The Corporation Law (Kaisha-Ho) was enacted on June 29 2005 and proclaimed on July 26 2005. It is an independent law that comprehensively covers the corporations law stipulated in Book 2 of the Commercial Code enacted in 1899, the Law for Special Provisions for the Commercial Code Concerning Audits enacted in 1974 and the Limited Liability Company Law enacted in 1938. The Corporation Law was drafted to modernize the existing law, and is expected to have a big impact on corporate governance. The enforcement of the Corporation Law is scheduled for the beginning of May 2006.

The enforcement of the part of the Corporation Law that enables the delivery of merged companies' cash or other assets, but not shares, to former company shareholders in merger or other corporate reorganization will be postponed until one year later. It could enable cash-out mergers, triangle mergers that deliver parent companies' shares, or other forms of flexible corporate reorganization. Its enforcement is postponed because of concerns that it might promote foreign investment in Japan and increase hostile takeover bids in the Japanese market.

The Corporation Law delegates many details to the Order of the Ministry of Justice, scheduled to be proclaimed in January 2006.

Type of company

Existing legislation considers four types of companies: kabushiki-kaisha (KK), a joint stock company that is the 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 both with unlimited and limited partners.

The Corporation Law abolishes YK and adds godo-kaisha, which is a limited partnership company with only limited partners. It is established with the US' limited liability company model in mind. It is said that the Japanese tax system may not authorize pass-through taxation to godo-kaisha because it is contrary to the intention of the Ministry of Finance. Yugen sekinin jigyou kumiai (the Japanese LLP), established by the law enacted on August 1 2005, may be used as a compromise between limited liability from creditors and pass-through taxation (partially restricted).

YK abolished

The Corporation Law abolishes YK. It will be impossible to establish a new YK after the enforcement of the Corporation Law. Existing YK will be deemed a certain type of KK after the enforcement of the Corporation Law. Transitional measures might permit existing YK to exist as special YK that have to continue using the term yugen-kaisha in their corporate name. A special YK is treated in a similar way to existing YK under the Corporation Law. A special YK need not establish an accounting auditor if it is a large company (as described below), need not publish an accounting publication, and has no limitations regarding terms of its directors and corporate auditors (if any). It is a workable option for existing YK to choose the special YK form to achieve lower management costs than KK.

Definition of parent company and subsidiary

Existing legislation defines a parent company as a company having a majority of voting rights in another KK or YK (the KK or YK is defined as a subsidiary). In contrast, the Corporation Law defines a parent company as a company having a majority of voting rights in another company or a company having control over another company. The term "having control" will be defined by Order of the Ministry of Justice and is expected to be the same as the definition used for financial statement regulations. The change of this definition affects regulations that prohibit subsidiaries from holding shares of parent companies or regulations that prohibit parent companies' corporate auditors from being a director, officer, accounting counsellor (as described below) or employee of a subsidiary at the same time.

Classification of KK

Existing legislation classifies KK as a large company, small company or medium-sized company. A large company is a KK with a stated capital of ¥500 million ($4.1 million) or a total of ¥20 billion or more stated in the liability section of its latest balance sheet. A small company is 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 is a KK that is 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. An open company is a KK without articles of incorporation that provide that a transfer of every class of shares requires the company's consent. Conversely, a closed company has articles of incorporation that provide that a transfer of every class of shares requires the company's consent. 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 classification between these companies and large companies.

Flexibility of governance structure

Existing legislation is primarily concerned with large and open companies as the typical form of company and is able to minimize the governance structure of small and closed companies. However, most KK are small and closed. In addition, the existing legislation fixes a certain type of governance structure for certain types of companies. It also provides few choices for companies with regard to their governance structure. Table 1 shows the present governance structures.

The Corporation Law is primarily concerned with small companies as the typical form of company and allows for expansion of governance for large companies. The Corporation Law has greater flexibility in governance structures than existing legislation. Under the Corporation Law, a company has a wide range of options for its articles of incorporation if the company complies with the following rules: a company has to conduct a shareholders' meeting and establish a director; an open company, a company with a board of corporate auditors or a company with committees has to establish a board of directors; a company without committees that establishes a board of directors or accounting auditors has to also establish a corporate auditor; a closed company with a board of directors may replace a corporate auditor with an accounting counsellor; and a large company or company with committees has to establish an accounting auditor. The Corporation Law provides for the governance structures shown in Table 2.

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

Directors

The differences in the regulations concerning directors between the existing legislation and the Corporation Law are shown in Table 3.

Board of directors

Under existing legislation, a resolution of the board of directors is needed to convene the board of directors, including by telephone conference. Under the Corporation Law, if the articles of incorporation so provide, a resolution will be deemed to exist in cases where every director consents and no corporate auditor objects.

Internal control system

Under existing legislation, the board of directors in a company with committees must establish rules or some other system for internal control by resolution. There is no formal requirement relating to the internal control system in a company with a corporate auditor. However, some courts have held that directors are obliged to establish appropriate risk control systems. The Corporation Law requires companies with committees and large companies to establish rules or some other system for internal control by resolution. The Corporation Law requires the resolution to be disclosed by business report.

Derivative lawsuits

The Corporation Law makes accounting auditors and accounting counsellors subject to derivative lawsuits. Under existing legislation, the court may reject a derivative lawsuit that is an abuse of rights. The Corporation Law stipulates that a shareholder is prohibited from initiating a derivative lawsuit in cases where the purpose of the lawsuit is to protect a third party's unlawful profit or to damage the company.

Under existing legislation, a derivative lawsuit is rejected when a stock-for-stock exchange or stock-transfer is effected in the company and the shareholder changes into the absolute parent company's shareholder. One criticism is that a company might terminate a derivative lawsuit by a stock-for-stock exchange or stock-transfer. In response to this criticism, the Corporation Law allows for the continuation of derivative lawsuits in cases where the plaintiff is a shareholder of the absolute parent company after a stock-for-stock exchange or stock-transfer is effected.

The Corporation Law stipulates that a company has to provide notice to a shareholder regarding the reasons for its decision in cases where the shareholder requests the company to sue a director and the company decides not to do so. It is expected that this notice will enrich the evidence and accelerate trials with no discovery procedures, such as those in the US.

Corporate auditors

The Corporation Law requires approval from the board of corporate auditors or majority of corporate auditors to submit an item concerning their appointment to a shareholders' meeting.

Under existing legislation, a corporate auditor of a small company or YK only has authority regarding accounting audits. Under the Corporation Law, a corporate auditor has authority over operational audits and accounting audits. A closed company (except for large companies or companies with corporate auditors) may restrict a corporate auditor's authority over accounting audits by its articles of incorporation. A company that establishes a corporate auditor without authority over operational audits should be deemed a company without a corporate auditor and increase the shareholders' supervisory authority. In a company without a corporate auditor or audit committee, on behalf of the corporate auditor, a shareholder may demand a meeting of the board of directors in cases where any director has performed, or is likely to perform, an act that is outside the scope of the company's purposes or is otherwise in violation of any law or regulation or the articles of incorporation. In cases where a shareholder demands a meeting, if a notice appointing the day within two weeks from the date of the demand as the date of a meeting of the board of directors fails to be dispatched within five days, the shareholder who made the demand may convene a meeting of the board of directors. A director who has found a fact that is likely to cause damage to the company must immediately report it to shareholders. A shareholder may inspect the minutes of the meeting of the board of directors without obtaining the permission of a court. In cases where any director has performed, or is likely to perform, an act that is outside the scope of the company's purposes or is otherwise in violation of any law or regulation or the articles of incorporation, shareholders have the right to demand the cessation as granted to corporate auditors. A company without a corporate auditor or audit committee may not provide, in its articles of incorporation, that the company may exempt a director from liability, by resolution of the board of directors or a majority of directors.

Shareholders' meetings

Under existing legislation, shareholders' meetings in a KK may adopt a resolution only on the matters provided in the law or the articles of incorporation. Members' meetings in a YK may adopt any resolution unrestricted by the law or the articles of incorporation. Under the Corporation Law, shareholders' meetings in a company without a board of directors (the structure of which is similar to the existing YK) may adopt any resolution unrestricted by the law or the articles of incorporation.

Under existing legislation, only a shareholder may apply to a court for the appointment of an inspector to investigate the convocation procedures of shareholders' meetings and the manner of the meetings' resolutions. Under the Corporation Law, a company may apply to a court for the appointment of an inspector.

Accounting auditors

Under existing legislation, a large company has to establish an accounting auditor and a medium-sized company may establish an accounting auditor in its articles of incorporation. Under the Corporation Law, a large company and a company with committees has to establish an accounting auditor and all companies except for large companies may establish an accounting auditor in their articles of incorporation. With the abolishment of YK, all large companies (except for special YK) have to establish an accounting auditor.

The Corporation Law requires the registration of the name of the accounting auditors in the registry.

Under existing legislation, the representative director or board of directors decides the remuneration of accounting auditors. The Corporation Law requires approval of the board of corporate auditors, audit committee or a majority of corporate auditors for a decision regarding remuneration of accounting auditors.

Accounting counsellors

The Corporation Law establishes the position of accounting counsellor (kaikei-sanyo). A KK may establish an accounting counsellor in its articles of incorporation. An accounting counsellor is appointed by the shareholders' meeting and should be a certified public accountant, an incorporated accounting firm, a certified public tax accountant or an incorporated tax accounting firm. The main purpose of an accounting counsellor is to draft financial reports (balance sheets, profit/loss statements and other documents stipulated by Order of the Ministry of Justice) in cooperation with directors or executive officers. If an accounting counsellor has a different opinion to directors or officers, the accounting counsellor may express their opinion in shareholders' meetings. An accounting counsellor has to draft a report that is stipulated by Order of the Ministry of Justice. They compile the financial reports separately from the company and disclose the reports to shareholders and creditors. An accounting counsellor may, at any time, inspect or copy the accounting books and materials, or request the directors, executive officers, managers or other employees to provide a report on accounting matters. They may request any subsidiary to provide a report on accounting matters and may investigate the status of the corporate affairs and assets of any subsidiary, if necessary to properly perform their duties. An accounting counsellor is liable for negligence to the company and intentional or gross negligence to third parties. They are liable for false statements with respect to any material matter in financial reports; unless, however, they prove that they did not fail to exercise due care in the performance of their duties. The presence of an accounting counsellor, name of an accounting counsellor and financial report's installation location are registered in the registry. It is expected that, particularly for small companies without accounting auditors, the fact that qualified accountants or tax accountants draft financial reports in cooperation with directors or officers, combined with the duty to store and disclose the financial reports separately from the company, will enhance confidence in the accuracy of financial reports.

Accounting publications

Under existing legislation, KK have to publish an annual accounting publication in the official gazette or on the internet, while YK are exempt from this requirement. With the abolishment of YK, all KK (except for special YK) have to publish an accounting publication.

Supplementary resolutions

The Corporation Law strengthens corporate governance in some regards, but there is a concern that greater flexibility in the Corporation Law would weaken corporate governance. With the resolution of the Corporation Law bill, the Lower House adopted 13 supplementary resolutions. Some resolutions required the government to give special consideration to adequately maintain corporate governance for preventing outflow of corporate assets and protecting shareholders and creditors, and called for the reconsideration of the Corporation Law if necessary.

Author biographies

Takanobu Takehara Nishimura & Partners Takanobu Takehara first joined Nishimura & Partners in 1987 and is now a partner at the Tokyo-based 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 and has written a number of articles on commercial law. He qualified in Japan in 1987 and in New York in 1992. He was educated at the University of Tokyo (LLB, 1981), the Legal Training and Research Institute of the Supreme Court of Japan, and at 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 also for one year in New York at Cleary Gottlieb Steen & Hamilton after completing his legal education in the US. Takafumi Nihei Nishimura & Partners Takafumi Nihei is an associate at Nishimura & Partners. He has worked at the firm since 2003, after being educated at Waseda University (LLB, 2001) and at 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.