The U.S. Securities and Exchange Commission ("SEC") released on January 8, 2003 its "Proposed Rule: Standards Relating to Listed Company Audit Committees" ("Proposed Rule") under Section 301 of the Sarbanes-Oxley Act of 2002.
We highly appreciate the Proposed Rule as it contains appropriate and rational provisions for the exemption of foreign corporations, duly respects the corporate governance systems of foreign countries, and maintains the principle of the open U.S. capital markets.
However, from the perspective of Japanese corporations, there are certain matters which remain unclear. We therefore take this opportunity to submit our comments as follows.
Regarding the required standards of the audit committee, the Proposed Rule provides for the exemption of foreign corporations thereby extending due respect to the corporate governance systems of foreign countries. This general principle should be maintained. Furthermore, this exemption should not be temporary and should be permanent. Accordingly, a sunset clause is not necessary. Especially in the case of Japanese companies, as outlined below, Japanese law provides for the equivalent level of corporate governance as is sought under the Sarbanes-Oxley Act. Therefore, Japanese corporations, being subject to such provisions of Japanese Law, should be exempted from the requirements of the Sarbanes-Oxley Act.
The Proposed Rule exempts foreign corporations from the independence requirement (10A-3(b)(1)) and the responsibility requirement of registered public accounting firms (10A-3(b)(2)) when "a board of auditors (or similar body), or statutory auditors" meets certain requirements. We highly appreciate the intent of the Proposed Rule to duly respect foreign corporations and their home-country legal systems which they comply with. In the context of the Japanese legal framework, boards of corporate statutory auditors under the board of corporate statutory auditor system and audit committees under the committee system are identified as equivalent alternatives under the Commercial Code and the Law for Special Exceptions to the Commercial Code Concerning Audits, etc. of Corporations (hereinafter "Special Law"). Hence, both boards of corporate statutory auditors and audit committees should be accorded the same treatment. In accordance with the principle of respecting the governance system of foreign countries, the exemption of Japanese audit committees from the independence requirement (10A-3(b)(1)) and the responsibility requirement of registered public accounting firms (10A-3(b)(2)) should be clearly stated. In this connection, because Japanese audit committees are established within the board of directors, the phrase "separate from the board of directors" appearing under 10A-3(c)(2)(i)(B) should be deleted or otherwise appropriately modified.
In Japan, corporations are unable to readily find outside appointees to the audit committee who are capable of fully performing auditing functions. Hence, it is believed that appointing full-time committee members from within the corporation will bolster the capability of the audit committee. (See "*" below.) This approach has the following advantages. Full-time members of the audit committee are well acquainted with the business operations of the corporation. On the other hand, in their position as non-executive officers, they remain independent of management. Due consideration should be given to these special conditions in Japan in determining the treatment of Japanese audit committees under the SEC Final Rule.
* In Japan, experts argue that an audit committee is generally unlikely to function when all its members are outside and non-full time.1
Under Japanese law, the membership of an audit committee must consist of a majority of outside directors. According to the commentary of the drafters of the legislation, the requirement was thus defined in consideration of the difficulty in finding qualified outside directors.2
As outlined in Attachment 1, Japanese law defines the rights and responsibilities of the board of corporate statutory auditors/audit committee regarding external accounting auditors. In our view, the board of corporate statutory auditors/audit committee satisfies the requirements of 10A-3(c)(2)(i)(E) (requirement concerning the direct responsibility of the board of corporate statutory auditors for the oversight of work of registered public accounting firms).
We believe that the wording of 10A-3(c)(2)(i)(E) or its interpretations should be appropriately modified, if necessary, in order to clearly indicate that the board of corporate statutory auditors/audit committee duly satisfies the requirements of 10A-3(c)(2)(i)(E) (requirement concerning the direct responsibility of the board of corporate statutory auditors for the oversight of work of registered public accounting firms) by the provisions of Japanese law as outlined in Attachment 1.
As regards a board of corporate statutory auditors, we believe that the requirements of 10A-3(c)(2)(i)(D) (Requirement concerning standards for the independence of boards of auditors (or similar bodies), or statutory auditors in home-country legal or listing provisions) are satisfied by the provisions of Japanese law as outlined in Attachment 2. In this regard, the prohibition of concurrent posting as auditor and director as provided under Article 276 of the Commercial Code, and requirements concerning outside auditors as provided under Article 18 Paragraph 1 of the Special Law are of particular significance.
With regard to audit committees, we believe that the requirements of 10A-3(c)(2)(i)(D) (Requirement concerning standards for the independence of boards of auditors (or similar bodies), or statutory auditors in home-country legal or listing provisions) are duly satisfied by the provisions of Article 21-8 Paragraph 4 of the Special Law which stipulates that the membership of the audit committee must consist of a majority of outside directors.
To prevent any misunderstanding that the provisions of Japanese law as outlined above do not satisfy the pertinent requirements, this interpretation should be explicitly stated, if necessary, to clearly indicate that the degree of independence is left up to the provisions of individual foreign countries.
Foreign corporations are exempted under general exemptions from the provisions of 10A-3(b)(2) which establish requirements concerning direct responsibility for compensation of registered public accounting firms. On the other hand, the Proposed Rule proceeds to establish 10A-3(b)(5)(i) which stipulates a contradictory required standard concerning payment of compensation to registered public accounting firms. This inconsistency should be rectified by also exempting foreign corporations from the provisions of 10A-3(b)(5)(i).
Even if the requirements of 10A-3(b)(5)(i) were applied to foreign corporations, it is our understanding that under the provisions of Japanese law as outlined in Attachment 3, the board of corporate statutory auditors/audit committee fully satisfies the requirements of 10A-3(b)(5)(i). To prevent any misunderstanding that the provisions outlined in Attachment 3 do not satisfy the pertinent requirements, this interpretation should be explicitly stated, if necessary, to clearly indicate that the provisions of Japanese law as outlined in Attachment 3 are sufficient in realizing the intent of the proposed 10A-3(b)(5)(i).
Regarding the independence requirement applicable to non-investment corporations, further to the definitions of "affiliate" and "affiliated person," a safe harbor has been proposed concerning "control" which is a central factor in this determination. We highly appreciate the safe harbor as it will facilitate determination of the independence requirement. According to this safe harbor, any person who is not a beneficial owner of more than 10% of the equity shares of the issuer, and is neither an executive officer nor a director of the issuer, is not deemed to have control over the issuer. Given that members of the audit committee must not be affiliated persons, other than in their capacity as a member of the board or other committee, it follows that a director who is not a beneficial owner of more than 10% of the equity shares of the issuer and is not an executive officer, but is a member of the audit committee, does not constitute an affiliated person. As such, it is our understanding that, so long as such persons satisfy the other requirement as provided under 10A-3(b)(1)(ii)(A), the independence requirement (10A-3(b)(1)(i)) is duly satisfied. If this interpretation is incorrect, the provision "not a director" should be deleted from the safe harbor, or otherwise appropriately modified.
Concerning the 10% rule in the safe harbor "not a beneficial owner directly or indirectly owning more than 10% of any class of shares in the issuer as provided under 10A-3(e)(1)(i)(A)," we believe this figure should not be lowered.
Unlike the United States, Japanese corporate governance is primarily based on its company laws (Commercial Code and the Special Law) and not on its securities regulations (the Securities and Exchange Law). Consequently, while corporate governance requirements under Japan's company laws may differ based on a corporation's capital stock and liabilities, as a rule, requirements do not differ according to whether or not a corporation is publicly listed or quoted. Under these circumstances, there are no grounds for applying the provisions of 10A-3(c)(2)(i)(A) (requirements concerning listing on a securities exchange outside the U.S.) to Japanese corporations. In the very least, this requirement should not apply to "large corporations" defined in the Special Law.
Regarding the determination of the applicability of exemption under general exemptions, we believe that exempt status should be recognized en masse for each country. At least, this approach should be followed for portions concerning the legal system of a foreign corporation's home country (such as 10A-3(c)(2)(i)(A) - (F)). In the case of Japan, it should be clarified that general exemptions are applicable to both the board of corporate statutory auditors and to the audit committee.
Regarding exempted foreign corporations, it is enough to require foreign corporations to disclose only their reliance on the exemption. In order to be exempted, foreign corporations must satisfy certain independence standards under domestic laws. Hence, exemption from U.S. requirements will not "materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements" stipulated in the Proposed Rule. Hence, we believe there is no reason to require disclosure of an assessment of the impact of exemptions.
The term "audit committee" appears in various rules in addition to the Proposed SEC Rule on Section 301. In connection with exempted foreign corporations, we believe that provisions should be made for the term "audit committee" to be interpreted to mean "a board of auditors (or similar body), or statutory auditors" in all such places (by addition of a provision similar to that of 10A-3(c)(2)(F)(ii) of the Proposed SEC Rule on Section 301).
The majority of Japanese corporations have adopted a March-end accounting period. It is normal for such corporations to convene their shareholders' general meeting in late June, at which time directors, corporate statutory auditors, and etc. are appointed. In addition, it takes several months to prepare for the shareholders' general meeting at which important matters are decided including the appointment of new directors and corporate statutory auditors because the preparation of nominations of new directors and corporate statutory auditors requires at least a few months to complete.
In light of this fact, if a Japanese corporation were ultimately found to be in defect under the SEC Final Rule on Section 301 (expected to be finally decided in April 2003), the corporation would not be able to cure the defect at any time prior to late June 2004.
Hence, we believe that an appropriate date of enforcement should be determined in consideration of this situation.
The board of corporate statutory auditors must consent to proposals to be submitted to the shareholders' general meeting by the board of directors concerning the appointment, re-appointment, and dismissal of external accounting auditors. (Special Law, Article 3 Paragraph 2, Article 5-2 Paragraph 3, Article 6 Paragraph 3.) Under the committee system, the audit committee has the authority to submit proposals concerning the appointment, re-appointment, and dismissal of external accounting auditors. (Special Law, Article 21-8 Paragraph 2-2)
An external accounting auditor found in violation of his/her duties may be dismissed by resolution of the board of corporate statutory auditors/audit committee without the approval of the shareholders' general meeting (while appointment requires the resolution of the shareholders' general meeting). (Special Law, Article 6-2 Paragraph 1, Article 21-36 Paragraph 1)
External accounting auditors must report directly to the board of corporate statutory auditors/audit committee concerning any illegal acts of directors. Furthermore, a corporate statutory auditor or an audit committee member appointed by the audit committee can directly receive reports concerning audits by external accounting auditors. (Special Law, Article 8 Paragraphs 1 and 2, Article 21-36 Paragraph 1)
The board of corporate statutory auditors/audit committee can directly receive audit reports of external accounting auditors. Corporate statutory auditors/ audit committee members can require external accounting auditors to directly present explanations concerning audit reports. (Special Law, 79e 13 Paragraphs 1 and 3, Article 21-28 Paragraph 1 and 3)
Corporate statutory auditors/audit committee member must examine whether the audit methods employed and results obtained by external accounting auditors are appropriate and correct. If deemed inappropriate by the board of corporate statutory auditors/audit committee, this matter and reasons thereof must be noted in the audit report. (Special Law, Article 14 Paragraphs 1 and 3, Article 21-29 Paragraph 2)
* Provisions concerning the audit committee shall come into force on April 1, 2003.
The following conditions apply to the members of the board of corporate statutory auditors as provided under the Commercial Code and the Special Law: [1] the influence of the board of directors is eliminated from matters pertaining to appointment, dismissal and terms of office of corporate statutory auditors (Section 1. below); [2] the eligibility of corporate statutory auditor shall be unrelated to the board of directors (Sections 2. and 3. below); [3] the independence of corporate statutory auditors is preserved in connection to the payment of compensation and audit expenses (Sections 4. and 5. below); [4] corporate statutory auditors comprise an independent organ empowered to make decisions on basic matters pertaining to audit (Sections 6. and 7. below). As such, the board of corporate statutory auditors and members thereof are "independent" of the board of directors. In particular, Sections 2. and 3. below can be interpreted to constitute standards for independence.
Corporate statutory auditors are appointed by the shareholders' general meeting which constitutes a separate organ from the board of directors (Commercial Code, Article 280 Paragraph 1, Article 254 Paragraph 1). The board of corporate statutory auditors, comprised of all corporate statutory auditors, is empowered to (1) veto the proposal of appointment of corporate statutory auditors by the board of directors to the shareholders' general meeting; (2) request the board of directors to place the appointment of corporate statutory auditors on the agenda of the shareholders' general meeting; and (3) identify specific nominees for appointment as corporate statutory auditors and request the board of directors to submit the proposal for the appointment of corporate statutory auditors to the shareholders' general meeting (Commercial Code, Article 18 Paragraph 3). Moreover, individual corporate statutory auditors are also empowered to voice their views on the appointment of corporate statutory auditors (Commercial Code, Article 275-3).
Similarly, a corporate statutory auditor can be dismissed only by the resolution of the shareholders' general meeting (Commercial Code, Article 280 Paragraph 1, Article 257), and corporate statutory auditors are empowered to voice their views at the time of dismissal (Commercial Code, Article 275-3). A corporate statutory auditor who has resigned his post is entitled to attend and to voice his/her views at the first shareholders' general meeting following his/her resignation (Commercial Code, Article 275-3-2).
The term of office of a corporate statutory auditor is four years and exceeds that of directors (2 years) (Commercial Code, Article 273 Paragraph 1). It is understood that the four-year term of office cannot be shortened by the resolution of the board of directors or by the articles of incorporation. 3
Corporate statutory auditors are prohibited from concurrently serving as director, executive officer, or as manager or employee of the corporation or its subsidiaries (Commercial Code, Article 276; Special Law, Article 18 Paragraph 4).
A corporation must appoint no less than three corporate statutory auditors, one or more of whom (to be amended to "the majority of whom" in May 2005) must be "[a] outside corporate statutory auditor[s]". An outside corporate statutory auditor is defined as a corporate statutory auditor who in the five years prior to appointment (to be amended to "prior to appointment") has not served as director, executive officer, or as manager or employee of the corporation or its subsidiaries (to be amended to "has never served as") (Special Law, Article 18 Paragraph 1).
The payment of compensation to corporate statutory auditors must be determined separately from compensation to directors, and must be determined by the articles of incorporation or by resolution of the shareholders' general meeting (Commercial Code, Article 279 Paragraph 1). Corporate statutory auditors are entitled to voice their views on the payment of compensation to them (Commercial Code, Article 279 Paragraph 3).
When a corporate statutory auditor requests advance payment for expenses incurred in the performance of his/her duties, the corporation may not reject payment unless it can prove that the expenses are unnecessary in the performance of the duties. The same provisions apply when a corporate statutory auditor who has paid for expenses from his/her own account requests reimbursement and interest thereon, or when he/she requests the corporation to repay on his/her behalf an obligation assumed by him/her in the performance of the duties (Commercial Code 279 Paragraph 2).
The membership of the board of corporate statutory auditors consists of all corporate statutory auditors (Special Law, Article 18 Paragraph 1) and is entitled to determine audit policies, the methods of investigating the operations of the corporation's business and assets of the corporation, and other matters pertaining to the performance of the duties of corporate statutory auditors (Special Law, Article 18-2 Paragraph 2).
The corporate statutory auditors select [a] full-time corporate statutory auditor(s) by mutual vote (Special Law, Article 18 Paragraph 2).
When a member of the board of corporate statutory auditors or a member of audit committee requests advance payment for expenses incurred in the performance of his/her duties, the corporation may not reject payment unless it can prove that the expenses are unnecessary in the performance of the duties. The same provisions apply when a corporate statutory auditor/audit committee member who has paid for expenses from his/her own account requests reimbursement and interest thereon, or when he/she requests the corporation to repay on his/her behalf an obligation assumed by him/her in the performance of the duties (Commercial Code, Article 279-2, Special Law, Article 21-9 Paragraph 4). These provisions are interpreted to cover the following expenses: expenses pertaining to on-site investigations conducted by corporate statutory auditors; expenses pertaining to the filing of suits; expenses incurred in retaining the service and assistance of lawyers and certified public accountants; and, expenses incurred in the employment of supporting staff. 4