).

5. Validity of the Competitive Transaction Itself (with Third Parties)

Generally, a director's breach of the internal duty of non-competition by engaging in an unauthorized transaction with an external third party does not, by itself, render the transaction with that third party invalid. This is to protect the security of transactions and bona fide third parties who may be unaware of the director's internal breach. The remedies for the company lie primarily against the breaching director.

Related Breaches: Employee Poaching and Misappropriation of Corporate Opportunity

The duty of non-competition under Article 356 is specific. However, a director's actions can also breach broader fiduciary duties, such as the duty of loyalty and duty of care, even if they don't perfectly fit the definition of a competitive transaction under Article 356. The scenario in Problem 34 raises two such related issues:

Employee Poaching

In Problem 34, Y causes several of X社's skilled employees to resign from X社 and join A社. The act of luring away key employees of the company to a competing business controlled by the director can be a separate breach of the director's duty of loyalty. The PDF's commentary references a Tokyo High Court judgment of October 26, 1989 (Heisei Gan), which found that luring away key personnel like programmers (who were considered vital assets for a software company) constituted a serious breach of loyalty. For X社, its skilled snack food technicians could similarly be considered valuable assets, and Y's act of poaching them for A社 could lead to liability for the damage X社 suffered due to their departure (e.g., disruption, loss of expertise, costs of replacement).

Misappropriation of Corporate Opportunity (会社の事業機会の奪取)

In Problem 34, Y uses information regarding suitable land in Hamamatsu (本件土地), likely acquired through his position at X社 during its Tokai expansion research, for the benefit of his own company, A社. While Japan does not have a formally codified "corporate opportunity doctrine" in the same way as some U.S. states, the director's overarching duty of loyalty (忠実義務 - chūjitsu gimu - Article 355) and duty of care (善管注意義務 - zenkan chūi gimu - Article 330, referencing Civil Code Article 644) can be used to address such situations. If a director diverts a business opportunity that rightfully belongs to the company, or one that the company is actively pursuing or has a clear interest and expectancy in, for their own benefit or for a third party, this can constitute a breach of these duties. The PDF's commentary for Problem 34 suggests that taking a corporate opportunity in this manner can be a breach of loyalty and good faith. X社 could potentially claim damages from Y for the lost opportunity related to the Tokai expansion, including the value of the land or the profits X社 might have made.

Comparison with U.S. Law

The Japanese director's duty of non-competition shares the same fundamental purpose as related doctrines in U.S. corporate law, such as the duty of loyalty and the corporate opportunity doctrine: to ensure directors prioritize the company's interests over their own when conflicts arise.

However, the mechanics differ. Japan relies on a specific statutory requirement for board disclosure and approval for transactions within the company's line of business (Articles 356 and 365). The U.S. approach, particularly for corporate opportunities, is largely common law-based and involves various tests developed by courts (e.g., "interest or expectancy" test, "line of business" test, "fairness" test) to determine if an opportunity belongs to the corporation.

The remedy under Article 423, Paragraph 2 of the Japanese Companies Act, which presumes the director's profit from an unauthorized competitive transaction to be the company's damages, is a powerful tool for the company. It has an effect comparable to disgorgement remedies or the imposition of a constructive trust in U.S. law, though its formulation as a presumption of damages is distinct.

Practical Considerations for Companies and Directors

To mitigate risks associated with the duty of non-competition:

• Clear Company Policies: Companies, especially those with directors involved in multiple ventures, should consider establishing clear internal policies regarding outside business activities and potential conflicts.
• Thorough Disclosure: Directors must be diligent in disclosing any potential competitive activities or interests to the board in a timely and comprehensive manner.
• Proper Board Approval: The board must carefully review such disclosures, ensure the interested director recuses themselves from voting, and properly minute its decision if approval is granted. The reasons for approval should be well-documented.
• Post-Transaction Reporting: Directors who engage in approved competitive transactions must remember their statutory duty to report back to the board.
• Articles of Incorporation: While the default is board approval, for non-board-managed companies, shareholder approval would be needed, and articles can sometimes modify these procedures (within limits).

Conclusion

The director's duty of non-competition is a cornerstone of corporate governance in Japan, safeguarding the company's legitimate business interests from self-dealing by its fiduciaries. Directors must navigate potential conflicts with transparency and adherence to the statutory approval process. Failure to do so can lead to significant personal liability, including accountability for any profits derived from the unauthorized competitive venture and damages for other related harms like employee poaching or usurpation of corporate opportunities. For companies, robust internal governance and vigilant board oversight are crucial to managing these risks effectively.