Rising Expectations for Outside Directors in Combatting Corporate Scandals in Japan

By Yoshie Midorikawa, Partner, Miura & Partners

1. An expanding role for outside directors

When a listed Japanese company notices a sign of fraud or other scandal at the company, a common response is to voluntarily conduct internal or independent investigations. In such cases, the reports prepared by the investigation committee are often disclosed to the public, which may invite regulators to commence their own investigations, or their investors to take legal action against the company or its directors. Such companies generally respect the findings of the reports when they decide to take disciplinary actions or legal actions against the wrongdoers or directors.

Until recently, it was not common for the reports of an investigation committee to find that outside directors were responsible for the failure of preventing scandals, or that the corporate structure was inadequate for preventing them. On the other hand, these reports sometimes found that executive directors were responsible for these problems. However, this assumption now seems to be changing. For example, an investigation committee in a recent fraud case found that some of their outside directors failed to fulfill their managerial responsibilities, because they had noticed that the similar fraud cases had happened in the company in the past, and had been informed of countermeasures which they should have found inadequate to recurrence of the similar problems. In that case, these outside directors did not take proactive actions including to report the problems to the boards.

The report also pointed out that the standard of managerial responsibilities of outside directors is lower than that of executive directors, as outside directors who are usually serving only part-time have limited resources to determine the origin of problems compared to the executive directors. Nonetheless, the report found that the committee cannot confirm that the outside directors fulfilled their managerial responsibilities in the specific fraud case. Some companies take these findings as warnings for the current practice in which the role of outside directors is limited to a passive role of monitoring the internal communications.

2. Outside directors and Japan’s new Corporate Governance Code

This change aligns with the intentions of the reform of Corporate Governance Code of Japan (“CGC”) by the Tokyo Stock Exchange (“TSE”) in 2021. The CGC emphasizes the roles of outside directors to improve corporate governance of each company. To this end, for example, the CGC requires that a company’s board contain more than one third outside directors in order to be listed in the Prime Market, whereas to be listed in the Standard Market or the Growth Market, companies only need to have two outside directors on their boards as the minimum requirement. In April 2022, the TSE will reorganize its market segments from a relatively complex system based on several market segments to a simpler system based on a tripartite division of the Prime Market, the Standard Market, and the Growth Market. The Prime Market segment is expected to include large global companies, making it a destination for major corporate investors. With the rising expectations for outside directors, companies need to carefully identify proper candidates with appropriate experiences and skills.