The Corporation Law (Kaisha-Ho) came into force on May 1 2006. The Corporation Law was drafted to modernize the previous law, and is expected to have a big impact on corporate governance.

Part of the Corporation Law enables the delivery of merged companies' cash or other assets (but not shares) to former company shareholders in a merger or other corporate reorganization. It could enable cash-out mergers, triangular mergers that deliver parent companies' shares, or other forms of flexible corporate reorganization. However enforcement of these provisions has been postponed because of concerns that it could promote foreign company investment in Japan and increase hostile acquisition in the Japanese market.

Types of company

The old Commercial Code considered four types of companies: kabushiki-kaisha (KK), a joint stock company, which is the form most commonly used in Japan; yugen-kaisha (YK), a limited liability company that is used for small businesses; gomei-kaisha, a partnership company with only unlimited partners; and goshi-kaisha, a partnership company with both unlimited and limited partners.

The Corporation Law abolishes YK and adds godo-kaisha, which is a limited partnership company with only limited partners.

Classification of KK

The Commercial Code categorized KKs into large, small or medium-sized companies. A large company was a KK with a stated capital of ¥500 million ($4.3 million), or a total of ¥20 billion or more stated in the liability section of its latest balance sheet. A small company was a KK with a stated capital of ¥100 million or less (except those satisfying the second condition for a large company). A medium-sized company was a KK that was neither a large company nor a small company.

The Corporation Law consolidates YK into KK and classifies KK as either an open company or closed company. A closed company has articles of incorporation that provide that a transfer of every class of shares requires the company's consent. An open company does not. Whether a company is open or closed has no relation to its listing. The Corporation Law consolidates medium-sized companies and small companies and makes a distinction between these companies and large companies.

Flexibility of governance structure

The Commercial Code was primarily concerned with large and open companies as the typical form of company and was able to minimize the governance structure of small and closed companies. However, most KK are small and closed. The Commercial Code also fixed a certain type of governance structure for certain types of companies and provided few choices for companies with regard to their governance structure. The governance structures allowed under the Commercial Code are shown in Table 1.

The Corporation Law is primarily concerned with small companies as the typical form of company and expands governance for large companies. The Corporation Law has greater flexibility in governance structures and gives companies a wider range of options for their articles of incorporation, provided they comply with the following rules:

• A company has to conduct a shareholders' meeting and appoint a director.
• An open company, a company with a board of corporate auditors or a company with committees has to appoint a board of directors.
• A company without committees that appoints a board of directors or accounting auditors must also appoint a corporate auditor.
• A closed company with a board of directors may replace a corporate auditor with an accounting counsellor.
• A large company or company with committees has to appoint an accounting auditor.

The governance structures available under the Corporation Law are shown in Table 2.

A shareholders' meeting chooses and defines the governance structure in the articles of incorporation. The structure is also disclosed through the registry.

The Corporation Law's flexibility allows for simple governance structures that could reduce the management costs not only for small and closed companies, but also for subsidiaries of big corporations, joint ventures or companies established by foreign investors.

Companies without committees

Companies with a board of directors: Directors are appointed at a general meeting to make decisions as a board on corporate affairs. The board of directors must appoint one or more representative directors who are responsible for executing the company's business. The board of directors may appoint one or more managing directors who are responsible for executing the business of the company.

Companies without a board of directors: Directors are appointed at a general meeting. If a company has two or more directors, unless otherwise provided in the articles of incorporation, a majority of directors make decisions on corporate affairs. Every director is responsible for executing the company's business.

Companies with corporate auditors: Corporate auditors are appointed at a general meeting to audit the company's accounting practices and the legality of the directors' execution of their duties. A corporate auditor cannot concurrently serve as a director, manager, executive officer, or other employee of the company or any subsidiary of the company. The role of corporate auditor is similar to the role of non-executive director and is separate from the accounting auditor's role.

Companies with committees

Directors are appointed at a general meeting to make decisions as a board on corporate affairs. Directors cannot generally execute the business of the company. The board of directors must appoint one or more executive officers to be responsible for executing the company's business. Directors can concurrently serve as executive officers of the company.

Independence of outside directors and auditors

The Corporation Law defines an outside director as a director who does not manage and has never managed the corporate affairs of the company or one of its subsidiaries as a director, executive officer, manager, or other employee and who is not an employee of the company or any of its subsidiaries.

Companies without committees: The board is not required to have any outside directors. For companies with a board of corporate auditors, at least half of the auditors must be outside auditors who have not been a director, executive officer, manager, or other employee of that company or any of its subsidiaries at any time before they assume office.

Companies with committees: At least half of the directors of each of the nominating committee, audit committee and compensation committee must be outside directors.

Outside directors and outside auditors need not be independent of the company. In practice, many companies appoint directors of their parent companies or of a business connection to the positions of outside director and outside auditors.

The Enforcement Regulations of the Corporation Law do not define the requirements of outside directors and auditors regarding independence and eligibility, but expect appropriate directors and auditors to be appointed through disclosure. For example, a reference document for a shareholders' meeting has to disclose a candidate's past performance as an outside director, independence from the company and experience of company management when appointing outside directors.

TSE requires governance report

The Tokyo Stock Exchange (TSE) established and released Principles of Corporate Governance for Listed Companies in March 2004. These principles were not designed to stipulate specific model policies on corporate governance and so do not require listed companies to adopt minimum standards or corporate governance models, nor do they require listed companies that do not adhere to the principles to explain why. In this respect, they differ from the New York Stock Exchange's Listing Standards on corporate governance and the London Stock Exchange's Best Practice Code for corporate governance. Although the principles are not mandatory, they can serve as guidelines to evaluate the corporate governance of listed companies.

However, from March 1 2006, the TSE has required listed companies to submit a corporate governance report. These reports and articles of incorporation, which are published on the internet, disclose basic policies and other information about corporate governance to investors.

Internal control systems

Under the previous legislation, the board of directors in a company with committees had to establish rules or other systems for compliance and internal control, including business risk management by resolution. There was no formal requirement relating to the internal control systems in a company with a corporate auditor. The Corporation Law requires large companies or companies with committees to improve systems to ensure directors perform their duties or any other systems necessary for ensuring appropriate operations of the company. These systems include internal control systems and business risk management. The Corporation Law requires an outline of the improved systems to be disclosed by business report. Under the previous legislation, some courts held that directors were obliged to establish appropriate internal control systems and risk control systems. The Corporation Law establishes this rule in statutory form.

FIEL requires internal control report

The law for amending the Securities and Exchange Law and other financial laws was promulgated on June 14 2006. This law reorganizes the Securities and Exchange Law (SEL) into the Financial Instruments and Exchange Law (FIEL) and aims to enhance internal control over financial reporting. The FIEL introduces mandatory management assessment (internal control reporting) into listed companies. The management assessment has to be audited by certified public accountants or an incorporated accounting firm. At the same time, the FIEL introduces mandatory certification of annual reports by management, in a similar way to Sarbanes-Oxley Section 404 in the US. The Business Accounting Council Internal Control Committee issued a public draft of the practice standard for assessment and auditing of internal control concerning financial reporting on November 21 2006, seeking comments from the public until December 20 2006. The amendment concerning internal control will be enforced from the business year starting in 2008. Some listed companies have begun to prepare for implementation of an internal control system.

Shareholder action

Shareholders, especially foreign investors and institutional investors, have strengthened their presence in the corporate governance of listed companies, unravelling interlocking shareholding relationships. Many listed companies submitted a proposal amendment of their articles of incorporation concerning the Corporation Law at their general meeting in June 2006. It is reported that the Pension Fund Association opposed some amendments that delegated dividend authority from the general meeting to the board of directors. It is also reported that Institutional Shareholder Services advised institutional investors to oppose the proposed amendments. Some proposals have been rejected or withdrawn.

Hostile acquisition

In 2006, three listed companies doing domestic business in Japan were exposed to hostile acquisition attempts. One example was the high-profile hostile acquisition attempt by Oji Paper of Hokuetsu Paper Mills in July. This was the first Japanese hostile acquisition attempt by one blue-chip company over another. The other two hostile acquisition attempts were by Don Quijote of Origin Toshu in January and by Steel Partners Japan Strategic Fund of Myojo Foods in October. Every hostile acquisition attempt failed because of so-called white knights.

The potential threat of hostile takeovers has caused directors of listed companies to think seriously about corporate governance.

Some listed companies pay out excessive amounts of retained earnings to shareholders through dividends or repurchases of treasury stock. In addition, some companies restore interlocking shareholding relationships between business connections or introduce defence packages against hostile acquisition.

Increasing MBO

Some listed companies have carried out management buyouts (MBOs) to escape the pressure of the capital markets. In 2006, Skylark, Yagi Corporation, Q'sai, Shinmei Electric, Toshiba Ceramics, Rex Holdings and Beltecno Corporation exercised takeover bids for MBO. However, the lack of independent directors creates suspicion about the validity of MBO prices in Japanese practice.

Derivative lawsuits concerning directors' duties

The Supreme Court reversed a decision of the Tokyo High Court and ordered a retrial regarding derivative lawsuits against former directors of Janome Sewing Machine Company. In 1989, the directors allegedly succumbed to blackmail by a notorious stock speculator shareholder, paying out ¥30 billion. The Supreme Court said that the former directors should have reported the matter to police or taken other appropriate action to deny the shareholder's unlawful demands, and reversed the decision of the Tokyo High Court that said the directors could not avoid accepting the shareholder's demands. Japanese courts tend to construe directors' duties strictly.

Livedoor

Yoshiaki Murakami, a high-profile fund manager in Japan, was arrested and indicted for insider trading. His fund (Murakami Fund) was suspected of executing insider trading concerning Livedoor's hostile acquisition attempt for Nippon Broadcasting. He was famous for wielding the concept of corporate governance over target companies.

Livedoor, which boasted the top market value on the Tokyo Stock Exchange Mothers market, was delisted on April 14 2006 for accounting fraud. The total market value of emerging markets decreased substantially because of investors' concerns regarding the corporate governance of emerging companies.

Author biographies

Takanobu Takehara Nishimura & Partners Takanobu Takehara first joined Nishimura & Partners in 1987 and is now a partner at the Tokyo firm. His main work, in the area of corporate acquisitions and restructuring, has seen him involved in a variety of transactions for clients ranging from large multinational corporations to Japanese government-owned entities. He is also a recognized authority on intellectual property law and has written a number of articles on commercial law. He was admitted to the Bar in Japan in 1987, and New York in 1992. He is a graduate of the University of Tokyo (LLB, 1981), the Legal Training and Research Institute of the Supreme Court of Japan, and the University of Michigan Law School (LLM, 1991). Takehara worked as a prosecuting attorney for the Japanese government for four years before joining Nishimura & Partners, and for one year at the New York firm, Cleary Gottlieb Steen & Hamilton after completing his legal education in the US. Other areas of his practice include bankruptcy and corporate crisis management. Takafumi Nihei Nishimura & Partners Takafumi Nihei is an associate at Nishimura & Partners. He has worked at the firm since 2003, after graduating from Waseda University (LLB, 2001) and the Legal Training and Research Institute of the Supreme Court of Japan. His main areas of practice are mergers and acquisitions, corporate law and restructuring. Nihei has authored a number of articles in English and Japanese for domestic and international legal publications.