The Sarbanes-Oxley Act

Author: | Published: 5 Jan 2004
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The enactment in the US of the Sarbanes-Oxley Act (the Act) in July 2002 produced a marked reaction from US capital markets participants around the world. Japan was no exception.

In Japan, companies with reporting obligations (reporting companies) under the US Securities Exchange Act of 1934 (the Exchange Act), as well as other companies contemplating a listing and/or offering in the US, were initially concerned that the language of the Act did not provide for any distinction between US and foreign issuers. The absence of such language in the Act would have required Japanese issuers to comply with both the Act and Japanese corporate governance laws. This was believed to be not just difficult, but for certain provisions, nearly impossible.

Some of the more publicized reactions of Japanese issuers to the Act included the announcements by companies, such as Fuji Photo Film, to postpone their plans to list their securities on a US national securities exchange or on the Nasdaq National Market. In January 2001, the Nihon Keizai Shimbun newspaper reported that 15 Japanese issuers were in the process of listing on the New York Stock Exchange (NYSE). At press time, only two Japanese companies have proceeded to list their securities in the US after the Act was enacted, and both of those companies started their listing procedures before the Act was introduced.

On the other hand, many Japanese reporting companies appear to have become increasingly comfortable with the changes in the regulatory environment the Act spurred. In some instances, these companies are using the rule changes as an opportunity to increase investor confidence in the transparency of their business and financial reporting and, in some cases, to improve their internal disclosure and controls processes. At press time, there were 30 Japanese reporting companies; all except two are listed on a US national securities exchange or quoted on Nasdaq.

Certain provisions of the Act have generated greater attention among Japanese reporting companies compared with others. Such provisions are: the new chief executive officer (CEO) and chief financial officer (CFO) certification requirements (sections 302 and 906); the disclosure controls and procedures requirement (section 302) and the internal control over financial reporting requirement (section 404); the new audit committee standards (section 301); the audit committee financial expert requirement (section 407); the auditor independence requirements, including the auditor service pre-approval requirement (section 202); and the prohibition on personal loans to directors and executive officers (section 402). This article discusses certain of these provisions and how they have impacted Japanese reporting companies to date.

CEO and CFO certifications

Section 906 added a new provision to the US criminal code and became effective immediately on the Act's enactment on July 30 2002. The section 906 certification requirement applies to all periodic reports containing financial statements filed with the US Securities and Exchange Commission (SEC). Regarding Japanese reporting companies this means annual reports filed on Form 20-F. The SEC has clarified that the section 906 certification requirement does not apply to Form 6-Ks.

Each annual report on Form 20-F must be accompanied, in the form of an exhibit, by a written statement by the company's CEO and CFO (or persons performing similar functions). The statement must certify that the report fully complies with the Exchange Act and that the information contained in the report "fairly presents, in all material respects, the financial condition and results of operations" of the issuer. Section 906 provides for criminal penalties for CEOs and CFOs who certify reports that do not meet the standards it sets forth. The section provides for a fine of up to $1 million and/or imprisonment of up to 10 years for certifying annual reports while knowing that the statements do not comply with the requirements of section 906. The maximum sanctions are increased to $5 million and a 20-year prison term if the violation is wilful.

On August 28 2002, in accordance with the provisions of section 302 of the Act, the SEC adopted rules requiring an additional certification by the CEO and CFO of a reporting company to accompany quarterly and annual reports. Again, for Japanese reporting companies, this means, in effect, annual reports filed on Form 20-F. This certification must address, among other things, the quality of the issuer's financial statements and other information in the report, the effectiveness of the issuer's disclosure controls and procedures and significant deficiencies in the issuer's internal control over financial reporting.

Generally speaking, the CEO and CFO have always faced litigation risks in connection with the issuer's continuing disclosure under the controlling-person liability theory set forth in section 20(a) of the Exchange Act. Under section 20(a), persons who are deemed to control an issuer can be held liable to the same extent as the issuer itself for violations of the Exchange Act. Accordingly, even before the Act, the CEO and CFO could be named as defendants in securities fraud class actions.

However, not only does section 906 provide criminal penalties for CEOs and CFOs as individuals but these officers are now also, as a result of signing the certifications, subject to primary actor liability. This has a lower threshold for establishing a cause of action and does not provide for certain defenses afforded to defendants under the controlling-person liability theory. Moreover, the certifications now require certifying officers to make affirmative statements regarding matters that were not previously required. Therefore, the addition of new statements attributable to the CEO and CFO may further increase the likelihood of being named as defendants, with plaintiffs alleging that the certifications were false and not based on sufficient facts.

Disclosure controls and procedures

The SEC rules implementing the provisions of section 302, as amended in June 2003, maintain that the CEO and CFO are responsible for establishing and maintaining the reporting company's disclosure controls and procedures. Moreover, the officers are required to disclose in the Form 20-F their conclusions as to the effectiveness of the disclosure controls and procedures as of the end of the fiscal year. The SEC defines the term disclosure controls and procedures as: "Controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the [Exchange] Act is recorded, processed, summarized and reported, within the time periods specified in the [SEC's] rules and forms".

The SEC has not given specific guidelines for companies to follow to ensure that they have adequate disclosure controls and procedures in place. However, the SEC, in the adopting release for the final rule related to disclosure controls and procedures, stated that each issuer should develop its own controls and procedures that are consistent with its business and its internal management and supervisory practices. Such controls and procedures should:

  • ensure that internal communications and other procedures result in important information (including new developments and risks) reaching the appropriate collection and disclosure points in a timely manner;
  • result in timely evaluation of information (including new developments and risks) that potentially should be disclosed by the issuer. Although a certification is not required for current reports, such as Form 6-Ks, the SEC states that the disclosure controls and procedures "are required to be designed, maintained and evaluated to ensure full and timely disclosure in current reports... even though there is no specific certification requirement relating to reports on those forms"; and
  • ensure that material information that is not otherwise required to be included in the applicable report is included as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.

The SEC recommends that each issuer establish a committee that is responsible for "considering the materiality of information and determining disclosure obligations on a timely basis". Suggested committee members include the principal accounting officer, the general counsel, the principal risk management officer, the chief investor relations officer, heads of business units and other persons that the issuer deems appropriate. The committee would report to senior management, including the CEO and CFO.

Steps taken by Japanese reporting companies
At the time the Act was enacted, Japanese reporting companies had in place their own procedures pursuant to which they made filings under Japanese laws and regulations and reports required under the Exchange Act. While steps taken by Japanese reporting companies in response to the certification requirements vary in degree and scope, many reporting companies chose to revise and formalize their existing disclosure controls and procedures.

The establishment of disclosure committees by Japanese reporting companies such as Toyota Motor Corporation, The Bank of Tokyo-Mitsubishi and Kyocera Corporation has received a fair amount of attention in the Japanese press over the past year. To our knowledge, these committees have generally been established in connection with the preparation of various disclosure, including annual reports on Form 20-F, and are comprised of members who are collectively accountable for all portions of the Form 20-F, such as the accounting and investor relations departments and the heads of business units.

Members often also include company directors (torishimariyaku) and/or executive officers (shikko yakuin). Members of the board of auditors (kansayaku) often participate in the disclosure committee as well. As a matter of practice, members of the disclosure committee, as well as other key employees of the issuer, are typically asked to sign back-up certificates in connection with the CEO and CFO certifications. Many of these issuers have also created disclosure guidelines and record-keeping procedures that set forth the responsibilities of the disclosure committee, the assignment of persons responsible for specific sections of the annual report, the specific procedures related to the preparation of annual reports and the issuer's document retention policy.

Internal control over financial reporting

The SEC has adopted rules that require the inclusion in annual reports on Form 20-F of an internal control report issued by management. The report must include an assessment of the effectiveness of the issuer's internal control over financial reporting as of the end of the fiscal year, and an attestation report issued by the issuer's outside auditor on management's assessment of the issuer's internal control over financial reporting. The provisions relating to the internal control report and auditor attestation become effective for Japanese reporting companies and other foreign private issuers in their annual reports on Form 20-F for fiscal years ending on or after April 15 2005.

In the Form 20-F covering subsequent fiscal years, issuers will be required to disclose any material changes in their internal control over financial reporting that occurred during the fiscal year. SEC rules define the term internal control over financial reporting as:

"A process designed by, or under the supervision of, the issuer's principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer's board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

  1. pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;
  2. provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and
  3. provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer's assets that could have a material effect on the financial statements."

Steps taken by Japanese reporting companies
The SEC rules require management to base the evaluation of the internal control over financial reporting on a suitable, recognized control framework, but do not mandate use of any particular one. The SEC specifically cited in its adopting release the framework promulgated by the Committee of Sponsoring Organizations of the Treadway Commission (Coso) as one that satisfies the rules' criteria. But the SEC has also acknowledged in the adopting release that other frameworks exist outside the US that meet the suitable standards.

Although the SEC explicitly recognized the evaluation frameworks in Canada, the UK and Australia in an open meeting held on May 27 2003, it did not refer to any frameworks employed by Japanese issuers. At press time, it was unclear which framework, including Coso, Japanese reporting companies will adopt and what requirements outside auditors will place on these companies before issuing their attestation reports. Most Japanese reporting companies view the provisions relating to internal control over financial reporting and the attestation as the most significant burdens overall for purposes of complying with the Act.

Listed company audit committees

In April 2003, the SEC adopted Rule 10A-3 under the Exchange Act to implement the provisions of section 301. These rules directed the national securities exchanges and national securities associations in the US (self-regulatory organizations or SROs) to adopt rules by December 1 2003 that prohibit the listing or quotation on an SRO of securities of an issuer that is not in compliance with certain audit committee independence requirements. On November 4 2003, the SEC approved the rules regarding the new corporate governance standards of the NYSE and Nasdaq, both of which address, among other things, the new SEC rules on audit committee independence.

Foreign issuers, including Japanese companies, with securities listed or quoted on an SRO (listed companies) must comply with most governance requirements related to audit committees by July 31 2005.

Audit committee requirements
Rule 10A-3 under the Exchange Act requires SROs to implement new listing standards for listed companies that, at a minimum, incorporate the following requirements.

Firstly, each member of the audit committee of the issuer must be independent according to specified criteria. Secondly, the audit committee must be responsible for the appointment, compensation, retention and oversight of the work of outside auditors. Thirdly, the audit committee must establish procedures for handling complaints relating to matters of accounting, internal controls and auditing (including confidential and anonymous submission by employees). Fourthly, the audit committee must have authority to engage independent counsel and other advisers. Finally, the issuer must provide suitable funding for the audit committee.

US domestic listed companies were required under NYSE and Nasdaq rules to have an audit committee even before the Act was enacted. But foreign listed companies were generally exempted from the audit committee requirements as the SROs deferred to home country practice of the issuer. Rule 10A-3 applies to foreign, as well as domestic, listed companies and, therefore, compliance with the new audit committee rules is now required for Japanese listed companies, subject to the exemptions described below.

Initial reaction of Japanese issuers
Section 301 of the Act provoked a strong reaction from foreign private issuers, including Japanese issuers. Discussions regarding the suitability and scope of exemptions from the audit committee requirements (both for domestic and foreign listed companies) began before the release in January 2003 of the SEC's proposed implementing rules for section 301.

After their release, more than 185 comment letters were filed with the SEC. Eleven of these comment letters were submitted by, or on behalf of, Japanese issuers. Most Japanese listed companies voiced concerns about the consistency of the audit committee requirements with Japanese corporate governance requirements, in particular the apparent conflict between these new requirements and the governance provisions prescribed by the Japanese Commercial Code. In addition, a number of Japanese issuers, either directly or through various business groups and government ministries, met with the SEC to discuss the applicability of the rules.

The independence standard for audit committees
Rule 10A-3 under the Exchange Act requires each member of the audit committee to be a member of the board of directors and otherwise be independent as defined in the rule.

Two requirements must be satisfied for an audit committee member to be considered independent. Firstly, each audit committee member must not accept from the listed company or any of its subsidiaries any consulting, advisory or other compensatory fees, directly or indirectly, other than fees received in the capacity of a board or committee member, subject to limited exceptions. Secondly, the audit committee member must not be an affiliate of the listed company or any of its subsidiaries.

The term affiliate means "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified". Control is defined to mean "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise".

The SEC has, for purposes of the audit committee independence standard, adopted a safe harbour providing that a person will not be deemed to be in control (and, therefore, not an affiliate) of the issuer if such person is not an executive officer of the listed company or the beneficial holder of more than a 10% of the listed company's voting equity securities.

The new SRO listing rules approved by the SEC on November 4 2003 have additional independence requirements for audit committee members, as well as other new requirements related to corporate governance. But the SROs continue to defer to the home country practice of foreign issuers to the extent permitted by SEC rules.

Consequently, under the new SRO listing rules, foreign issuers, in essence, are required to comply only with the audit committee independence standards under Rule 10A-3 and disclose, among others, the ways in which the issuer's governance differs from that required for US companies under the SRO rules.

General exemption for listed companies with a board of auditors
After the SEC comment process, which involved the active participation of Japanese listed companies and others, an exemption for issuers that maintain a board of auditors or statutory auditors (the board of auditors) pursuant to home country legal or listing provisions was incorporated into Rule 10A-3 and the SRO rules. This exempts foreign listed companies with a board of auditors from the audit committee independence requirements if certain criteria are satisfied, including: the board of auditors being either separate from the board of directors or composed of both members and non-members of the board of directors; the board of auditors not being elected by the issuer's management and no executive officer being a member of the board of auditors; and home country laws or listing standards setting forth standards for independence of the board of auditors from management.

Effects of the audit committee rules on Japanese listed companies
The Japanese board of auditors system as provided by Japanese law (kansayakukai-seido) qualifies for the exemption from the SEC's audit committee independence rules. Japanese listed companies that have a board of auditors are still required to comply with the other requirements related to audit committees (in this case, the board of auditors), including: the appointment, compensation, retention and oversight of outside auditors; the handling of complaints; engagement of independent advisers; and appropriate funding.

Recognizing that some of these requirements may conflict with local laws or listing regulations, the SEC made each such requirement subject to the standard of "to the extent permitted by law" and these requirements "are to apply consistent with home country requirements".

Starting in April 2003, Japanese companies have the option of becoming a committee-based system corporation (iinkai-tou secchi kaisha) under the Japanese Commercial Code. Despite calls by several Japanese corporations, business groups and government ministries for an exemption from the audit committee independence requirements for Japanese listed companies that choose the committee system, the SEC has, to date, declined to extend such relief.

These Japanese interest groups have made several arguments in favour of the exemption applying to the Japanese committee system. They argue that the audit committee under the Japanese system, although not identical to the US system, is based on the US model and, in the opinion of some, is intended to further improve the oversight of financial reporting by public companies. We understand that the Japanese committee system requires a majority of audit committee members to be independent (as defined under Japanese law), rather than all members being independent as set forth in Rule 10A-3.

Some argue that it would be difficult for an audit committee comprised solely of independent directors to perform all of the functions required of it under Japanese law. Nonetheless, some Japanese reporting companies that have adopted the committee system have decided to comply with the requirements under Rule 10A-3, regardless of the final decision of the SEC with respect to this issue.

Audit committee financial expert

In January 2003, the SEC implemented the provisions of section 407 by adopting a rule requiring disclosure in annual reports on Form 20-F with respect to whether the issuer has at least one audit committee financial expert on its audit committee (the board of auditors, in the case of Japanese companies that use the board of auditors system) and, if not, the reasons for this. Issuers, including foreign private issuers, must provide this disclosure for their fiscal years ending on or after July 15 2003.

An audit committee financial expert is, in summary, defined as a person who has an understanding of generally accepted accounting principles (Gaap), experience in the preparation, audit or analysis of financial statements and an understanding of internal control for financial reporting. In the context of this definition, Gaap refers to the Gaap used by the issuer to prepare its primary financial statements as filed with the SEC.

Most Japanese reporting companies voluntarily prepare US Gaap financial statements for Form 20-F reporting, unlike almost all reporting companies from other countries that provide a reconciliation of their home country Gaap numbers to US Gaap. Thus, an audit committee financial expert of a Japanese reporting company must have an understanding of US Gaap, rather than Japanese Gaap.

This requirement raises concerns for Japanese reporting companies because it is expected that identifying a suitable audit committee financial expert will be a challenge. Because most Japanese reporting companies manage their business in Japanese Gaap, they prepare their Japanese Gaap financial statements first and use these statements as a basis to convert their financial results into US Gaap financial statements. Therefore, most experts in financial reporting and financial statements resident in Japan are experts in Japanese Gaap.

In addition, although the number of US-qualified accountants in Japan is gradually increasing, the experience of most of these accountants is unlikely to meet the standards required under the rules to qualify as an audit committee financial expert. A Japanese reporting company that does not appoint an audit committee financial expert must disclose that fact and explain why it has not done so.


Despite the initial negative reaction among Japanese issuers to the introduction of the Sarbanes-Oxley Act, we believe that most Japanese reporting companies are taking steps to comply, with some issuers even choosing to treat the Act as an opportunity to further improve corporate disclosure and governance.

The dissipating anxiety among Japanese issuers can be attributed, in part, to the clarification of the specific requirements of each provision of the Act and the acceptance of the added responsibilities, and, in part, to the exemptions extended to certain foreign private issuers, including Japanese reporting companies. Although the final impact on Japanese issuers of certain provisions of the Act, including sections 404 and 407, remains to be seen, the initial uncertainty and concern that passage of the Act sparked is expected to further recede in the coming months.

The experience since the introduction of the Act 16 months ago demonstrates the importance of effective communication among foreign private issuers, foreign governments, interest groups, professionals (including accountants and attorneys) and the SEC. Without such dialogue, it would prove quite difficult to reach an effective understanding of various corporate governance practices and then fine-tune the Act as necessary to apply to foreign reporting companies. An example of the fruits of such dialogue is the general exemption from the audit committee requirements granted to Japanese reporting companies with a board of auditors.

Continued efforts should be made to further enhance coordination among interested parties across various jurisdictions to develop corporate governance standards and capital markets regulations that take into account the varying perspectives, practices and standards of issuers inside and outside the US.

Author biographies

Masahisa Ikeda

Shearman & Sterling

Masahisa Ikeda is the managing partner of Shearman & Sterling's Tokyo office. His practice focuses on capital markets transactions, representing issuers and underwriters in SEC-registered offerings, private placements and stock exchange listings. In particular, he has worked on more than 50 capital markets offerings in his career, including many by Japanese issuers. He also represents various companies and financial institutions in M&A transactions.

Ikeda started his legal career in New York and relocated to Tokyo in 2000. He is a Japanese citizen and graduated from the University of Tokyo with an LLB degree, from Harvard University with an AB degree in economics and from Harvard Law School with a JD degree. He is a member of the Bar in New York, of the Bar of the District of Columbia and of the Dai-ichi Tokyo Bar Association (registered as a foreign lawyer).

Isamu Watson

Shearman & Sterling

Isamu Watson is a senior associate in Shearman & Sterling's capital markets group. He returned to the Tokyo office in April 2003 after spending one year in the New York office. He was based in the Tokyo office from March 1999 to March 2002. During his time in Japan, he has represented both issuers and underwriters in connection with debt and equity offerings in Japan and other Asian countries. During his time in New York, he focused primarily on capital markets, with particular emphasis on high-yield and convertible debt offerings.

He graduated from the University of Washington with a BA in international studies. He received his JD degree from Georgetown University Law Center. He grew up in Japan and speaks Japanese. He is a member in good standing of the Bar in New York and of the Daini Tokyo Bar Association (registered as a foreign lawyer).

Satoko Kato

Shearman & Sterling

Satoko Kato is an associate in the capital markets group in the Tokyo office of Shearman & Sterling. She relocated to Tokyo from New York in April 2003 and has experience in various areas including tender offers, private placements, notes offerings and funds. She has also represented a number of Japanese clients in matters relating to US securities laws and general corporate law.

She graduated with an LLB degree from Sophia University and a JD degree from Georgetown University Law Center. She is admitted to practice in New York.

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