What does a director of a Japanese corporation need to do for appropriate internal control?

Background:

When a non-Japanese executive is asked to serve as a director on a Japanese company’s board, what liability such a position may trigger is always an uncomfortable question. In addition, directors are increasingly criticized for failing to do something rather than doing something actively inappropriate. Then came a recent trend in Japan that companies must implement adequate internal controls to prevent possible problems (as outlined in the Companies Act since the 2000’s), failing which responsible directors are held liable for failure to implement an appropriate action. What is appropriate to implement is not obvious and depends on facts and circumstances. A recent case from Kumamoto District Court^[1] addressed this difficult question and attempted to articulate a standard on what constitutes illegal inaction for directors in the area of internal controls. While the case deals extensively with nuanced facts to curb excessive work hours (a topic for employment law), this article focuses on the directors’ need to implement adequate internal controls.

Facts:

An employee at a commercial bank in Kyushu committed suicide after a long period of extraordinary overwork. A shareholder brought this lawsuit as a derivative action after making a rejected demand on the bank’s board to bring an action against certain responsible directors in human relations that were involved in letting this problem continue. The claims related to causing the bank damages for the lost life and the loss of the bank’s reputation by failing to implement an appropriate internal control system to prevent work hour excess under the circumstances.

While the measures that the bank had taken may not have been perfect, there appear to have been overall genuine efforts to ensure proper work hours.

While the cause of liability could have been structured as negligence of the directors, the plaintiff argued that liability arose from the directors’ failure to appropriately implement an internal control system with respect to the management of work hours. Similar claims can be repeated in other situations.

Issues:

1. What is the standard by which the court determines illegal failure to implement appropriate internal control measures under such facts?
2. May the business judgment rule be applied in evaluating the directors’ responses to the circumstances?

Holdings:

• Directors directly responsible for employees’ work hours have a legal obligation to structure and implement an appropriate internal control system that allows work hours to be managed legally and appropriately.
• What constitutes an appropriate internal control system is a matter to be referred to the business judgment rule. To assess violation of the duty of care, the following review should be made: (a) whether the collection, analysis, and evaluation of relevant information that led to the formulation of the management response were unreasonable; and (b) whether the management response was patently irrational based on the relevant information so collected, analyzed, and evaluated.
• In light of the actual methods employed for managing work hours and efforts made to improve the situation (control over work hours was a material management agenda for the bank at the time) in the present case, the current collection, analysis, and evaluation of information cannot be faulted as unreasonable. The management response to such information did not show material deviation from reasonableness. Thus the directors are deemed to have exercised adequate care in implementing and practicing necessary internal controls.

Discussion

The judgment holds that management is responsible under the duty of care for establishing a safe and secure workplace, including ensuring appropriate work hours. When directors cannot easily fulfill this responsibility by their own activity, they owe the obligation to create an internal control system that allows the company to achieve the goal by adhering to the system. Commentators have felt that this duty can also curb various forms of workplace harassments (e.g., bullying) and excesses under the same principle.

The holding that agreed to the application of the business judgment rule is much debated under these facts because the safety and security of a workplace are so fundamental that they may be at odds with the possibility of broad management discretion. Nonetheless, a varying degree of discretion may indeed come into play in implementing this duty for the directors, albeit that the scope of discretion may be narrower than regular business judgment. It is the breadth of business judgment that needs to be refined in case law in the future, assuming that the application of the business judgment rule continues to be permitted. To me, what is essential is how we define the scope of discretion, whether or not resorting to (or calling the rule) the business judgment rule. However, the present articulation helps the management in the sense it is director-friendly.

It is noteworthy that the court mentioned in its judgment the government’s internal guidelines, the Standard re Evaluation of Appropriate Work Hours, as a benchmark for how internal controls should be constructed. The court effectively held up the guidelines as a basic and important standard, although beyond such guidelines the management still has broad discretion as to how to polish an appropriate internal control system in light of, e.g., technical knowledge of the matter, experience in human resources management, and cost-benefit analysis of available means.

The case also discusses directors’ duty to monitor appropriate adherence to internal controls and the need to address inappropriate deviations.

Takeaways

1. Directors must implement adequate internal controls and enforce them consistently with the program’s purpose in managing a company.
2. There is room for discretion as to what to implement in an internal control system and how to do so, although, depending on the legal interest involved, the degree of discretion may be restricted. Government and industry guidelines when available should serve as a basic standard in crafting a control program.
3. How much discretion the management has in implementing and enforcing an internal control system is a nuanced issue. Industry standards among different companies should be investigated, compared, and taken into account. The company should avoid deviating materially from the common industry norm so as not to violate the duty of care.