The Asian Corporate Governance Association(ACGA) has published a paper analyzing in detail, and comparing, the legal roles and actual functions (in reality) of kansayaku boards with audit committees. BDTI’s Representative Director Nicholas Benes advised ACGA with respect to the kansayaku system, drawing upon both personal experience as well as interviews and advice from dedicated kansayakuand other audit experts. The full paper can be downloaded in English athttp://bdti.mastertree.jp/f/o53butw7 and in Japanese at http://bdti.mastertree.jp/f/6rmx0y28.
Important excerpts(the introduction and the conclusion) are set forth below. However, the report merits reading in full, given its clear explanations and detail -which is much needed by many foreign investors.
1. Introduction
The aim of this paper is to compare the roles and functions of Japanese Kansayaku (statutory auditor)1 Boards and, secondarily, three-committee system audit committees (3C audit committees) in Japan with Audit Committees as they operate in other developed markets in Asia and the West. After several years of advocacy work in Japan, it has become clear that the Kansayaku system is not fully understood outside Japan, nor how it differs from the 3C audit committee system. Conversely, there appears to be some misunderstanding in Japan as to what non-Japanese mean by an “Audit Committee” (which we capitalise in this paper to avoid confusion with the 3C audit committee). The argument is often put forward that Kansayaku are a substitute for an Audit Committee—a view we do not share because the powers and functions of the two entities, although overlapping to some extent, are quite different in important respects.
Our conclusion from assessing the evidence is that a genuinely independent and well-run Audit Committee has the potential to strengthen board governance and oversight of management more effectively than the Kansayaku system. Audit Committees are usually composed of all or a majority of independent directors and chaired by one (something that is often not the case at Japanese companies with 3C audit committees). Being directors with the right to vote, Audit Committee members have the ability to exert direct influence on board decisions. Because of this, they have greater authority and ability than Kansayaku to influence the integrity of financial reporting, the independence of the external accounting auditor, and the robustness of a company’s internal controls, internal audit practices, and risk management systems. In recent years, some Audit Committees have taken on additional tasks such as reviewing the implementation of whistleblowing systems.
In contrast, Kansayaku are not fully part of the board’s formal decision-making and approval process, and do not have the authority of directors (although they do sit in on board meetings and in some companies act as trusted advisers to the president/CEO). Much of the work of the full-time Kansayaku is taken up with “business audits”, which in many respects task him or her to act more like a quasi-compliance officer who makes sure the company is adhering to laws and regulations. While Kansayaku also carry out “accounting audits”, this role largely involves setting audit policy, overseeing the work of the external accounting auditor, listening to reports by the full time Kansayaku, and mechanically checking the company’s financial position.
We acknowledge that in recent years Japanese regulators have worked to strengthen the Kansayaku system, and that truly independent and strong-minded Kansayaku can make a valuable contribution to the corporate governance of Japanese companies. We also acknowledge that some practices of Kansayaku could be usefully adopted by Audit Committees. We also acknowledge that Audit Committees often fail to live up to their potential and that the system is far from perfect.
On balance, however, we believe that both in terms of structure and actual practice, the powers of Kansayaku Boards are weaker than those of Audit Committees, which are an integral part of the board and their members full participants in board decisions. If one were designing a system of board governance and management oversight from scratch in a modern capital market, we do not believe that the Kansayaku system would be the outcome. Paradoxically, in one way the weakness of the system derives from the fact that most of the formal powers given to individual Kansayaku are so strong and confrontational in nature—forexample, the right to conduct independent investigations, to command directors to cease actions or to sue directors—that, in reality, they are almost never exercised.
In this paper, we elaborate on our views by comparing the formal, expected and actual roles of Kansayaku and Audit Committees. We also provide short histories of the two systems as they have evolved in Japan and the West, and offer some suggestions for moving forward.
We would like to make explicit at the outset that the purpose of this paper is primarily to shed light on a complex subject and, we hope, enhance mutual understanding between Japanese companies and foreign investors. While we believe that Japanese companies would be better served by well-functioning Audit Committees than Kansayaku Boards, we are not at this stage calling for the mandatory implementation of Audit Committees in Japan. To do so would require, at the very least, a significant change in Japan’s Companies Act—something we elaborate on in Part 7 (and which would be no easy task, unless there is a dramatic change in government thinking and behaviour). It would also necessitate the introduction of robust rules on independent directors, since Audit Committees cannot function without properly independent directors. (While progress is being made in this area in Japan, it remains slow and minimal.) In other words, the vast majority of listed companies in Japan, which are statutory auditor-type companies, lack the institutional and legal basis for forming Audit Committees. Other changes need to take place first before such a system could work effectively.
We hope this paper provides food for thought for companies, investors, regulators and others involved and interested in corporate governance reform in Japan. We also hope that it is read in the context of other papers that we have written on Japan in recent years, namely our 2008 White Paper, 2009 Statement and other advocacy submissions on independent directors and company law reform. For all these documents, see our website: www.acga-asia.org. The papers can be found under “ACGA Archive / Reports”…
…..
7. Conclusion & Recommendations
As this paper shows, there are strengths and weaknesses with both the Kansayaku and Audit Committee systems. In many ways, the best and worst aspects of the two systems are mirror images of each other.
We acknowledge that the Kansayaku system has certain strong points. First, it allows the presence of a full-time non-executive person who knows the company well with legally prescribed and audit-related duties on the premises. Second, it grants each Kansayaku the right to pursue his or her own investigations, with full rights to any and all information, and to take strong actions that are legally sanctioned. As with any system of corporate governance, the most effective Kansayaku will be those who embrace the spirit, not merely the formal requirements, of their role.
However, the system also has significant gaps in design, which permit a marked variance between intended and actual outcomes. For instance, many of the powers granted to Kansayaku are confrontational in nature (such as obtaining a court order) and are therefore extremely unlikely to be exercised in a corporate culture that prizes consensus—especially by a Kansayaku acting alone. And in the absence of detailed disclosure, it is difficult for investors to assess how effectively Kansayaku are fulfilling their duties at different firms.
As for Audit Committees, their greatest weakness is that their members often rely (or are forced to rely) too much on management to keep them informed of major corporate developments. Hence, they may not know as much about the goings-on inside the company as they should. Unlike full-time Kansayaku, Audit Committee members only work part-time and will likely have other competing commitments, such as their own careers. The effectiveness of an Audit Committee is therefore highly dependent on the variable and undeterminable commitment of busy people—as well as the board culture of the company on which they serve.
Conversely, the greatest potential strength of Audit Committees derives from the fact that their members are mostly independent directors who wield voting power in the board, who can meet without management present, and who have a direct line to both the internal and external auditors. This allows them to have input into board decision-making and places them, in principle, on an equal footing with executive directors and other non-executive directors. As a system of supervision, this clearly offers the potential for more robust outcomes—and can better ensure that problems in financial reporting and internal controls come to the fore more quickly.
We believe that corporate governance in Japan would be best served over the long-term if companies moved towards adopting Audit Committees. It would be ideal if this could be done in a way that incorporated the best aspects of the Kansayaku function. We recognise this would not be easy and could not be achieved overnight. However, we believe the following steps offer a constructive way forward:
Companies are encouraged to take note of the growing official support for independent directors and the practice of many leading companies, including those with Kansayaku Boards, to appoint such directors to their board of directors voluntarily. This trend picked up pace in 2013.
Companies with Kansayaku Boards should create a completely independent Nomination Committee under the board of directors for the selection and nomination of Kansayaku (as well as directors, of course). The members of this committee would all beindependent outside directors, pursuant to voluntary corporate governance guidelines disclosed by the company.Shining the spotlight of accountability for Kansayaku selection on the members of this committee would make it less likely that Kansayaku appointments were as heavily influenced by CEOs as they are at present, and more likely that knowledge regarding accounting and law were considered essential qualifications for Kansayaku appointments.Where companies have not established a Nomination Committee, the board should provide a clear explanation of their nomination process and the job criteria for Kansayaku.
Over the medium term, and when permitted by changes in the company law, companies should consider moving towards a more independent board able to create legally valid board committees of all types, in particular Audit Committees and Nomination Committees.
Such a transition would be more advisable than adopting the new “Company with Audit and Supervisory Committee” board structure. Although the Audit and Supervisory Committee would replace the Kansayaku Board and the majority of its members would be outside directors, we believe it would not be as robust as the two-step Nomination and Audit Committee system we are describing above.
The lynchpin of our recommended reforms would be an amendment of the Companies Act. We strongly recommend that the Government of Japan amend the company law to permit all companies to form board committees (a) for any purpose; and (b) which are legally valid and recognised, including, in particular, Audit Committees and Nomination Committees. Companies that choose to form an Audit Committee which is composed of only independent directors should not be required to appoint Kansayaku or have a Kansayaku Board, if they also form a similarly independent nominations committee.
The Board Director Training Institute (BDTI) is a "public interest" nonprofit in Japan dedicated to training about directorship, corporate governance, and related management techniques. It is certified by the Japanese government to conduct these activities as a regulated nonprofit. Read a summary about BDTI here, and see a menu of its services for both corporations and investors here.