Japan

Author: | Published: 9 Oct 2003
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Japanese companies now have more choice when establishing their corporate governance system. There are now two clear options: the Shikko-yakuin system, which is usually comprised within a 'statutory auditor/board of statutory auditors structure' and this is the traditional Japanese corporate governance system. And the Shikko-yaku system which is based on a 'company with committees' system, a newly-introduced system under the revised Commercial Code of Japan. The Shikko-yakuin system can be adopted in combination with the company with committees system as well. According to Sony's press release dated April 24 2003, even after it adopted the company with committees system, nevertheless the Shikko-yakuin system would continue as a unique Sony system.

In order for the company to adopt the company with committees system, the company must be a large company or a Kabushiki-Kaisha whose articles of incorporation contain the provision under the Audit Special Exceptions Law article 2 paragraph 2. The term large company means a Kabushiki-Kaisha which falls under any one of the following items: (1) that, its capital amount is ¥500 million ($4.3 million) or more; (2) that, the total amount entered in the part of liabilities of the last balance sheet is ¥20 billion or more (The Audit Special Exceptions Law articles 1-2 paragraph 1).

After the revised Commercial Code became effective on April 1 2003, some companies, including Sony, adopted the Shikko-yaku system along with the company with committees system while others, including Toyota, maintained or adopted the Shikko-yakuin system keeping the statutory auditor/board of statutory auditors structure.

The purpose of this article is to provide companies doing business in Japan with pointers on establishing an appropriately customized corporate governance system.

OUTLINE OF THE SHIKKO-YAKU SYSTEM

The aim of the company with committees system

In order to understand the aim of the Shikko-yaku system, which falls under the company with committees system, one must first have some knowledge of the aims of the company with committees system.

There are a large number of items, required by the Commercial Code, to be decided by the board of directors. Because there are often a number of directors and some of them may even work in foreign countries, it can be difficult to hold frequent meetings of the board of directors. It has been suggested by some commentators that the number of these items should be decreased in order to facilitate prompt decision-making.

However, because the distinction between the corporate board's oversight function and its business operation function was not clear and because the representative director had virtually the power to determine the nomination and compensation of directors, other directors could not supervise the representative director's business operations effectively.

Under these circumstances, in order to transfer most of the decision-making function of the board of directors to the Shikko-yaku by revising the Commercial Code, it was necessary first to strengthen the oversight function of the board of directors.

The company with committees system was designed to enable the board of directors to transfer most of its decision-making function to the Shikko-yaku and at the same time exercise sufficient oversight of Shikko-yaku. Since it was introduced to provide companies with a variety of choices for proper corporate governance, adoption of this system is optional.

Authority of Shikko-yaku

The Shikko-yaku is entitled to make decisions regarding business operations entrusted by the board of directors and operate the business of the company with committees (under the law on special exceptions to the commercial code concerning audit, etc, of Kabushiki-Kaisha - usually called the Audit Special Exceptions Law, article 21-12). Within the company with committees, although the board of directors retains the authority to determine the business operations of the company, most of its decision-making function can be transferred to the Shikko-yaku except for certain specified items (the Audit Special Exceptions Law, article 21-7, paragraph 3). While some or all directors are entitled to operate their area of business within the company under the statutory auditor/board of statutory auditors structure, directors of companies with the company with committees structure, in principle, are not entitled to operate the business (the Audit Special Exceptions Law, article 21-6, paragraph 2) and the business operation function belongs instead to the Shikko-yaku.

For the purpose of maintaining a distinction between the oversight function and the business operation function, holding joint posts as director and Shikko-yaku should be prohibited. However, it is also true that if some members of the board of directors hold the concurrent post of Shikko-yaku and understand day-to-day operations, it can in fact contribute to the performance of proper oversight by the board of directors. Based on this viewpoint, the revised Commercial Code does not prohibit the holding of joint posts as director and Shikko-yaku except for outside directors and members of the audit committee (The Audit Special Exceptions Law, 21-13, paragraph 5). "Outside director" means a director who does not execute the company's business, has not assumed the position of director, Shikko-yaku, manager or any other employee where such position involves the execution of the business of such company or subsidiaries (meaning the subsidiaries under the Commerical Code article 211-2 paragraph 1) in the past, and also who does not assume the position of director, Shikko-yaku, manager or any other employee who is now executing the business of such company or subsidiary (the Commercial Code article 188 paragraph 2 item 7-2). The majority of the member directors of each committee must be outside directors who are not Shikko-yaku of the company with committees (the Audit Special Exceptions Law article 21-8 paragraph 4).

OUTLINE OF "SHIKKO-YAKUIN" SYSTEM

The Shikko-yakuin structure was originally introduced as a new corporate governance system by Sony in 1997. An article in the Nihon Keizai Shimbun, a newspaper widely read in Japan, dated May 27 1997 says "Sony's directors will be reduced from 38 to 10 members and the company will establish a new corporate governance system by introducing a Shikko-yakuin system so that the business decision-making function is clearly distinguished from business operations. ... This is the first attempt for domestic enterprises to introduce the US-style corporate governance system which clearly differentiates policymaking from business operation. ... Meanwhile, the board of directors will concentrate on the decision-making and the oversight function and aim for the speedy management of its business".

The Shikko-yakuin system was originally introduced as a method for distinguishing the decision-making function from business operations. It was designed to contribute to the oversight function of the board of directors and a reduction in the number of existing directors by providing new posts for them so that substantial discussion and prompt decision-making by the board of directors could be enhanced. After Sony introduced this system, some other Japanese companies also began to adopt this system. While the Shikko-yaku is a concept introduced by the most recent amendment to the Audit Special Exceptions Law, the Shikko-yakuin is a concept adopted by Sony for its corporate governance structure before the introduction of the Shikko-yaku system and has no statutory basis.

THE CHOICE OF CORPORATE GOVERNANCE SYSTEM

Adoption of the company with committees system under the revised Code is optional. Japanese companies can either remain with the existing corporate governance structure (statutory auditor/board of statutory auditors structure) or adopt the company with committees system under the revised Commercial Code. An article in the Commercial Law Review (No 1669), a journal widely read among Japanese lawyers, published on July 25 2003 says "A total of 55 companies have adopted the company with committees system since the revised Commercial Code became effective on April 1 2003."

COMPARISON BETWEEN SHIKKO-YAKU AND SHIKKO-YAKUIN

Outline

As mentioned above, the Shikko-yaku system and the Shikko-yakuin system are both designed to enable a company to make prompt business decisions so that Japanese companies can enhance their international competitiveness. Also, they are both designed to establish a distinction in roles and responsibilities between oversight and operational functions within a corporation so that reinforcement of the oversight function of the board of directors can be enhanced. In order to contrast the differences between the Shikko-yaku system and Shikko-yakuin system, the Shikko-yakuin system herein is assumed to be comprised within the statutory auditor/board of statutory auditors structure.

In order to achieve this goal, specified scope of authority and responsibilities is assigned to Shikko-yaku and Shikko-yakuin. However, the scope and flexibility of the authority and their responsibilities differ between Shikko-yaku and Shikko-yakuin. Because the Shikko-yaku system is prescribed in the Commercial Code, the scope of authority and responsibilities of Shikko-yaku is comparatively clear. Because the Shikko-yakuin system is not based on the Commercial Code, the scope of authority and responsibility depends on the interpretation of the contract between the company and the Shikko-yakuin. However, the system is flexible compared to Shikko-yaku system.

The following are the key differences between Shikko-yaku and Shikko-yakuin with regard to their areas of authority and responsibilities.

Details

Transfer of the decision-making function of the board of directors

In the company with committees structure, the board of directors can delegate company decision-making - which the Commercial Code otherwise requires of the board of directors - to Shikko-yaku, excluding certain limited items (The Audit Special Exceptions Law, article 21-7 paragraph 3). Because it is companies which want to carry out speedy decision-making that are assumed to adopt the company with committee system, the decision-making function of the board of directors should be substantially transferred to Shikko-yaku.

In the company with the statutory auditor/board of Statutory auditors structure, although there are a few exceptions, the board of directors must decide the business operations of the company as the Commercial Code requires. This causes inconvenience with regard to prompt decision-making. One of the ways to solve this problem is to reduce the number of directors and enable board members to hold meetings frequently so that prompt decision-making can be achieved.

Sharing the post of a director

In the company with committees structure, a director can also act as a Shikko-yaku (the Audit Special Exceptions Law, article 21-13, paragraph 5).

Similarly, in the company with the statutory auditor/board of statutory auditors structure, a director can also act as Shikko-yakuin.

Appointment and Dismissal

In the company with committees structure, the Shikko-yaku are appointed and dismissed by the board of directors so that the oversight function of the board of directors can be performed effectively (the Audit Special Exceptions Law, article 21-13, paragraphs 1 and 6).

In the company with the statutory auditor/board of statutory auditors structure, the Shikko-yakuin are also appointed and dismissed by the board of directors as is required for key employees (the Commercial Code, article 260, paragraph 2).

Auditing system

In the company with committees structure, three committees (nomination, compensation and audit) are established. The majority of these are staffed by outside directors who are not Shikko-yaku of the company with committees so that the independence from the representative Shikko-yaku who may have a interlocking post as a member of the board of directors is retained. This system is designed to avoid the representative Shikko-yaku from using its virtual power to single-handedly determine the nomination and compensation of directors. Because audit committee members who have voting rights on the board of directors supervise the validity of the business operations, the oversight function of the board of directors is expected to be strengthened.

In the company with the statutory auditor/board of statutory auditors structure, the oversight function is assigned to the board of directors and the statutory auditor/board of statutory auditors. With regard to a large company, there must be more than three auditors, among whom more than one, during the preceding five years, must have been neither directors, Shikko-yaku, managers, or any other employees of the large company or its subsidiaries (the Audit Special Exceptions Law, article 18 paragraph 1). This article was revised in 2001 and the following is a new provision which will be effective on May 1 2005. "With regard to a large company, there shall be more than three auditors, among which more than half, must have been neither directors, Shikko-yaku, managers or any other employees of the large company or subsidiaries." The oversight function of the board of directors tends not to be performed properly for the reasons mentioned above.

Reporting obligation

In the company with committees, each Shikko-yaku must make report on his or her duties to the board of directors at least once every three months (the Audit Special Exceptions Law, article 21-14, paragraph 1) so that the business operation oversight function of the board of directors can be performed effectively. Also, when a Shikko-yaku finds any fact that threatens to cause considerable damage to the company with committees, the Shikko-yaku must immediately report it to the audit committee members (the Audit Special Exceptions Law, article 21-14, paragraph 5).

In the company with the statutory auditor/board of statutory auditors structure, if the relationship between the Shikko-yakuin and the company is mandated, Shikko-yakuin must, at any time on demand from the company, report on the condition of the management of the affairs entrusted to him or her (the Civil Code, article 645). However, not only is it unclear to whom Shikko-yakuin must report, but it is also unclear as to when Shikko-yakuin should report (other than when it is demanded by the company). Therefore, the company should in addition prepare and implement detailed reporting obligations for Shikko-yakuin.

Responsibility of Shikko-yaku and Shikko-yakuin to the company

When any Shikko-yaku neglects his or her duties, they have an obligation to the company with committees to compensate for the damages suffered by the company due to this negligence (the Audit Special Exceptions Law, article, 21-17 paragraph 1). The provisions of derivative action by shareholders of the Commercial Code (articles 267 to 268-3) apply mutatis mutadis with respect to the action to enforce the liability of Shikko-yaku (the Audit Special Exceptions Law, article 21-25, paragraph 2).

The responsibility of Shikko-yakuin depends on the contract between Shikko-yakuin and the company and the above provisions of derivative action by shareholders do not apply to actions against Shikko-yakuin.

Responsibility of Shikko-yaku and Shikko-yakuin to the third party

When a Shikko-yaku has been guilty of bad faith or gross negligence in his or duties, the Shikko-yaku is liable to compensate for the damages sustained by any third party (the Audit Special Exceptions Law, article 21-22 paragraph 1).

There are no laws which expressly provide for the responsibility of Shikko-yakuin for third parties. However, if the Shiiko-yakuin intentionally or negligently violates the right of another, they are liable to compensate them for damages (the Civil Code, article 709).

ANALYSIS

Judging from the above, while the scope of authority and responsibilities of Shikko-yaku is comparatively clear, that of Shikko-yakuin depend on the interpretation of the contract between the company and the Shikko-yakuin. However, because the relationship between the company and the Shikko-yakuin is determined by the contract, the Shikko-yakuin system is more flexible.

Because the Shikko-yakuin system has this flexibility, in both the positive and negative sense, whether or not the company can accomplish its goals with the Shikko-yakuin system depends on the company's management of the system.

This is also true, to some extent, with the Shikko-yaku system because this system also has some flexibility. For example: the scope of delegation of the decision-making function of the board of directors can be decided at the board's discretion; the number of directors who also have posts as Shikko-yaku can be decided by the board; and, people who have very close relationships with Shikko-yaku, such as relatives, can become outside directors. Whether or not the company can accomplish the goal of the Shikko-yaku system also depends on the company's management of the system.

CONCLUSION

In order for Japanese companies to achieve international competitiveness and establish the accompanying oversight systems, the revised Commercial Code introduced a new option for the corporate governance system. Although, there are more options for companies to accomplish their goals, they are not perfect. Regardless of the system the company adopts, it is important that the company properly implements that system so that the primary goal of the system can be accomplished. This in turn should be supervised by concerned parties such as the shareholders and creditors of the company.


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