Decoding the Deal: A Deep Dive into Contractual Due Diligence in Japanese M&A

In any Merger and Acquisition (M&A) transaction, a thorough examination of the target company's contractual relationships is a cornerstone of effective legal due diligence (法務DD - Hōmu DD). Contracts form the bedrock of a company's operations, defining its rights, obligations, revenue streams, cost structures, and relationships with customers, suppliers, employees, lenders, and other critical stakeholders. A meticulous review of these agreements provides invaluable insights into the target's business, its inherent risks, and its true value. Within the Japanese M&A context, this process involves not only a careful reading of the contractual text but also an understanding of how these agreements function within local business practices and legal norms.

This article will detail the objectives and scope of contractual due diligence in Japanese M&A, the methodology for selecting contracts for review, the process of verifying contract existence and documentation, a focused examination of key clauses and their implications (such as change of control and non-compete provisions), and strategies for addressing findings, including how to approach unwritten agreements.

I. Objectives of Contractual Due Diligence (契約関係に関するDDの目的 - Keiyaku Kankei ni Kansuru DD no Mokuteki)

The review of a target company's contracts during M&A due diligence serves several critical objectives for the potential acquirer:

1. Assessing Business Continuity Post-M&A (M&A実施後の対象事業に関する取引継続性の把握 - M&A Jisshi-go no Taishō Jigyō ni Kansuru Torihiki Keizokusei no Haaku):
   A primary goal is to determine whether the target's key commercial relationships, as embodied in its contracts (e.g., with major customers, critical suppliers, licensors of essential technology), are likely to continue on favorable terms after the M&A transaction is completed. The potential termination or adverse modification of material contracts due to the change in ownership can severely impact the target's future performance and, consequently, its value to the acquirer.
2. Identifying Contractual Impediments to Business Operations or the M&A Itself (M&A実施後の事業実施の障害となる契約の把握 - M&A Jisshi-go no Jigyō Jisshi no Shōgai to naru Keiyaku no Haaku):
   The review aims to uncover any contractual provisions that could hinder the acquirer's intended operation or integration of the target business post-acquisition. This includes identifying restrictive covenants (such as exclusivity or non-compete clauses), unfavorable terms, or clauses that might be triggered by the M&A transaction itself (e.g., assignment restrictions, change of control provisions requiring consent or leading to termination).
3. Understanding Obligations, Liabilities, and Financial Risks (その他対象会社・対象事業が負担する義務・債務の把握 - Sonota Taishō Kaisha / Taishō Jigyō ga Futan suru Gimu / Saimu no Haaku):
   Due diligence seeks to identify significant financial or operational obligations, potential default scenarios or breaches of contract, indemnification duties owed by or to the target, unusual or onerous liabilities, and other financial risks embedded within the contractual framework. This helps in assessing the overall risk profile of the target.
4. Informing Valuation and Shaping Transaction Terms:
   The findings from contractual due diligence directly influence the valuation of the target company. For instance, a portfolio of long-term, stable customer contracts would enhance value, whereas contracts with high termination risk or onerous obligations might diminish it. Furthermore, these findings are crucial for negotiating and drafting the definitive M&A agreement, particularly in shaping representations and warranties, specific indemnities, pre-closing covenants, and conditions precedent to closing.

II. Scope and Selection of Contracts for Review (調査対象の選別 - Chōsa Taishō no Senbetsu)

Given that a target company, especially one with a history, can be a party to a vast number of contracts, a pragmatic approach to scoping the review is essential.

A. The Challenge of Volume:
It is often impractical and prohibitively expensive, particularly in deals involving Small and Medium-sized Enterprises (SMEs) with limited due diligence budgets, to conduct an exhaustive review of every single contract. Therefore, a systematic process for selecting and prioritizing contracts is critical.

B. Prioritization Based on Materiality and Risk:
The core principle is to focus the review effort on contracts that are most material to the target's business operations, financial condition, and risk profile, or those most likely to be impacted by the M&A transaction.

1. Requesting a Comprehensive Contract List (契約一覧表 - Keiyaku Ichiranhyō): A common starting point is to request the target company to provide a detailed list of all its contracts. Ideally, this list should be categorized (e.g., customer, supplier, financing, employment, IP, real estate) and include key information for each contract, such as the counterparty, a brief description of the subject matter, contract value or revenue/expense impact, term (start and end dates), and renewal provisions.
2. Criteria for Selecting Contracts for Detailed Review: Based on the contract list and an understanding of the target's business, contracts are typically prioritized for detailed review based on criteria such as:
   • Financial Significance: Contracts with a high impact on revenues or expenditures (e.g., agreements with top customers or major suppliers, significant financing arrangements).
   • Strategic Importance: Contracts that are critical to the target's core operations, its access to key technology (e.g., inbound license agreements), essential supply chains, distribution channels, or its fundamental market position.
   • Long-Term or Irrevocable Commitments: Agreements that impose significant long-term obligations or are difficult to terminate.
   • Presence of Specific Risk Clauses: Contracts known or suspected to contain Change of Control (COC) clauses, assignment restrictions, exclusivity provisions, non-compete clauses, or unusual liability/indemnity terms.
   • Atypical or Unusual Nature: Contracts that deviate from standard industry practice or appear unusual for the type of business.

C. Leveraging Business Understanding:
Effective contract selection is not merely a mechanical exercise based on lists. It requires a solid understanding of the target company's business model, its industry, and its operational drivers. This commercial context helps the due diligence team identify which types of contracts are likely to be most critical, even if they don't appear significant based solely on financial thresholds. Collaboration with financial and commercial due diligence teams is crucial in this regard.

III. Verification of Contract Existence and Documentation (契約書の有無の確認 - Keiyakusho no Umu no Kakunin)

Once a prioritized list of contracts for review has been established, the next step is to obtain and verify the actual contractual documentation.

A. Obtaining Copies:
The acquirer will request complete and executed copies of all selected contracts, including any amendments, addenda, schedules, exhibits, or side letters that form part of the agreement. This is typically done via the VDR.

B. Addressing Missing or Incomplete Documentation:
Particularly in the context of SMEs in Japan, it is not uncommon to find that:

• Important business relationships are based on informal or verbal understandings rather than comprehensive written contracts.
• Written contracts exist but are incomplete, poorly drafted, unsigned, or poorly organized and difficult to locate.
  Identifying key commercial arrangements where formal written contracts are absent is an important part of this phase, as it signals a different type of risk (uncertainty of terms, enforceability issues).

C. Reviewing Ancillary and Related Documents:
The review should not be limited to the main contractual document. It must extend to all ancillary materials that might modify, clarify, or supplement the primary terms. This includes:

• Amendments, addenda, and riders.
• Schedules and exhibits explicitly incorporated by reference.
• Side letters that may contain important (and sometimes less obvious) agreements.
• Standard terms and conditions if incorporated by reference (e.g., on a website or in a separate document).
• Relevant purchase orders, invoices, and key correspondence that might evidence variations to standard terms or specific understandings.

IV. Examination of Key Contractual Clauses and Provisions (契約書が存在する契約の調査 - Keiyakusho ga Sonzai suru Keiyaku no Chōsa)

The detailed review of selected contracts focuses on identifying provisions that could create risks, impose significant obligations, or affect the transaction.

A. Contract Continuity, Termination, and Renewal (解除、契約期間、更新等契約の継続性に関わる条項 - Kaijo, Keiyaku Kikan, Kōshin tō Keiyaku no Keizokusei ni Kakawaru Jōkō):
This is a paramount area of focus.

1. Change of Control (COC) Clauses (チェンジ・オブ・コントロール条項 - Chenji obu Kontorōru Jōkō): These are among the most critical provisions to identify. A COC clause typically grants the counterparty certain rights if there is a change in the ownership or control of the target company (as defined in the clause). These rights might include:
   • The right to terminate the contract.
   • The requirement for the counterparty's prior consent for the contract to continue post-acquisition.
   • The triggering of adverse consequences, such as accelerated payment obligations, loss of exclusivity, or a requirement to renegotiate terms.
     The precise wording of COC clauses varies greatly, and their interpretation can be complex. Legal DD must carefully analyze the definition of "change of control," the nature of the rights triggered, and any notice or consent requirements. For material contracts, assessing the likelihood of a counterparty enforcing a COC clause and developing a strategy for obtaining necessary consents or waivers is a key task. In Japanese SMEs, positive pre-existing personal relationships between the target's owner and key counterparties can sometimes (though not always reliably) mitigate the formal risk posed by COC clauses, provided such relationships are proactively managed during the M&A process.
2. Term and Renewal Provisions: Understanding the remaining term of key contracts, any automatic renewal provisions, conditions for renewal or non-renewal, and required notice periods for termination or extension is vital for assessing future revenue and cost stability.
3. Termination Rights: Identifying rights for either party to terminate the agreement, whether for cause (e.g., material breach, insolvency) or for convenience (without cause), and any associated financial penalties or wind-down obligations.
4. Assignment Clauses: Reviewing restrictions on the target company's ability to assign its rights and obligations under the contract. While less critical in a share deal (where the contracting party remains the same), these are highly relevant for asset deals or if post-acquisition internal restructurings involving contract assignments are contemplated.

B. Restrictive Covenants:
These provisions can limit the operational flexibility of the target business or the acquirer post-acquisition.

1. Non-Compete Clauses (競業禁止条項 - Kyōgyō Kinshi Jōkō): Identifying any provisions that restrict the target company (or, by extension, the acquirer's group after the acquisition) from engaging in certain types of business activities, operating in specific geographic areas, or soliciting certain customers for a defined period. The scope, duration, and enforceability of such clauses need careful assessment.
2. Exclusivity Clauses (独占権等の優先権や有利な取引条件を付与された条項 - DokUSenken tō no Yūsensei Kenriya Yūri na Torihiki Jōken o Fuyo sareta Jōkō): Analyzing contracts where the target company grants or receives exclusive rights (e.g., exclusive supply agreements, exclusive distribution rights, exclusive licenses). These can be valuable assets but can also restrict future business development if not aligned with the acquirer's strategy.
3. Non-Solicitation Clauses: Restrictions on soliciting the employees or customers of the contractual counterparty.

C. Significant Obligations, Liabilities, and Financial Terms (その他対象会社が負う義務・債務に関する条項 - Sonota Taishō Kaisha ga Futan suru Gimu / Saimu ni Kansuru Jōkō):
Beyond termination and restrictions, numerous other clauses can harbor significant risks or obligations:

• Payment Terms, Pricing, and Volume Commitments: Scrutinizing payment cycles, pricing mechanisms (e.g., fixed, variable, subject to adjustment), minimum purchase or supply obligations, and penalties for failure to meet such commitments.
• Indemnification and Limitation of Liability Clauses: Understanding how risks for breaches, third-party claims, or specific events are allocated between the parties. Identifying any caps on liability, exclusions from liability, or unusually broad or one-sided indemnification obligations.
• Warranties and Guarantees: Reviewing the scope and duration of performance warranties, product warranties, or financial guarantees provided by or to the target company.
• Confidentiality Obligations: Assessing the scope and duration of confidentiality duties, especially those that survive contract termination.
• Dispute Resolution Mechanisms: Noting the agreed methods for resolving disputes (e.g., litigation, arbitration), the governing law of the contract (which may not always be Japanese law, especially in international agreements), and the jurisdiction for disputes.

D. Intellectual Property Provisions (within general commercial contracts):
Even in non-IP specific contracts, there can be important clauses regarding the ownership of intellectual property developed during the contractual relationship, or licenses granted for the use of IP necessary for the performance of the contract.

E. Identifying Atypical or Onerous Clauses:
A key skill in contract review is spotting provisions that are unusual for the type of agreement or industry, or that impose particularly burdensome or one-sided obligations on the target company.

V. Addressing Contracts Without Formal Written Agreements (契約書が存在しない契約の調査 - Keiyakusho ga Sonzai shinai Keiyaku no Chōsa)

In Japan, particularly among SMEs or in long-standing business relationships, it is not uncommon for significant commercial arrangements to exist without a comprehensive, formally executed written contract. Business may be conducted based on verbal agreements, an exchange of basic purchase orders and invoices, or established patterns of dealing.

A. Identifying Key Unwritten Understandings:
A crucial part of DD is to identify these key informal or unwritten commercial relationships, as they can be just as critical to the target's business as formal contracts.

B. Reconstructing the Terms:
Where written contracts are absent or inadequate, the DD team must attempt to reconstruct the likely terms of these arrangements through:

• Review of related documentation, such as email correspondence, memoranda, purchase orders, invoices, and payment records.
• Analysis of the historical course of dealing and performance between the parties.
• Extensive interviews with the target's management and relevant operational personnel to understand their perception of the terms and obligations.
• Consideration of customary practices within the specific industry in Japan.

C. Risks Associated with Unwritten Agreements:
The primary risks associated with unwritten agreements include:

• Uncertainty of Terms: The precise rights and obligations of each party may be unclear or disputed.
• Difficulty in Enforcement: Proving the terms of a verbal agreement in the event of a dispute can be challenging.
• Potential for Misunderstandings: The lack of a clear written record increases the likelihood of misunderstandings or divergent expectations between the parties.
• Higher Risk for Key Relationships: If a critical customer or supplier relationship is undocumented, its continuity post-acquisition may be less certain.

D. Potential Remediation Strategies:

• Formalization: If an unwritten agreement is deemed critical to the target's business, the acquirer may request, as a condition to closing the M&A transaction, that the target company and the counterparty formalize their arrangement into a written contract before the deal is completed.
• Representations and Warranties: If formalization is not feasible, the acquirer may seek specific representations and warranties from the seller regarding the key terms and stability of important unwritten commercial relationships.
• Valuation Adjustment: The increased risk and uncertainty associated with material unwritten agreements might be factored into the valuation of the target company or the purchase price.

VI. Practical Steps and Responding to Contractual DD Findings

The findings from the contractual due diligence process will inform several subsequent actions:

A. Seeking Consents and Waivers:
If material contracts contain Change of Control clauses that require counterparty consent for the contract to remain effective post-acquisition, a strategy for obtaining these consents or waivers must be developed. This process can be time-consuming and may involve the seller making the initial approaches to key counterparties. The success of obtaining these consents can significantly impact deal certainty.

B. Renegotiation or Termination of Problematic Contracts:
For contracts with particularly onerous terms, unacceptable risks, or provisions that conflict with the acquirer's post-acquisition plans, the possibility of renegotiating those terms with the counterparty, or even seeking to terminate the contract (if permissible and commercially viable), may be explored.

C. Impact on the Definitive M&A Agreement:
The DD findings are crucial for drafting and negotiating the definitive M&A agreement:

• Representations and Warranties: The seller will be asked to make specific representations regarding the accuracy of the provided contract list, the validity and enforceability of material contracts, and the absence of material breaches.
• Specific Indemnities: If specific risks are identified in relation to particular contracts (e.g., a high risk of termination of a key customer contract, or potential liability under an unusual indemnification clause), the acquirer may seek specific indemnification from the seller for losses arising from these identified contractual risks.
• Conditions Precedent: The successful obtaining of essential third-party consents for material contracts, or the satisfactory resolution of other critical contractual issues, may be included as conditions precedent to the acquirer's obligation to close the transaction.

D. Purchase Price Adjustments:
If the contract review reveals that key contracts are less favorable than initially assumed, if significant risks are identified that cannot be fully mitigated through other means, or if substantial costs are anticipated (e.g., to replace a critical contract that is likely to be terminated), the acquirer may seek an adjustment to the purchase price.

E. Informing Post-Merger Integration (PMI) Planning:
A clear understanding of the target's key contractual obligations, rights, and relationships is essential for effective PMI. This includes planning for the novation or assignment of contracts if necessary, ensuring compliance with ongoing contractual duties, and managing relationships with key counterparties during the integration process.

Conclusion: A Vital Exercise in Risk Assessment and Value Preservation

The meticulous examination of contractual relationships is a cornerstone of legal due diligence in any M&A transaction, providing profound insights into the operational framework, commercial vitality, legal obligations, and inherent risks of a target company. In the Japanese M&A environment, this review demands not only a careful textual analysis of written agreements but also an appreciation for business practices where informal understandings and long-standing relationships can play a significant role, particularly within the SME sector.

A diligent, strategic, and context-aware approach to contract review—focusing on materiality, potential financial and operational impacts, and alignment with the acquirer's objectives—is crucial for mitigating risks, accurately valuing the target, and ultimately structuring a successful and sustainable M&A deal in Japan.