When Are Directors Liable for Company Losses Due to Legal Violations in Japan?

Japanese Attorney at Law - Bengoshi L.L.

• 9 min read

Directors of Japanese corporations (kabushiki kaisha) are entrusted with managing the company's affairs and are subject to fundamental duties of care and loyalty. When a company suffers losses as a result of violating laws or regulations, a critical question arises: to what extent can its directors be held personally liable for those losses? This issue lies at the intersection of corporate compliance, director responsibility, and shareholder protection.

Under Article 423, Paragraph 1 of the Japanese Companies Act (会社法 - Kaishahō), directors (and other officers) are liable to compensate the company for damages caused when they have "neglected their duties" (任務を怠ったとき - ninmu wo okotatta toki). This broad term encompasses breaches of the duty of care (善管注意義務 - zenkan chūi gimu) and the duty of loyalty (忠実義務 - chūjitsu gimu). This article explores how this liability framework applies when the company's underlying conduct involves a violation of specific laws or regulations.

Prior to the current Companies Act (enacted in 2005), the old Commercial Code explicitly listed "an act in violation of any law or ordinance or of the articles of incorporation" as a specific ground for director liability. The Supreme Court of Japan, in a significant judgment on July 7, 2000 (Heisei 12), concerning the Snow Brand milk poisoning incident, interpreted the term "laws or ordinances" (hōrei) very broadly under the old Commercial Code. The Court held that it included not just company law or criminal statutes, but essentially all legal provisions that a company is required to comply with in the course of its business operations. This broad interpretation emphasized the directors' responsibility to ensure the company as a whole operates lawfully.

The current Companies Act replaced this explicit reference with the more general concept of "neglect of duties." However, causing or permitting the company to violate laws or regulations is widely understood to fall within this concept. The crucial point is that the legal violation by the company serves as a factual predicate, but the director's liability hinges on their own neglect of duty in relation to that violation.

A mere violation of law by the company does not automatically render every director personally liable. The focus is on whether the directors, individually or collectively, failed in their duties, leading to or failing to prevent the violation and consequent losses.

Key considerations include:

  1. Director's Knowledge, Intent, or Negligence Regarding the Violation:
    • Knowing Violations: If a director knowingly causes the company to violate the law, or consciously permits an ongoing violation to continue, this almost invariably constitutes a neglect of duties (specifically, a breach of the duty of loyalty and care). The director's motive (e.g., perceived short-term benefit for the company) generally does not excuse a knowing breach of law.
    • Negligent Violations: Even without direct intent, a director can be found to have neglected their duties if they failed to exercise the necessary care of a "good manager" (善管注意義務 - zenkan chūi gimu) to prevent the violation. This involves assessing what a reasonably prudent director in a similar position would have known or done. The Supreme Court in its July 7, 2000 judgment indicated that even if a director's act results in a legal violation by the company, the director would not be liable if they were unaware of the facts constituting the violation and were not negligent in being so unaware. The burden is on the director to show this lack of negligence concerning the violation.
  2. The Duty of Oversight and Internal Controls:
    For directors not directly involved in the specific act of violation, liability can arise from a breach of their duty to oversee the company's operations and to ensure that adequate compliance systems (internal controls) are in place and functioning. If a legal violation occurs due to a systemic failure that diligent oversight and proper internal controls could have prevented, directors responsible for that oversight may be deemed to have neglected their duties. This ties into the broader obligations regarding internal control systems (a topic discussed in a separate article).
  3. Inapplicability of the Business Judgment Rule (BJR):
    The Business Judgment Rule (経営判断の原則 - keiei handan no gensoku), which generally provides deference to directors' informed and disinterested business decisions, does not typically shield directors from liability for decisions or actions that involve a known violation of law. Causing the company to break the law is not considered a legitimate exercise of business judgment.

Illustrative Case Study Analysis (Problem 43)

The PDF's Problem 43 provides a scenario where A社, a food retail company, sold shumai (a type of dumpling) that contained a food additive prohibited by the Food Sanitation Act (食品衛生法 - Shokuhin Eisei Hō).

  • Director Y₁ (Directly Involved): Y₁ was informed by a competitor (C) about the prohibited additive in the shumai manufactured for A社 by B社 in a foreign country (甲国 - Kō-koku). Despite this knowledge, Y₁ decided to continue sales to avoid immediate disruption to special contract retailers and even paid C 50 million yen as hush money.
    • Neglect of Duties: Y₁'s actions demonstrate a clear and knowing neglect of duties. Continuing to sell a product known to violate food safety laws is a direct breach of the duty to ensure lawful operations. The payment of hush money is a further illicit act. Y₁ cannot claim lack of knowledge or lack of negligence regarding the violation.
  • Senior Managing Director Y₂ (Informed and Acquiesced): Y₁ reported the additive issue to Y₂, who, understanding the potential impact on retailers, agreed to Y₁'s request to delay stopping sales and destroying inventory.
    • Neglect of Duties: Y₂, upon being informed of a serious legal violation by a fellow director, had a duty to take corrective action. Acquiescing to continued illegal sales, even for perceived business reasons, constitutes a neglect of his duty of care and loyalty. He failed to ensure the company complied with the law and failed in his oversight role.
  • Representative Director Y₃ (Briefed and Took Insufficient Action): Y₃, upon learning of the additive issue from other sources, questioned Y₂ (and presumably Y₁). He was told the "problem was already dealt with" (問題はすでに対処済み - mondai wa sude ni taisho-zumi) and took no further specific action.
    • Neglect of Duties: As Representative Director, Y₃ has ultimate oversight responsibility. Whether his reliance on Y₂'s assurance was reasonable is a key question. Given the potential severity of a Food Sanitation Act violation (which was later confirmed by a public health inspection and media reports), a reasonably prudent representative director might be expected to inquire more deeply, demand concrete evidence of how the issue was "dealt with" (e.g., product recall, cessation of sales), and ensure the matter was appropriately handled at the board level if necessary. Simply accepting a vague assurance for a potentially serious legal breach could be seen as a failure of oversight, amounting to neglect of duties, possibly rising to the level of gross negligence depending on the specifics of the information he had and the inquiry he failed to make.

Causation and the Scope of Damages

For directors to be liable, their neglect of duties must have caused the damages suffered by the company. The scope of these damages can be extensive.

Establishing Causation

The company (or a shareholder in a derivative suit) must demonstrate a causal link between the directors' specific neglect of duty and the losses incurred. For example:

  • Y₁'s decision to continue sales and conceal the violation directly led to prolonged exposure, increased potential harm, and the eventual costs of recall, reputational damage, and fines when the issue became public.
  • Y₂'s acquiescence contributed to the continuation of the illegal sales.
  • Y₃'s potential failure to adequately investigate and intervene allowed the situation to persist, exacerbating the eventual damage.

Types of Recoverable Damages

Problem 43 illustrates the varied losses a company can suffer due to legal violations:

  1. Compensation to Third Parties: A社 paid 5 billion yen as "business compensation" (営業補償 - eigyō hoshō) to special contract retailers for their sales decline. This is a direct consequence of selling a non-compliant product.
  2. Corrective Action and Reputational Repair Costs: 2 billion yen was spent on a "trust recovery campaign" (信頼回復キャンペーン - shinrai kaifuku kyanpēn).
  3. Direct Costs of Violation: 300 million yen for the disposal of tainted inventory.
  4. Lost Profits: 2 billion yen in decreased operating profit during the period of disruption.
  5. Fines and Penalties: A社 received a 200,000 yen fine for violating the Food Sanitation Act.
  6. Improper Payments: The 50 million yen paid by Y₁ as hush money is a direct loss.

The total claimed damages in the problem are 9.3502 billion yen. Directors whose neglect of duty caused these losses would, in principle, be liable for them.

Apportionment Among Multiple Liable Directors

Under Article 430 of the Companies Act, if multiple directors are liable for the same damage, their liability is joint and several (連帯責任 - rentai sekinin). This means the company can claim the full amount from any one of them, and it is then up to the paying director to seek contribution from the others.

However, courts sometimes consider the differing degrees of culpability or causal contribution when assessing individual liability in complex scenarios, although the statutory default is joint and several liability for the portion of damage caused by a common neglect. The PDF's commentary on Problem 43 mentions that the Osaka High Court (January 18, 2007, Heisei 19), in a case concerning monitoring duty breaches, did not apply a "proportional causation" (割合的認定 - wariaiteki nintei) approach to limit a specific director's liability to a percentage of the total damage, while other lower court cases have sometimes done so. The more common approach, if multiple directors are involved with differing levels of neglect, is to determine which portion of the total damage is attributable to each director's specific breach, if separable.

Company's "Contributory Negligence" (過失相殺 - Kashitsu Sōsai)

If the company itself, through broader systemic failures or the actions of other employees/directors not party to the suit, contributed to the occurrence or exacerbation of the loss, could this reduce the liability of the sued directors? This is the concept of kashitsu sōsai. The PDF commentary notes that some past court cases have recognized a form of company-side negligence (e.g., failure of oversight by other directors) as a basis for reducing the damages owed by the defendant directors. However, applying this is complex, especially when the "company's negligence" is essentially the negligence of other fiduciaries.

Offset of Illegally Gained Benefits (損益相殺 - Son'eki Sōsai)

If the company derived some financial benefit from the illegal activity (e.g., profits from the continued sale of the non-compliant shumai before the recall), should this amount be deducted from the damages claimable from the directors? The PDF commentary refers to the Osaka High Court (January 18, 2007) decision, which reportedly denied such an offset. The reasoning was that the primary damage arose from the loss of public trust and subsequent business decline when the violation became known, and any profits from the illegal sales prior to that point were not a direct offset against that type of damage. This remains a debated point, with some arguing that if the company would not have made those sales at all had it acted lawfully from the outset, then those "profits" are indeed tied to the wrongful conduct and should be considered in the overall damage calculation.

Comparison with U.S. Law

The Japanese framework for director liability for legal violations by the company has conceptual parallels with U.S. corporate law:

  • Duty of Obedience to the Law / Duty of Good Faith: U.S. directors are expected to ensure the corporation conducts its business lawfully. Knowingly causing the corporation to violate the law is generally considered a breach of the duty of loyalty or good faith.
  • Caremark Claims (Duty of Oversight): For liability based on a failure of oversight (i.e., not preventing illegal acts by subordinates), Delaware courts apply the Caremark standard. This requires plaintiffs to show either (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention. This is a very high standard, requiring a showing of bad faith or a conscious disregard of known duties. Japanese law, while also requiring neglect, may sometimes appear more readily to find a breach of the general duty of care in oversight failures without necessarily requiring the same level of "conscious disregard" as Caremark, especially if basic preventative systems were lacking for foreseeable risks.
  • Causation and Damages: Both systems require a showing of proximate cause between the director's breach and the corporation's harm. The types of damages (direct costs, lost profits, reputational harm) are also broadly similar, though quantification methods and judicial approaches to speculative damages can differ.

Conclusion

Directors in Japan face a significant responsibility to ensure their company operates within the bounds of the law. When a company suffers losses due to legal violations, directors can be held personally liable if it is established that they "neglected their duties" in relation to those violations. This neglect can range from direct involvement in or knowing acquiescence to illegal acts, to a negligent failure to implement or oversee adequate compliance and risk management systems.

While the Business Judgment Rule typically does not protect directors for decisions that entail legal breaches, the question of a director's awareness and diligence concerning the specific violation remains crucial. The potential damages can be substantial, reflecting the wide-ranging impact that legal non-compliance can have on a company's finances, reputation, and stakeholder relationships. Therefore, a proactive and robust approach to legal compliance and corporate ethics is not just a matter of good governance but a critical element in mitigating director liability in Japan.