How to Determine Officer Compensation and the Procedures Under the Companies Act

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

Even in a company where the representative director decides the compensation of each officer, that decision-making authority must have a basis. The Companies Act provides that the compensation of directors is to be determined by a resolution of the shareholders' meeting unless it is provided for in the articles of incorporation. When a company that started with only its founding members reaches the stage of welcoming outside shareholders, it becomes difficult to continue a practice that has relied on verbal promises or the representative director's judgment.

Even if no objections to compensation amounts have arisen in a company made up only of founding members, whether the required procedures have been completed is a separate question to check. However, once outside shareholders such as venture capital firms come in, the situation changes completely. Based on the investment agreement or shareholders' agreement, there are more occasions on which the company is asked to submit financial statements or explain important matters, and with respect to the determination of officer compensation as well, the company will be asked specifically "what resolution has been passed at the shareholders' meeting." It is important to use this moment to reorganize the process for determining officer compensation in line with the requirements of the Companies Act.

The Principle of Determining Compensation by Resolution of the Shareholders' Meeting

This column mainly deals with the compensation of directors in companies that adopt a standard governance structure. Different rules apply to the compensation of company auditors and to the compensation committee of a company with a nominating committee, etc. Article 361, Paragraph 1 of the Companies Act provides that, for compensation, bonuses and other property benefits received from the stock company as consideration for the execution of duties by directors (compensation, etc.), if these are not provided for in the articles of incorporation, they must be determined by a resolution of the shareholders' meeting. Because directors are in a position to influence their own compensation through the execution of their duties, leaving compensation amounts to be freely decided by the board of directors or by the representative director alone could invite conflicts of interest through self-dealing in compensation. Requiring a resolution of the shareholders' meeting is understood to be intended to place the content of compensation, etc. under the supervision of shareholders.

The matters to be determined by resolution of the shareholders' meeting differ depending on the form of compensation, etc. Article 361, Paragraph 1 of the Companies Act provides that, for compensation, etc. whose amount is fixed, the amount must be determined, and for compensation, etc. whose amount is not fixed, the specific method of calculation must be determined. In addition, when the company's own shares or share options are granted as compensation, etc., the resolution must cover the upper limit on the number of each and other statutory matters, and when monetary claims for acquiring these are granted, the amount and other prescribed matters must be determined. For other non-monetary compensation as well, the specific content must be made a matter for resolution. Furthermore, under the current Article 361, Paragraph 4 of the Companies Act, there is an obligation to explain to shareholders at the shareholders' meeting the reasons why the amount, calculation method and so on of compensation, etc. are appropriate.

Setting an Aggregate Cap and the Practice of Delegating to the Board of Directors

In addition to determining individual compensation amounts at the shareholders' meeting, there is a method of setting an upper limit on the aggregate compensation of all directors (a so-called aggregate cap) by resolution of the shareholders' meeting and delegating the specific allocation to each director to the board of directors. Against the requirement in Article 361 of the Companies Act that "for those whose amount is fixed, the amount," this design of resolving an aggregate upper limit and entrusting the determination of the individual breakdown is widely accepted as a lawful practice.

When adopting this method, the minutes of the shareholders' meeting record the content of the resolution, such as "the compensation, etc. of directors shall not exceed JPY [ ] per year, and the specific allocation to each director shall be left to the decision of the board of directors." Check the period during which the resolution is effective and the scope of delegation; as long as the cap remains validly in effect, the board of directors can revise individual allocations within the cap in subsequent fiscal years without a new shareholders' meeting resolution. When the board of directors further delegates the decision on individual allocations to the representative director, also set the scope of that authority, the decision policy and how the board of directors will check it.

When newly inviting an outside director, or when outside shareholders request the appointment of an independent outside director, it is important in practice to check in advance whether the new director's compensation fits within the existing aggregate cap. If there is no room within the aggregate cap, arrangements must be made to resolve an increase in the aggregate cap at the shareholders' meeting in line with the appointment; if there is a gap in timing between the appointment and the resolution, there will be a period in which there is no legal basis for paying compensation.

Non-Monetary Compensation Such as Share-Based Compensation and Procedures for Revising Compensation

Incentives for officers can also be designed using the company's own shares or share options (stock options) in addition to cash. When granting the company's own shares or share options as officer compensation, arrangements are made under Article 361, Paragraph 1 of the Companies Act to set the upper limit on the number to be allotted, the calculation method and so on in the articles of incorporation or by resolution of the shareholders' meeting. When providing property other than cash in kind, a shareholders' meeting resolution on the specific content is also required. A point to note is that granting shares or share options requires, together with the resolution on the compensation cap under Article 361 of the Companies Act, separately and lawfully carrying out the procedures for issuing shares for subscription or share options for subscription (such as Articles 199 and 238 of the Companies Act).

Regarding revisions to compensation amounts, the points to note differ between increases and decreases. When paying an amount exceeding the existing aggregate cap or newly introducing non-monetary compensation, the cap itself must be increased or revised by resolution of the shareholders' meeting. On the other hand, care is also needed when reducing officer compensation. If an individual compensation amount has been agreed in advance between the company and a director, the company cannot unilaterally reduce the individual compensation just because there is room within the shareholders' meeting's aggregate cap. The reduction should be carried out carefully after confirming whether there is a contractual basis with the individual director or the director's consent.

Legal Risks Arising from a Missing Basis for Payment

Officer compensation for which no basis for payment, such as the articles of incorporation or a valid shareholders' meeting resolution, can be confirmed carries legal risks such as claims by the company for restitution of unjust enrichment and disputes among officers. If the minutes cannot be found, determine from the agreements and documents at the time whether there was no resolution at all or whether there was a defect in preparing or keeping the records. There are also cases, such as where the articles of incorporation provide a clear basis for payment, in which the absence of a resolution does not immediately mean the payment is invalid. Whether a claim for restitution of unjust enrichment can be made is also judged individually, taking into account the circumstances of payment, whether there has been subsequent correction, whether the statute of limitations has run and so on. It is not permissible to retroactively create fictitious shareholders' meeting minutes after the fact to cover up past defects.

If such defects in resolutions come to light after outside shareholders have invested, problems may also arise in relation to the representations and warranties in the investment agreement or shareholders' agreement. Whether past officer compensation was lawfully determined in accordance with laws and regulations is often included within representations and warranties concerning governance, and depending on the terms of the contract, it may lead to indemnification claims for breach of representations and warranties. Even if a new aggregate cap is resolved going forward, that alone does not automatically make past defective payments lawful. In my view, it is desirable to inspect past minutes and payment records before welcoming outside shareholders and, if there are inconsistencies, to sort them out, including how to deal with past payments.

Distinguishing Salary for Employee-Officers and Tax Considerations

Some companies have so-called employee-officers, who are directors while also serving in an employee capacity such as department head. In this case, the portion of salary corresponding to their duties as an employee is treated as different in nature from "compensation, etc.," which is consideration for the execution of duties as an officer. In practice, the prerequisites for clearly distinguishing the two are that an employee salary system is clearly established in the same way as for other employees, that the person actually engages in work as an employee, and that the resolution of the shareholders' meeting expressly states that the aggregate cap on officer compensation does not include the employee portion of salary.

If this distinction is neglected in the minutes and only a vague aggregate amount including the employee portion of salary is resolved, doubts are likely to arise as to whether the officer compensation cap has been exceeded. It is practical to state expressly in the minutes that "the employee portion of salary of employee-officers is excluded" and to manage officer compensation and employee salary separately in internal regulations as well. Note that the determination of whether a person qualifies as an "employee-officer" for tax purposes and the requirements for deducting officer compensation as an expense, such as fixed regular payments, follow tax law standards that are separate from the compensation rules under the Companies Act. Even compensation that satisfies the procedures under the Companies Act may not be deductible for tax purposes, so check the timing of revisions and the form of payment with a tax accountant in advance.

Advance Preparation for Accepting Outside Shareholders

If you begin inspecting the procedures for officer compensation just before accepting outside shareholders, you will be busy investigating and correcting the status of past resolutions, which will overlap with due diligence for the fundraising and create an excessive burden. For a company that has not previously passed a resolution on an aggregate cap, it is realistic to start by setting an upper limit on the aggregate compensation of all directors at the most recent shareholders' meeting, passing a resolution delegating individual allocation to the board of directors, and putting the minutes in order.

Even for a company that has already set an aggregate cap, reconfirm whether the current payments fit within the cap, and if there are plans to welcome a new outside director or to introduce share-based compensation, prepare in advance an increase in the cap or the prescribed resolution items. If there are employee-officers, also check whether the exclusion of the employee portion of salary is clear in the resolution, so that you can respond calmly in investor due diligence as well. If you are at the stage of designing officer compensation in combination with share-based compensation or an incentive plan, Designing Stock Options as Part of Capital Policy is a useful reference. If negotiations on the investment agreement are proceeding in parallel, also reviewing Review Points for Investment Agreements: Practice from the Issuer and Management Shareholder Side makes it easier to grasp the overall picture, including how to deal with representations and warranties concerning compensation.

Establishing procedures for officer compensation is closely connected with building a corporate governance framework, including preparing shareholders' meeting minutes, reviewing board of directors regulations and designing incentive schemes, and there is value in carrying it out as part of a capital policy for accepting outside capital. If you are aligning the timing of reelections and compensation resolutions, see Directors' Terms of Office, Reappointment Registration, Resignation and Removal; for preparing the shareholders' meeting as a whole, see Your First Annual Shareholders' Meeting. LegalAgent supports the review of resolution procedures for officer compensation as part of establishing a Corporate Governance framework, and also supports contract matters arising in the fundraising process through our Startup Legal services.