Liability Limitation, Indemnification and D&O Insurance: Preparations Before Appointing Outside Officers

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

When approaching a candidate for an outside director or outside company auditor position, a company needs to explain whether its articles of incorporation permit a liability limitation agreement and whether it has arranged indemnification agreements and D&O insurance. Setting the appointment date first can leave insufficient time for the necessary shareholders' meeting or insurance arrangements.

An agreement limiting liability to the company, an agreement under which the company indemnifies expenses or losses, and insurance under which an insurer covers losses each have different scopes and procedures. Before assuring a candidate that insurance is in place, the company should establish to whom the officer may be liable, under what conditions, and who will bear the resulting financial burden.

Officers' Liability and the Minimum Liability Amount

Article 423(1) of the Companies Act (Japanese) provides that directors, accounting advisors, company auditors, executive officers and accounting auditors are liable to compensate the company for damage resulting from their neglect of duties. Outside officers also have duties corresponding to the positions to which they are appointed. Outside status alone does not eliminate liability.

Separately, officers who act in bad faith or with gross negligence in performing their duties are liable for damage caused to third parties under Article 429(1). Claims by the company and claims by shareholders, business partners or other third parties differ in their legal basis and subject matter. The liability limitation agreement discussed below directly addresses liability to the company under Article 423(1).

For liability under Article 423(1), partial exemption by a shareholders' meeting resolution is permitted where the officer performed their duties in good faith and without gross negligence under Article 425(1). The maximum exemption under that provision is the liability amount less the statutory minimum liability amount. This mechanism provides partial relief after damage has occurred.

The minimum liability amount is not necessarily a simple multiple of the officer's current annual income. It combines the annual remuneration equivalent calculated under the applicable Ministry of Justice ordinance, multiplied by a factor for the officer's category, with the value of financial benefits relating to share options covered by the provision. The multipliers are six for representative directors and representative executive officers; four for other directors involved in business execution and other executive officers; and two for other directors, accounting advisors, company auditors and accounting auditors.

Even when explaining that an outside officer's liability is limited to two years of remuneration, the company needs to check the calculation method and whether relevant share options exist. Being able to explain the relationship between the contractual limit and the statutory minimum liability amount is part of preparing for the appointment.

Eligibility for Liability Limitation Agreements and the Articles of Incorporation

Article 427(1) of the Companies Act permits liability limitation agreements with non-executive directors and certain other officers. Eligible persons are directors other than those involved in business execution, accounting advisors, company auditors and accounting auditors. Eligibility depends on the statutory category, rather than being limited to outside directors and outside company auditors.

The contractual liability limit is the higher of the amount predetermined by the company within the amount specified in its articles of incorporation and the statutory minimum liability amount. Good faith and the absence of gross negligence remain conditions, so a figure in the agreement does not cap liability in every circumstance. If the officer subsequently becomes a director involved in business execution or another person in the relevant executive category, the agreement ceases to have effect prospectively under Article 427(2).

The articles of incorporation must authorize the company to enter into these agreements. If they do not, the company first needs to amend them. An amendment generally requires a special resolution of a shareholders' meeting under Articles 466 and 309(2)(xi). Introducing a provision permitting liability limitation agreements with directors may also require consent from company auditors or other relevant supervisory officers, depending on the company's governance structure and the director's category, under Articles 427(3) and 425(3).

The person responsible should check the relevant provision in the current articles together with the candidate's intended position, whether they will execute business, and the internal decisions required. An existing provision allowing agreements with outside company auditors does not necessarily cover a newly appointed director. The persons covered by the articles must be compared with the proposed contracting party.

Expenses and Losses Eligible for Indemnification

Under an indemnification agreement pursuant to Article 430-2 of the Companies Act, the company may cover expenses incurred by an officer in responding to suspected legal violations or liability claims concerning the performance of their duties. Eligible losses also include payments of damages to third parties and settlement payments in disputes concerning those damages. Defense expenses and losses arising from damages or settlements should be addressed separately in the agreement.

The damages an officer owes directly to the company under Article 423(1) are not losses from compensation to third parties covered by this mechanism. In addition, where the officer would be liable to the company under Article 423(1) if the company compensated the third party, the portion attributable to that liability cannot be indemnified under Article 430-2(2)(ii). There are limits on using indemnification to shift that same financial burden back to the company while liability to the company remains.

Defense expenses exceeding the amount ordinarily required cannot be indemnified. Losses arising from damages or settlements where the officer is liable to a third party because of bad faith or gross negligence are also excluded under Article 430-2(2)(i) and (iii). However, those provisions do not automatically exclude all defense expenses solely because bad faith or gross negligence exists. If, after indemnifying expenses, the company learns that the officer performed their duties to obtain an improper benefit for themselves or a third party, or to cause damage to the company, it may seek repayment of the indemnified amount under Article 430-2(3).

The terms of an indemnification agreement must be determined by a shareholders' meeting resolution or, in a company with a board of directors, a board resolution. A provision in the articles of incorporation is not required to introduce the agreement. In a company with a board, the director who provided indemnification and the director who received it must report the material facts to the board without delay under Article 430-2(4). I believe that, when entering into the agreement, the company should also identify who will receive claims, review expenses and report after payment.

Approval and Coverage of D&O Insurance

D&O insurance covers losses arising when officers incur liability or face liability claims in connection with the performance of their duties. The terms of a contract falling within the directors' and officers' liability insurance provisions of Article 430-3(1) of the Companies Act must be determined by a shareholders' meeting resolution or, for a company with a board, a board resolution. Here too, the Act does not require a provision in the articles of incorporation authorizing the contract.

Obtaining the resolution required by the Companies Act and having a particular claim paid by an insurer are separate matters. Actual coverage depends on the insurance terms and endorsements. Check the insured persons, policy period, payment limits, exclusions, treatment of defense costs and notification requirements in the policy documents and terms.

Under an indemnification agreement, the company bears expenses or losses itself. D&O insurance contemplates payment by an insurer, but exclusions and limits mean that the company's indemnification obligations may not match the insurance coverage. Whether expenses first indemnified by the company are insured, whether payment is made to the officer directly, and whether expenses may be incurred before the insurer consents depend on the particular policy.

When explaining coverage to a candidate, identify when they will become an insured person and the principal coverage conditions, in addition to whether insurance exists. Distinguish obtaining a quotation from completion of approval and application procedures and commencement of coverage. Matters that remain unsettled should not be described as already insured.

Preparations and Documents Needed Before the Appointment

When introducing these three mechanisms, check the limit on liability to the company, indemnification of expenses and losses by the company, and payment by the insurer separately. Even where legal staff prepare the agreements and administration or finance staff arrange insurance, a common set of documents identifying the persons, periods and conditions covered can help prevent inconsistent explanations.

The preparation documents can be grouped by function as follows.

• The current articles' liability limitation provisions, any necessary amendment proposals and records of consent
• Draft liability limitation and indemnification agreements, and board or shareholders' meeting proposals determining their terms
• Insurance quotations, terms and endorsements, and documents confirming insured persons and the coverage start date

First, check the current articles and the candidate's position. If an amendment or consent is needed, incorporate it into the shareholders' meeting schedule. Next, determine the terms of the indemnification agreement and insurance, then coordinate execution of the liability limitation and indemnification agreements and the insurance application or addition of insured persons with the appointment date. Record planned execution separately from completed agreements and insurance arrangements.

The original explanation should also be revisited if the officer changes positions or the insurance is renewed. Check whether the liability limitation agreement remains applicable and whether the officer continues to be insured. Keeping candidate briefing materials together with the corresponding executed agreements and policy documents should also assist when a claim later arises.

Governance provisions in shareholders' agreements are discussed in Reviewing Shareholders' Agreements: Prior Consent, Information Rights and Founder Obligations. Agreements between founders are covered in our column on founder agreements.