International Financial Markets of the Financial Services Agency of Japan
January 10, 2003
Mr. Jonathan G. Katz
Re: Proposed Strengthening the Commission's Requirements Regarding Auditor
Dear Mr. Katz:
As the Director for International Financial Markets of the Financial Services Agency of Japan ("FSA"), I am pleased to submit this letter on behalf of the FSA in response to the request of the Securities and Exchange Commission ("SEC") for comments on its proposed rules ("Proposed Rules") under Section 208(a) of the Sarbanes-Oxley Act of 2002 on strengthening the Commission's requirements regarding auditor independence, as contained in Release Nos. 33-8154; 34-46934; 35-27610; IC-25838; IA-2088; and FR-64.
The Sarbanes-Oxley Act is an important accomplishment for restoring confidence in the United States securities markets. We recognize that the issues dealt with by the Sarbanes-Oxley Act are global. From this viewpoint, the FSA also has been working to reform its securities markets for the same purpose, considering also the international developments including those related to the International Organization of Securities Commissions ("IOSCO") and the Sarbanes-Oxley Act. For example, in addition to various reform measures that have been put into place during the last several years, the FSA announced on August 6, 2002 the "New Comprehensive Program for Promoting Securities Markets Reform", pursuant to which important concrete reform measures are being implemented. Japan also has recently enhanced its corporate governance system by revising the Commercial Code and the Law for Special Exceptions to the Commercial Code concerning Audits, etc. of Corporations ("Special Law").
In addition to these enhanced measures and revisions, the Subcommittee on Regulations of Certified Public Accountants of the Financial System Council, an important advisory council established within the FSA, issued on December 17, 2002 a report calling for comprehensive reform of the certified public accountant and audit firm system in Japan. The report includes proposals for further enhancing auditor oversight, further strengthening auditor independence, and reviewing CPA examinations to increase the number of CPAs and enhancing the quality of CPAs. The FSA intends to submit a bill to the coming regular Diet session this year in order to revise the Certified Public Accountants Law ("CPAs Law") of Japan.
Since the Sarbanes-Oxley Act affects Japanese institutions, we have a strong interest in how the Sarbanes-Oxley Act is being, and will be, implemented. We have concerns with some provisions of the Sarbanes-Oxley Act, which are in direct conflict with the Japanese legal system. Section 106 (Foreign Public Accounting Firms) and Section 301 (Public Company Audit Committees) are the provisions with which we have the most serious concerns. Therefore, we have been respectfully requesting that the SEC provides appropriate exemptions from Section 106 to Japanese audit firms and from Section 301 to Japanese "issuers" within the meaning of the Sarbanes-Oxley Act. We recognize that the SEC voted on January 8 to publish for comment a rule proposed to implement Section 301.
Our Views on the Sarbanes-Oxley Act and the Proposed Rules Regarding Auditor Independence
(1) General Views
Turning to the issues contained in the Proposed Rules by the SEC regarding auditor independence, we appreciate that the SEC has given careful consideration to foreign jurisdictions by inviting them to submit specific comments. First of all, we believe that it is not necessary to subject Japanese audit firms to the related provisions of the Sarbanes-Oxley Act and the Proposed Rules. Japanese audit firms are subject to the Japanese legal auditor independence regulations. These regulations will be further strengthened based on the report by the Subcommittee of the Financial System Council and consistent with the Statement of the Technical Committee of the IOSCO titled "Principles of Auditor Independence and the Role of Corporate Governance in Monitoring an Auditor's Independence" which was made public last October. The strengthened regulations will further achieve equivalent purposes expected by the Sarbanes-Oxley Act and the Proposed Rules. We respectfully request the SEC to provide an appropriate exemption to Japanese audit firms from the provisions of the Sarbanes-Oxley Act and the Proposed Rules regarding auditor independence, together with an appropriate exemption from Section 106 of the Sarbanes-Oxley Act in particular. Therefore, there should be an appropriate exemption clause in the final rules for foreign audit firms which are subject to laws and regulations of their home jurisdictions. In addition, there should also be an appropriate exemption clause in the final rules to enable audit firms to provide "prohibited" non-audit services listed in Section 201(a) of the Sarbanes-Oxley Act to foreign private issuers where local laws require such services (e.g. contribution in-kind reports).
The report by the Subcommittee of the Financial System Council includes proposals to further strengthen auditor independence regulations in Japan for the same purpose as the Proposed Rules, such as avoiding involvement in making business decisions and in the audit of the audit firm's own work. The report's major proposals are as follows:
2. Views on Audit Partner Rotation
The most serious concern with the proposed rules is the five year time-out period. Under the Proposed Rules, following rotation, a partner may not provide such services for a period of five consecutive years. We fully agree with the public policy goals of the introduction of the time-out period. One goal is to foster high quality audits through a periodic fresh look, and the other related goal is to promote investor confidence. It is important to strike the right balance between these policy goals and practical considerations in the real world. A two-year time-out period should be sufficient to achieve these goals. The proposed five year time-out period could adversely affect the quality of audits because those CPAs who are knowledgeable and experienced in U.S. GAAP accounting are limited in number in foreign jurisdictions including Japan as expressed by the participants at the Roundtable on International Impact of Proposed Rules on Auditor Independence held at the SEC on December 17, 2002. This is in particular a serious problem for small firms. Section 203 (Audit Partner Rotation) of the Sarbanes-Oxley Act does not specifically require such a long time-out period. The FSA respectfully requests the SEC to shorten the time-out period from the proposed five years to two years, in addition to an appropriate treatment for small firms on an audit partner rotation period.
3. Views on Audit Committee Administration of the Engagement
The sections of the Sarbanes-Oxley Act and the Proposed Rules relating to auditor independence refer to the involvement of the "audit committee" as defined by the Sarbanes-Oxley Act, and thus relate to the issues on corporate governance raised by Section 301 thereunder.
Sections 201(a), 202, 204 and 205(a) of the Sarbanes-Oxley Act and the Proposed Rules assume the existence of an "audit committee" as defined by the Sarbanes-Oxley Act. These provisions require preapproval for auditing and non-audit services by the "audit committee" and the submission of auditor reports to "audit committees". The term "audit committee" is defined by Section 2(a)(3) of the Sarbanes-Oxley Act as well as by Section 3(a)(58) of the Exchange Act, as added by the Sarbanes-Oxley Act, as "(A) a committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and (B) if no such committee exists with respect to an issuer, the entire board of directors of the issuer."
In Japan, the Special Law provides "large corporations" (which definition covers all Japanese issuers registered with the SEC) with a choice between two alternative corporate governance systems. It is an essential aspect of the Special Law that large corporations are free to choose between the two systems. One option, which is the only available option at present (because the other option will be available in April 2003 by an amendment enacted May 2002), is to have within the corporation a board of corporate statutory auditors, separate from the board of directors. This system has been enhanced several times in recent years including the latest enhancement effective May 2002. The other option is to establish nominating committee, audit committee and compensation committee by and among the board of directors. The Special Law does not specifically provide the corporate statutory auditors or the audit committee with the specific powers and duties for auditor independence that the "audit committee" should have as stipulated by Sections 202 (Preapproval Requirements) and 204 (Auditor Reports to Audit Committees) of the Sarbanes-Oxley Act.
However, audit firms are required to submit audit reports to the board of corporate statutory auditors or the audit committee under the Special Law. Audit reports should include such matters as the method of auditing and whether or not the change of accounting policies for the balance sheet and profit and loss statement is proper and the reason thereof. In addition, both the corporate statutory auditors and the audit committee have strong and detailed legal powers for auditing affairs of the corporation including a power to request audit firms to make reports on their auditing as necessary. We believe that the Japanese corporate governance system (both the current system and the alternative system available from April 2003 under the Special Law) provides a governance structure that is equivalent to the one provided by the corporate governance system contemplated by the provisions relating to the audit committee under the Sarbanes-Oxley Act.
The Statement of the Technical Committee of the IOSCO refers to the role of the "audit committee", which is defined as "any governance body or bodies with responsibilities for overseeing the external auditor, regardless of whether they have that title". This shows that the IOSCO fully recognizes and respects differences in corporate governance systems among the IOSCO members' jurisdictions. For the same reason, the FSA respectfully requests the SEC to respect the equivalent Japanese corporate governance system in finalizing the proposed rules on auditor independence.
The Japanese laws and regulations on auditor independence and corporate governance systems are designed to achieve the same goals as the related provisions of the Sarbanes-Oxley Act and the Proposed Rules. We respectfully request that the SEC will take full accounts of our comments in promulgating the final rules.