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July 4, 2006

Guest Column: Japan Ruling on Merit-Based Compensation

[Editor's Note: Japanese companies have for a very long time relied upon seniority- based compensation systems, but over the past 10-15 years, some have attempted to move toward compensation at least partially based on merit. Japanese law has not entirely smoothed the way for employers, but apparently something of a breakthrough has occurred. We are grateful to William Herbert, a foreign law associate at Lexwell Partners in Tokyo, whose comments on a recent High Court ruling of note follow.]

On June 22, the Tokyo High Court overruled a lower court decision that had held invalid a Kanagawa Prefecture electronics manufacturer's April 2001 change to its rules of employment. The change involved adopting a "results" based compensation structure in place of a seniority based structure. After the modification to the rules of employment, employees were evaluated based on their achievement and ability. Three employees who were demoted and had their base salaries reduced under the new structure filed suit against their employer in 2002. The plaintiffs alleged that the change was an unjust and illegal modification of their rules of employment, and demanded damages for compensation they would have received had the modification not been implemented. Japanese Supreme Court cases have held that as a general rule, a unilateral modification to employee working conditions that leaves employees worse off than they had been before the modification is invalid, unless the reasons for and substance of the modification are reasonable.

The plaintiffs in the court of first instance were employees between the ages of 44 and 53. As a result of the modification to the rules of employment, the employees were demoted (some from managerial positions to non-managerial positions) and their base monthly salaries had been reduced by 38,000 to 75,000 yen. To compensate the employees for the reduction in salary, the employer had provided each with a special allowance for the entire amount their pay had been reduced in the first year after the modification to the rules of employment, and one-half of the amount their pay had been reduced in the second year after the modification.

The defendant had argued that the modification to the rules of employment was necessary to strengthen competitiveness and increase labor efficiency in light of the fact that its primary products compete in the global market.

The defendant further argued that the modification to the rules of employment was reasonable because the purpose of the modification was to offer incentives to individual employees commensurate with results they achieved and to encourage them to be active problem solvers.

The court of first instance had found partly in favor of the plaintiffs, ruling that the transition measures the defendant had provided to them had been inadequate, finding that the revisions to the rules of employment were void, and ordering the defendant to pay approximately 3 million yen to the plaintiffs.

The Tokyo High Court rejected all of the plaintiffs claims and, in finding that the modification to the rules of employment was reasonable, noted that

(1) the total amount of money allotted for employee salaries did not decrease for the employees as a whole; (2) treatment of the employees as a whole was fair because under the modification, each employee has the opportunity to advance and to receive increases in salary through personal improvement; and (3) the system for evaluating employee achievement and ability included a sufficient minimum amount of fairness.

The Tokyo High Court noted that the defendant had turned in four consecutive years of losses, and in the current economic climate, the modification to the rules of employment had been based on great business necessity. The modification was therefore reasonable.

According to the Tokyo High Court judgment, this decision was the first in which a change in a seniority-based compensation system to a merit based one has been found to be reasonable. The case is expected to draw much interest as companies across Japan continue to adopt merit-based employee compensation systems. The plaintiffs indicated that they would appeal the decision.

Comments

Posted by: Shawn Beilfuss at July 6, 2006 2:28 AM

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