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Japan's Latest D&O Insurance Changes

April 26, 2016

Japan Downtown

New tax treatment and policies in Japan are changing the way that directors and officers interact with companies and shareholders. These new policies indicate an increased awareness and integration of corporate governance concepts that are aimed at promoting more diverse boards. Specifically, new laws are affecting the way that Director & Officers (D&O) insurance is treated in relation to shareholder derivative actions. The new tax treatment allows companies to not treat insurance premiums for shareholder derivative actions as director’s salary income, as long as the company bears the premium costs and does so pursuant to corporate approval methods.

Japan is an important arena for corporate governance in Asia. Their decisions and policies have the potential to bring about many changes in the area and globally. Read on to learn more about the different changes that the tax treatments may bring about for Japan.

Specific D&O Insurance Premiums as Salary Income

D&O liability insurance is an option to protect directors and officers from liability in instances where the more traditional indemnification (statutory protection) is unavailable or not applicable. These insurance costs are typically shouldered by the company and provide some insulation from liability for various issues such as a breach of fiduciary duty or securities-related fraud.

Problems may arise when D&O liability insurance is applied in connection with shareholder derivative actions. When a director is sued for damages connected with a shareholder derivative suit, it could spell a conflict of interests when the company shoulders the costs of the D&O insurance premiums for that dispute. One can quickly see how the company would have to weigh the interests of the director against the interests of the shareholders, which can be problematic.

In order to remedy this, many Japanese D&O insurance providers are in the practice of excluding shareholder derivative claims from the general D&O insurance agreement. Instead of the company bearing those costs, the directors themselves would pay the coverage premiums in a separate agreement, which specifically addresses shareholder derivative liability.

In other words, directors and officers in Japan have been expected to shoulder D&O insurance premiums for coverage related to shareholder derivative lawsuits. If the company bears the premium costs, the premiums have typically been classified as fringe benefits, and then taxed as salary income for the director.

Effects of Previous D&O Tax Policies on Governance and Response from Government

This traditional way of processing D&O liability for shareholder derivatives as salary in Japan has had some negative effects, namely:

  • The tax treatment may be deterring qualified candidates from accepting office in a company
  • Overall corporate governance has been affected, especially with regards to board diversity and the hiring of external directors

In 2015 the Tokyo Stock Exchange (TSE) implemented a new corporate governance code, requiring listed companies to have at least two external, independent directors. As you can see, the previous tax treatments run contrary to efforts at diversifying boards, as they acted as a deterrent for interested office candidates.

Cognizant of this conflict, and following reports from Japan’s Ministry of Economy, Trade and Industry (METI), the National Tax Agency (NTA) of Japan agreed that it will not treat the insurance premiums as salary income when paid for by the company, if:

  • The board of directors approves the payment and
  • Consent is obtained by all external directors (or by a discretional committee comprised of a majority of external directors)

Call for Increased Actions and Involvement from Shareholders

On the one hand, we are beginning to see more direct interaction between government ministries and companies in terms of crucial corporate governance issues. On the other hand, many feel that government reform can only take Japan’s economic situation so far. Pressure from investors and engagement with shareholders is equally as important. All sides need to be fully informed and critically engaged when it comes to important company decisions.

There is much value in increasing board diversity, especially with regards to external directors as well as a more diverse board in terms of age, professional background, and gender. However, economic stability in any country will benefit mostly by a push (both internally and externally) for more transparency as well as a concerted effort to prevent fraud at all levels. In the future, we expect to see more governance rules focusing on these areas.

Issues like D&O liability insurance are important because they affect not just the individual officer or director, but the entire company. If you have any concerns or questions regarding important governance considerations, contact us today at Kessler Topaz. Our team of attorneys is focused on assisting companies in creating sound, independent, and diligent boards in order to increase shareholder value.