What should a director of a Japanese company do for proper internal control?
When a non-Japanese executive is invited to sit on the board of directors of a Japanese company, the question of what responsibility such a position may entail is always an uncomfortable question. Additionally, administrators are increasingly being criticized for failing to do something rather than doing something actively inappropriate. Then came a recent trend in Japan that companies must have adequate internal controls in place to prevent potential problems (as outlined in company law since the 2000s), failing which directors are held accountable. responsible for failure to take appropriate action. What to implement is not obvious and depends on the facts and circumstances. A recent case from the Kumamoto District Court addressed this difficult question and attempted to articulate a standard for what constitutes unlawful inaction for directors in the area of internal controls. While the case deals extensively with nuanced facts to limit excessive working hours (a topic for labor law), this article focuses on the need for directors to put in place adequate internal controls.
An employee of 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 failed request to the bank’s board to sue certain responsible human relations directors who helped perpetuate this problem. The claims related to damages caused to the bank for life lost and loss of reputation of the bank by failing to implement an appropriate internal control system to prevent overtime in the circumstances.
While the measures taken by the bank may not have been perfect, overall there appears to have been genuine efforts to ensure proper working hours.
While the cause of liability could have been structured as directors’ negligence, plaintiff argued that liability arose from the directors’ failure to properly implement a system of internal control regarding the management of working hours. Similar claims may be repeated in other situations.
- What is the standard by which the court determines the unlawful failure to implement appropriate internal controls in such facts?
- Can the business judgment rule be applied to assess directors’ responses to the circumstances?
- The administrators directly responsible for the working time of the employees have the legal obligation to structure and set up an appropriate internal control system allowing a legal and appropriate management of the working time.
- What constitutes an appropriate internal control system falls under the business judgment rule. In assessing the breach of duty of care, the following consideration should be made: (a) whether the collection, analysis and evaluation of relevant information that led to the formulation of the management response was unreasonable; and (b) whether management’s response was manifestly irrational based on the relevant information so gathered, analyzed and evaluated.
- In view of the concrete methods of managing working hours and the efforts made to improve the situation (the control of working hours was then an important management program of the bank) in this case, the collection, analysis and current assessment of the information cannot be considered unreasonable. Management’s response to this information did not show a material departure from reasonableness. Thus, directors are deemed to have exercised adequate care in setting up and implementing the necessary internal controls.
The judgment states that management is responsible under the duty of care for establishing a safe and secure workplace, including ensuring appropriate working hours. Where directors cannot easily fulfill this responsibility through their own activity, they have an obligation to create an internal control system that enables the company to achieve the objective by adhering to the system. Commentators have argued that this duty can also curb various forms of workplace harassment (eg bullying) and excesses on the same principle.
The decision that accepted the application of the business judgment rule is hotly debated on these facts because the safety and security of a workplace is so fundamental that it may conflict with the possibility broad management discretion. Nonetheless, a varying degree of discretion may indeed come into play in implementing this duty for directors, although the scope of discretion may be narrower than usual business judgment. It is the scope of business judgment that needs to be clarified in future case law, assuming that the application of the business judgment rule continues to be permitted. For me, what is critical is how we define the scope of discretion, whether or not we resort to (or call the rule) the business judgment rule. However, the current articulation helps management in that it is admin-friendly.
It should be noted that the court mentioned in its judgment the government’s internal guidelines, the Standard for Assessing Appropriate Hours of Work, as a benchmark for how internal controls should be constructed. The court did consider the guidelines to be a fundamental and important standard, although beyond these guidelines, management still has wide discretion as to how to fine-tune an internal control system appropriate to the light, for example, of technical knowledge in the matter, experience in human resources management and cost-benefit analysis of the means available.
The case also discusses the duty of directors to monitor appropriate adherence to internal controls and the need to remedy inappropriate deviations.
Take away food
- Directors should establish adequate internal controls and apply them consistent with the program’s objective in running a business.
- There is a margin of discretion as to what to implement in an internal control system and how to do it, although depending on the legal interest at issue, the degree of discretion may be limited. Government and industry guidelines, when available, should be used as the basic standard for developing a control program.
- The degree of management discretion in implementing and enforcing an internal control system is a nuanced issue. Industry standards between different companies should be studied, compared and taken into account. The company must avoid materially deviating from the common industry standard so as not to violate the duty of care.