RIETI Report August 2008

Lessons from SOX and Perspectives for J-SOX

Japan's Financial Instruments and Exchange Act was announced in June 2006 and enacted this April 4. Modeled after the U.S. Sarbanes-Oxley Act (SOX) the Japanese version (J-SOX), came in response to major corporate scandals. J-SOX requires the roughly 3,800 listed companies in Japan, and their foreign subsidiaries, to implement a management assessment of internal control over financial reporting. A RIETI International Seminar earlier this summer invited U.S. experts on SOX to share their perspectives and draw lessons for J-SOX. SHISHIDO Zenichi, RIETI Faculty Fellow and Professor at the Seikei University School of Law chaired the event and summarized the proceedings.

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Lessons from SOX and Perspectives for J-SOX

SHISHIDO ZenichiFaculty Fellow, RIETI
Professor, School of Law, Seikei University

Dr. Shishido has served at Seikei University for the last 25 years. He was an Assistant Professor (1983-1985), Associate Professor (1985-1994), and Professor (1994-2004) of its Faculty of Law and has been a Professor of its School of Law since 2004. He has also held overseas research positions including: Visiting Professor, Harvard Law School; Visiting Professor, Boalt Hall School of Law, the University of California at Berkeley; and Visiting Professor, School of Law, Columbia University. In addition, he has been an expert member of the Committee on Industrial Structure (on Corporation Law) at the Ministry of Economy, Trade and Industry since 2000. His research interests cover law and economics, corporation law, commercial law, commercial transactions, and international transactions. Dr. Shishido received a Ph.D. in Law and an LL.B. from the University of Tokyo. His recent publications include: Doki-zuke no shikumi to shiteno kigyo: insentibu shisutemu no hoseido-ron [The firm as an incentive mechanism: the role of legal institutions], Yuhikaku, 2006; "Reform in Japanese Corporate Law and Corporate Governance: Current Changes in Historical Perspective," American Journal of Comparative Law, vol. 49, no. 4, 2001; and "The Turnaround of 1997: Changes in Japanese Corporate Law and Governance," in Aoki, Masahiko, Gregory Jackson, and Hideaki Miyajima, eds., Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford University Press, 2007.

June 25, 2008: RIETI International Seminar - Summary

Lessons from SOX and Perspectives for J-SOX: Effects of the Legal System on Corporate Activities

SHISHIDO Zenichi

The Sarbanes-Oxley Act of 2002 (SOX), enacted in response to major corporate and accounting scandals including those involving Enron and WorldCom, is said to be the most important regulatory reform in the 70 plus-year history of U.S. federal regulation of securities transactions, and has already been widely evaluated from a legal perspective. Japan learned from the U.S. and, effective the fiscal year commencing April 1, 2008, implemented the Financial Instruments and Exchange Act, known as J-SOX for its similarity to SOX, requiring public companies to report on internal control.

In this RIETI International Seminar, three prominent U.S. academics presented their views on SOX and its effect on corporate activities while Sadakazu Osaki, executive fellow at the Center for Knowledge Exchange & Creation, Nomura Research Institute discussed the differences between SOX and J-SOX, and related problems. These presentations were followed by a roundtable discussion with participants including Shinji Hatta, professor at the Graduate School of Professional Accountancy at Aoyama Gakuin University and auditor for RIETI.

Zenichi Shishido, RIETI faculty fellow and professor at the Seikei University School of Law, first highlighted the significance of the seminar. The United States, after six years of regulatory experience since implementing SOX, is currently discussing possible amendments to the law, while Japan has just entered its first year under J-SOX. Thus it is quite important for Japanese and U.S. experts to exchange views. Noting that the seminar is part of a RIETI research project titled "Enterprise Law as a Structure for Incentives" begun last fiscal year, he explained as follows. The project defines an enterprise as a place for incentive negotiations among shareholders, creditors, employees, and management; the first two players provide monetary capital and the last two provide human capital. "Enterprise law" is thus a legal system affecting such negotiations. In this context, SOX and J-SOX, which affect not only negotiations between shareholders or creditors and management but also negotiations between employees and management, are perfect examples of enterprise law.

Donald C. Langevoort, professor of law at Georgetown University, provided a historical overview of the internal control reporting system in the U.S., the most controversial provision of SOX. Section 302 of SOX requires that the chief executive officer (CEO) and chief financial officer (CFO) of each public company attest to the effectiveness of internal control and the adequacy of financial statements. Furthermore, Section 404 provides that the company's management assess the effectiveness of internal controls over financial reporting and that the external auditor attest to and report on that assessment. Any "significant deficiencies" must be reported by the company's management and an independent auditor. The inclusion of this requirement in the law points to congressional concern that under the then-existing rules there was a reasonable possibility for a material misstatement in financial statements to not be prevented on a timely basis.

Responding to criticism over substantial increases in compliance costs associated with the reporting requirements, the regulatory authorities have adopted new standards calling for a "top down, risk-based approach" for testing the effectiveness of internal controls. However, when disagreements arise over the adequacy of internal control, the company's management and independent auditor then negotiate, which places excessive costs on management because the auditors' bargaining power is substantially strengthened by, among other things, the presence of the Public Company Accounting Oversight Board (PCAOB), a new regulatory organ. This prospect causes corporate managers to adopt more risk-averse behavior.

Dr. Langevoort also pointed out that shareholder protection is not the sole purpose of SOX. The legislation has multiple aspects and was devised to enhance the transparency and accountability of listed companies as public entities.

Attention must be paid to incentive effect of disclosure requirements

Many believe that increasingly abundant and precise information disclosure and its resulting greater transparency are always desirable. However, in his presentation using the results of model analysis, Benjamin E. Hermalin, professor in the Department of Economics, University of California, Berkeley, showed this is not necessarily the case from the perspective of good governance. He argued as follows. With respect to ex post evaluation, CEOs inevitably become risk-averse, both from the viewpoint of retaining their current positions and in view of their desire to improve their reputation amid today's job-hopping market. Disclosure of more precise information increases the likelihood for the ex ante evaluation of a CEO to be changed to ex post. Therefore, higher-quality information increases the expected payoff to shareholders but decreases the payoff to the CEO. The CEO in turn demands higher compensation. That, however, is not the only outcome of requiring the CEO to provide more precise information. The demand for greater disclosure provides the CEO with the incentive to manipulate information or choose high-risk, low-return projects. External efforts to enhance information disclosure can be harmful and reduce social welfare. Companies disclose information to differing extents, which means they are selecting their optimal level of disclosure in accordance with the conditions they face.

The last of the U.S. speakers, Roberta Romano, professor at Yale Law School and director of its Center for the Study of Corporate Law, attempted to gauge whether and how SOX will be rolled back by reviewing four commissioned reports and examining media and congressional responses to the critiques of SOX. Since the enactment of SOX, four prominent committees have examined and reported on problems arising from the law. Among these, an advisory committee to the Securities and Exchange Commission (SEC) focused on the question of whether compliance costs associated with internal control requirements may be disproportionately large for smaller public companies. The other three committees dealt with the problem of whether the implementation of SOX may be hindering U.S. capital market competitiveness. The SEC initially estimated the annual cost of complying with the internal control provisions of SOX at around $91,000 per company. Yet actual expenditures in the second year of the implementation of the law, even with a reduction in compliance costs, amounted to $900,000 on average. There has been a substantial decrease in the number of initial public offerings (IPOs), especially those by foreign companies, in the U.S. market following the enactment of SOX, whereas transactions associated with delisting have been increasing.

Media response in the U.S. to the four commissioned reports has also been increasing. National newspapers tend to focus on the international competitiveness of the U.S. securities market, whereas regional newspapers focus relatively more on concerns over excessive compliance costs of smaller companies. A majority of the SOX amendment bills submitted to Congress address problems faced by small public companies because regional papers have greater influence on election results than national ones. Although none of the amendment bills have to date been enacted, it has been observed that not only Republicans, who are the sponsor of these bills, but also some Democrats support them. At the moment, the application of Section 404's external auditor attestation requirement is postponed for companies with a public float under $75 million, which account for 44% of listed companies.

Under the highly decentralized U.S. political system, it generally takes a number of years to revise or repeal laws even when the media, academia, and the public have recognized the legislation's flaws. Given today's political climate, it would be extremely difficult to modify or repeal SOX. The most likely response would be to exempt small companies from the application of all or part of Section 404.

U.S. SOX criticism factored into J-SOX legislation

Sadakazu Osaki of Nomura Research Institute then reported on the characteristics and problems of J-SOX, as compared to SOX. In principle, J-SOX is quite similar to the SOX. Under it, all listed companies are required to submit a report on the evaluation of internal control over financial reporting and have the report independently audited. However, the J-SOX has incorporated criticism of the SOX and calls for a more concise and efficient internal control system. This is because discussion on J-SOX legislation began in 2005, after the revelation of the stock scandal in which Seibu Railway Co. misrepresented information about shareholders in financial statements. Another difference from the U.S. case is that implementation guidelines were created before J-SOX provisions took effect.

In actual cases involving internal control activities, some companies were found to be incurring excessive compliance costs. Certain accounting firms have been urging companies to prepare a set of three documents - business manual, business flowcharts, and a risk-control matrix - for each business process. Large costs associated with such overreaction may be one reason behind the decreased number of initial public offerings (IPOs) in Japan. Japan has now entered its first year under J-SOX and how the market will react when a company reports "material weakness" in its internal control will be a focal point of interest. Unlike in the U.S., in Japan there have been few voices sympathetic to smaller listed companies. Instead, there has been strong support for strengthening supervision over companies listed on the emerging stock exchange, rather than over established companies such as Toyota and Sony, reflecting the fact that many of the account fraud cases revealed in the past several years were committed by start-ups.

The four main speakers then joined other participants for a roundtable session. They discussed the following.

1) The U.S. SOX attaches greater importance to the role of independent directors as a management watchdog and as a mediator between management and independent auditors. The question is, can this internal control system function properly in Japan where the independent director system has yet to take root? Would the reinforced corporate auditor system be able to compensate for any deficiencies?
2) What movements have been observed in the share price of companies that have reported "material weakness" in the U.S.?
3) What methods can be used to balance the costs and benefits of internal control? And in this regard, how do shareholders, particularly institutional shareholders, as the cost-bearers perceive this problem and how would implementation guidelines work?

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