Can Your Japanese Counsel Serve as an Auditor? Conflicts and Requirements for Corporate Auditors in Japan

Japanese Attorney at Law - Bengoshi L.L.

• 7 min read

In the intricate framework of Japanese corporate governance, the statutory auditor (監査役 - kansayaku) plays a crucial oversight role, distinct from that of the board of directors. As companies, including Japanese subsidiaries of foreign corporations, seek qualified individuals for these positions, a common question arises: can the company's existing external legal counsel (komon bengoshi) also serve as a statutory auditor? While leveraging their existing familiarity with the company might seem efficient, this dual role navigates a complex interplay of legal prohibitions, independence requirements, and corporate governance best practices.

1. The Bedrock of Auditor Independence: Prohibition on Concurrent Roles

The Japanese Companies Act (会社法 - Kaishaho) establishes a fundamental principle to safeguard auditor independence. Article 335, Paragraph 2 (cross-referencing Article 331, Paragraph 3, Item 1) explicitly prohibits a statutory auditor from concurrently serving as:

  • A director of the company.
  • An employee of the company.
  • An accounting advisor (kaikei sanyo) of the company.

This prohibition extends to equivalent positions within the company's subsidiaries. The rationale is clear: an auditor cannot objectively oversee or critique their own actions or those of individuals to whom they report or work alongside in an executive or managerial capacity. This prevents the inherent conflict of "self-auditing."

The Companies Act does not explicitly list "legal counsel" as a prohibited concurrent position. However, the permissibility of a company's legal counsel serving as its statutory auditor is not automatic and has been a subject of legal interpretation. The core issue often revolves around whether the nature of the legal counsel's engagement makes them, in substance, akin to an "employee" or part of the executive machinery, thereby compromising their independence.

  • Varying Interpretations:
    • One perspective argues that if a legal counsel is deeply integrated into the company's operations, effectively acting under the direction of management for day-to-day legal affairs, their role might blur into that of an employee or an executive arm, thus falling foul of the spirit, if not the letter, of the prohibition.
    • Conversely, if the legal counsel maintains a clearly independent practice, providing advice on specific legal matters upon consultation and not being subject to the company's day-to-day command structure, their independence as an auditor is less likely to be compromised.
  • Guidance and Judicial Precedent:
    • Historically, a view from the Ministry of Justice (prior to the current Companies Act) suggested that if a company's legal counsel were to be appointed as its auditor, it would be appropriate for the legal advisory contract to be terminated upon the counsel's acceptance of the auditor position.
    • A more prevailing view, supported by bodies like the Japan Federation of Bar Associations (JFBA), emphasizes a substantive assessment. If the lawyer is exclusively retained by one company and operates under its significant direction, they might be deemed an "employee." However, a lawyer in independent practice serving multiple clients, who advises the company on legal issues as an external expert, would generally not fall into this category.
    • A key judicial precedent is the Osaka High Court decision of October 24, 1986. While interpreting the former Commercial Code provisions (which were precursors to the current Companies Act rules), the court held that appointing a company's legal counsel as its auditor did not, in itself, violate the prohibition on concurrent roles. However, it crucially added a caveat: this holds true unless special circumstances exist, such as the legal counsel being placed in a position of subordination to the company's executive organs or being effectively bound to serve that company exclusively.

Therefore, the assessment is highly fact-dependent. Companies must look beyond the formal title of "legal counsel" and examine the actual nature of the working relationship, the scope of duties, the degree of independence, and the potential for the individual to exercise impartial judgment as an auditor. From a corporate governance standpoint, the paramount consideration is whether the counsel, as auditor, can genuinely fulfill their oversight responsibilities without being unduly influenced by their advisory role or by management.

3. The Stricter Standards for External Auditors (Shagai Kansayaku)

The Companies Act imposes more stringent independence criteria for "external auditors" (社外監査役 - shagai kansayaku). This is particularly relevant because certain types of companies, such as those with a board of statutory auditors (監査役会設置会社 - kansayakukai setchi gaisha), are required to ensure that at least half of their statutory auditors are external auditors (Article 335, Paragraph 3).

The definition of an external auditor is detailed in Article 2, Item 16 of the Companies Act. Merely being an external legal counsel does not automatically qualify one as an external auditor. The criteria are extensive and designed to ensure a high degree of detachment from the company's management and recent history. Key disqualifying conditions for an external auditor include (but are not limited to):

  • Having been a director, accounting advisor, executive officer, or employee of the company or any of its subsidiaries at any time within the ten years preceding their appointment as auditor.
  • If they were an auditor of the company or its subsidiary at any time within the past ten years, they must not have been a director, accounting advisor, executive officer, or employee of the company or its subsidiary for the ten years prior to that initial auditor appointment.
  • Currently being a director, statutory auditor, executive officer, or employee of the company's parent company (or a "Specified Controlling Person" as defined by Ministry of Justice Ordinance).
  • Currently being an executive director or equivalent in a "sister company" (another subsidiary of the company's parent company).
  • Being a spouse or a relative within the second degree of kinship of a current director, manager, other important employee of the company, or a natural person who is a "Specified Controlling Person" of the company.

While being a legal counsel is not an automatic disqualifier, the nature and history of the relationship, including any past roles or significant financial dependencies, would need to be carefully scrutinized against these detailed criteria if the counsel is being considered for an external auditor position. The extended look-back periods are particularly important.

4. Full-Time vs. Part-Time Auditor Status: Practical Implications

Japanese companies with a board of statutory auditors are legally required to appoint at least one "full-time statutory auditor" (常勤監査役 - jokin kansayaku) from among their auditors (Article 390, Paragraphs 2(2) and 3).

  • Defining "Full-Time": While not rigidly defined in statute, a full-time auditor is generally understood to be an individual who dedicates the substantial majority of their working hours to the duties of that specific auditor role for that company. They typically would not hold other concurrent full-time employment or demanding professional commitments that would prevent them from fulfilling this primary dedication.
  • Implications for Practicing Lawyers: For a lawyer actively engaged in a legal practice serving multiple clients, fulfilling the demands of a full-time auditor role for one company would likely be practically impossible. Therefore, if a company requires a full-time auditor and the legal counsel maintains an active external practice, the counsel would typically only be eligible for a part-time auditor position. This is feasible if the company already has another individual serving as the full-time auditor or if the company is not required to have a full-time auditor (e.g., it doesn't have a board of statutory auditors).

5. Can an Auditor (Who is a Lawyer) Act as the Company's Litigation Representative?

Another practical question that arises is whether a statutory auditor who is also a qualified lawyer (弁護士 - bengoshi) can represent the company in legal proceedings.

  • General Permissibility: The prevailing legal view, supported by a Supreme Court decision on February 18, 1986, is that this dual role is generally permissible. The reasoning often hinges on the inherent professional independence and ethical obligations of lawyers, which are seen as sufficient to manage potential conflicts and ensure they can still perform their auditor duties fairly even while acting as a litigation representative in a specific matter.
  • Corporate Governance Considerations: Despite this legal permissibility, companies should still give careful thought to the corporate governance implications. In certain sensitive litigation, having an auditor also act as the company's legal counsel in that specific dispute could raise perceptions of compromised objectivity, even if legally tenable. The board should consider, on a case-by-case basis, whether such an arrangement truly serves the best interests of the company and its stakeholders in maintaining the integrity and perceived independence of the audit function. Factors such as the nature of the litigation and its relationship to the auditor's oversight responsibilities might influence this decision.

If a company is contemplating appointing its legal counsel as a statutory auditor, several practical steps and considerations are advisable:

  • Substantive Independence Review: Conduct a rigorous, documented assessment of the counsel's actual relationship with the company to ensure they can act with the requisite independence, free from managerial control or undue influence.
  • Verification of External Auditor Criteria (if applicable): If the position is intended to satisfy an external auditor requirement, meticulously verify the counsel's background against all statutory criteria for externality.
  • Clarity on Role (Full-time/Part-time): Determine if a full-time auditor is required and if the counsel's existing commitments allow for such a role.
  • Management of Concurrent Roles: If the counsel continues to provide legal advice while serving as auditor, establish clear protocols for managing potential conflicts of interest and ensuring the primacy of the auditor's oversight duties. This might involve, for example, ensuring that advice given as counsel is not then "audited" by the same individual without additional safeguards or review by other auditors.
  • Disclosure to Shareholders: Ensure transparency with shareholders regarding the appointment, particularly if the individual also serves as legal counsel, explaining how independence is maintained.
  • Expertise and Resources: Confirm that the legal counsel possesses not only legal acumen but also the necessary understanding of accounting, finance, and business operations pertinent to the auditor role, and has the time and resources to dedicate to it effectively.

Conclusion

Appointing a company's existing legal counsel as a statutory auditor in Japan is not prohibited outright but requires a careful and substantive evaluation rather than a purely formalistic one. The critical litmus test is the auditor's ability to maintain genuine independence and perform their oversight duties impartially. While their legal expertise can be an asset, potential conflicts arising from an advisory relationship must be meticulously managed. Furthermore, if the role is to fulfill an "external auditor" requirement, the stringent statutory criteria for externality must be satisfied. Ultimately, the decision should prioritize the integrity and effectiveness of the company's audit function, ensuring robust corporate governance.