* Toshiba seen as too big to fail - analyst
* ISS urges shareholders not to approve earnings statement
* Auditor gave mixed review to Toshiba's earnings (Adds analyst comment, chip investment)
By Makiko Yamazaki
TOKYO, Oct 11 (Reuters) - The Tokyo bourse said on Wednesday it was taking Toshiba Corp off a special watchlist, citing improved internal controls - a move that lessens but does not completely remove the risk of a delisting for the embattled conglomerate.
But offering a starkly different view of Toshiba's accounting practices, proxy advisory firm ISS said it has recommended that Toshiba's shareholders do not approve the firm's earnings statements for the past financial year after a mixed review from its auditor.
Toshiba was placed on the bourse's watchlist in the wake of a 2015 accounting scandal. It plunged into crisis again as of late last year after billions of dollars in liabilities emerged at its now bankrupt U.S. nuclear unit Westinghouse - problems that also raised fresh accounting concerns.
Aiming to plug the hole in its balance sheet, the Japanese company last month agreed to sell its chip unit to a consortium led by U.S. private equity firm Bain Capital for $18 billion, although the deal still needs to clear regulatory reviews and overcome legal challenges.
"The market had been expecting that the Tokyo bourse will remove Toshiba from the list and allow it to remain listed because the firm is too big to fail," said Masayuki Otani, chief market analyst at Securities Japan.
Not only does the Japanese government see Toshiba's chip business as vital to its national interests, the conglomerate's domestic nuclear business is also key to the decommissioning of the Fukushima plants damaged in the 2011 earthquake and tsunami.
But the Tokyo stock exchange could come under further pressure to delist Toshiba if it is in negative net worth for a second year in a row at the end of March - a very real possibility as the chip deal may not gain regulatory clearance by then and it may struggle to raise funds by other means.
S&P Global Ratings said this month that there was "over a one-in-three chance that Toshiba will fail to receive sale proceeds and resolve its insolvency by March 31."
If shareholders do not sign off on Toshiba's earnings at a Oct. 24 extraordinary meeting as recommended by ISS, that could also imperil Toshiba's ability to the recover from the crisis. Japanese shareholders, however, rarely reject proposals by management.
Auditor PricewaterhouseCoopers Aarata LLC gave Toshiba's financial statements a "qualified opinion" that endorsed Toshiba's finances despite some minor problems, but also made an "adverse" statement on Toshiba's internal controls.