Trouble reducing headcount in Japan? Try cutting pay instead.

By Hiromasa Ogawa, Darcy Kishida, and Mutsuki Shibata

INTRODUCTION

Companies with a legitimate need to cut costs in Japan face tremendous hurdles in reducing their workforce due to the country’s strong pro-labor laws. This is also true for employers looking to shed subpar workers. A less drastic alternative would seem to be cutting pay instead of laying people off. But is it a realistic option?

BACKGROUND

Companies seek to cut pay for two main reasons. First, companies often wish to reduce overall costs, typically through across-the-board pay cuts. Although companies can generally implement company-wide pay reductions under Japanese law, the cuts must be reasonable both in terms of size and necessity. The second reason is to implement selective pay cuts for subpar employees who fail to pull their weight. This is typically accomplished by demotions. We discuss below the requirements and limitations of both.

ACROSS-THE-BOARD CUTS

By having everyone share the pain, across-the-board pay cuts would seem to be an attractive option in Japan, where layoffs are both frowned upon and legally difficult. However, as with most employer actions in Japan that are detrimental to employees, the issue is typically not so clear-cut. There are three main ways to implement across-the-board pay cuts.

First, a company can obtain consent from each of its employees individually. If all agree, the company has effectively implemented an across-the-board pay cut. Even if there are a few holdouts, however, the company will still enjoy significant cost savings. Employers should ensure that: (i) they provide a complete and detailed explanation that the pay cuts are necessary for the company to be more successful or, in the worst-case scenario, to avoid bankruptcy; and (ii) the consent is in writing to avoid potential challenges down the line.

A company can also implement across-the-board-pay cuts by reaching an agreement with the union. This agreement will of course apply to the company’s unionized workers but may under certain circumstances also apply to non-union members. There is a catch, however. Even agreements that are “blessed” by the union can be found invalid in whole or in part if the pay cuts end up being applied unevenly to certain employees.
The other possible way to implement across-the-board pay cuts is to revise the company’s rules of employment to provide for such cuts (within certain limits, of course). The rules should also contain a reasonably detailed calculation of how the company determines the salary of its employees. For employers that decide to go this route, the revision must:

• Not be unreasonably detrimental to the workers
• Be made to address a genuine need for cost reduction
• Be appropriate in light of the company’s particular circumstances
• Take into account the status of any negotiations with the union or, if the employees are not unionized, with a representative of a majority of the employees

Passing the reasonability test requires employers to demonstrate dire financial circumstances and the necessity of pay cuts to restore the health of the company. In addition, the pay for directors and highly compensated employees should be cut first before cutting the pay of regular employees. If the cuts will instead be made all at once, the employer should consider applying deeper cuts for directors and highly compensated employees than it imposes on regular employees.

POOR PERFORMERS

It would perhaps be more appropriate to call this section “Demotions” because that’s the basic mechanism of cutting the pay of poor performers. The demoted employee’s pay is technically not “cut”; it is simply reduced to match the employee’s new (lower) position or title. Perhaps it is this distinction that gives employers relatively broad discretion to demote subpar employees.

This discretion isn’t without its limits, of course. The company’s rules of employment must allow for the possibility of demotion-based pay cuts. The same goes for the company’s employment agreements. Moreover, companies may find it harder to demote individuals hired for a specific job or title, at least compared to those who follow the traditional career path of being hired straight out of college and working their way up through the ranks of the company. Companies should also as specifically as possible inform at-risk employees what goals or performance targets the company expects them to achieve. By doing so, companies will have an easier time demoting employees who fail to meet these targets.

As is the case with layoffs, companies must be careful not to abuse their power as employers when conducting demotions. In this connection, the validity of a company’s actions are determined by several factors, including the necessity for the demotion, the skills and experience of the affected employee in relation to his or her current position, and the impact of the demotion on the employee. As long as it’s not too drastic, a pay cut that accompanies a valid demotion is generally also regarded as valid. (However, the case discussed below shows that this isn’t always true.)

HOW LOW CAN YOU GO?

Regardless of the approach, there’s a limit to how drastic the pay cuts can be. A review of the relevant case law does not provide absolute numbers, but the upper limit for across-the-board cuts seems to be somewhere in the range of a 10-20% reduction, while the comparable figure for subpar employees is higher, perhaps between 30-40%.

More than one case found a 20% or 30% across-the-board cut to be too high, even though the company had revised its rules of employment to allow for such cuts. The reasoning was that an across-the-board pay cut can have a drastic impact on the livelihood of many employees who may not have been responsible for the company’s financial problems. In one extreme case involving a company on the brink of bankruptcy, the court allowed a 40% reduction. This case is probably an outlier, however. In practice, such large cuts are very rarely permitted.

Of course, this rationale does not apply to subpar employees, which may explain the court’s greater tolerance for deeper cuts. In one case involving a poorly performing employee, the court found that a 40% cut was too high. In that case, the company demoted a manager and cut his annual pay from 11,500,000 yen to just 6,900,000 yen. Although the court found the demotion itself valid, the court deemed the pay cut too extreme. The court cited the lack of provisions in the company’s rules of employment that would justify such a large cut, meaning that the company had almost unfettered discretion in this area. As a result, the employee had no way of knowing that the company could cut his pay so drastically, and did not know the basis for the cut. This leaves open the question of whether a court would allow a 40% cut that was provided for in the rules of employment, assuming the employee was fully aware that such a large pay cut was possible.

AVOID USING PAY CUTS AS RETALIATION

Although pays cuts may be valid depending on the circumstances, companies are typically not allowed to use them to pressure an employee to resign. Even if this was not the company’s intention, a court could find a violation if there’s an appearance of coercion. To minimize the chances of this happening, a company should cut an employee’s pay prior to any suggestion or proposal that the employee resign. Reversing the order of these two steps could create the appearance of retaliation, which is prohibited.

If you have questions about this topic, please contact any of the authors directly or our firm’s Labor and Employment Practice Group through the contact information available on our firm’s website.

KOJIMA LAW OFFICES  | Tokyo | www.kojimalaw.jp