Acquiring Japanese companies: the acquisition agreement

In the acquisition of a Japanese company by a foreign party, the negotiation and execution of the acquisition agreements is the most important stage. Common acquisition contracts include share purchase agreements, share subscription agreements, demerger agreements and business transfer agreements. The following are certain significant provisions in these agreements.

Price adjustment clause

The purchase price is normally determined by the parties calculating and assessing the target’s business value as at an agreed reference date. However, the closing date is often several weeks or months after the reference date. During this time, the value of the target’s business may change significantly. The price adjustment clause is the provision by which the parties adjust the purchase price to reflect changes in business value due to time delay. It should be noted that in a tender offer, there is an indefinite number of potential sellers, so the tenderer will not be able to use the price adjustment mechanism to change the tender price.

Working capital adjustment

The purchaser usually attaches great importance to the working capital amount on the completion date. However, as the target’s working capital fluctuates daily, when an acquisition agreement is executed, the parties will not be able to foretell the exact amount of working capital on the completion date. Therefore, they will pre-determine a base amount, using the target’s historic working capital average balance. If, on the closing date, the working capital is lower than the base amount, the seller will pay the shortfall by deducting an equivalent amount from the purchase price.

Conversely, if the working capital on the closing date exceeds the base amount, the purchaser will pay the excess by way of an increase in the purchase price.

Earn-out

After completion of the acquisition, if the target company achieves a certain financial target, the purchaser will pay an additional sum. If the financial target is not achieved, the seller will refund part of the purchase price.

The earn-out period can be divided into quarterly, half-yearly or yearly assessment periods. It is, however, not easy to decide what a suitable standard will be for assessment purposes. For instance, should it be net profit, operating profit, cashflow, EBITDA, or a standard that is a combination of all or some of the above?

Post-completion adjustment

Sometimes, a company’s real value can only be determined after the acquisition has been completed. For example, there may be an exodus of key staff after the acquisition, or the target company may turn out to have major litigation outstanding. The acquisition agreement may therefore contain provisions which allow price adjustments post-completion if certain events occur.

Representations and warranties

In a share acquisition, the representations and warranties of the seller are particularly important. The seller is generally unwilling to inform the buyer of matters that do not put the target company in a good light. Furthermore, it may even wish to transfer the target’s debts and liabilities to the buyer through the acquisition transaction.

In relation to representations and warranties, the following should be noted:

1. Should the reference date for determining the truthfulness or otherwise of the representations and warranties be the date when the acquisition agreement is signed, or the completion date, or both?
2. Should the representations and warranties be limited to matters within the knowledge of the seller, or should they include matters which the seller can be (but is not yet) aware of, or even matters which the seller cannot be expected to be aware of?
3. Should the consequences of a breach of the representation and warranties clause be limited to a right to damages, or should it also be a cause for termination of the agreement?
4. In relation to liability to damages as a consequence of a breach of the representations and warranties clause, should the liability be triggered by a minor breach, or should it be limited to significant breaches, or should there be a de minimis provision?

Compensation and termination

The representations and warranties clause needs to be supported by a damages clause and termination clause, to encourage the truthfulness and reliability of the representations and warranties. Even so, the damages clause and termination clause cannot be foolproof. For example, the target company may cease to exist after completion of a merger transaction, and so can no longer be liable for the representations and warranties. In these situations, the only ways to deal with the issue will be to have guarantees from third parties such as the vendor, or the retention by the purchaser of part of the purchase price for a certain period.

Governing law and jurisdiction

The governing law in contracts between Chinese and Japanese enterprises can be Chinese law, Japanese law, or even the laws of a third country or territory (such as Singapore, New York state or Hong Kong). It is difficult to say categorically whether it is advantageous or not to choose a particular law. Nonetheless, generally speaking, both the Chinese and Japanese party will want to choose a law they are familiar with.

Because both China and Japan are signatories to the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, the arbitration awards of both countries will be recognized, and therefore can be enforced, by the courts of both countries. However, a reply by the PRC Supreme People’s Court in 1995 established the precedent that judgments of Japanese courts are not recognized by Chinese courts. In April 2003, the High Court in Osaka decided that judgments in civil matters made by Chinese People’s Courts are not recognized in Japan. Accordingly, court judgments of both countries are not recognized by, and thus cannot be enforced in, the other country. Therefore, the author strongly recommends that arbitration should be used as the dispute resolution method in Sino-Japanese agreements.

Hiroshige Nakagawa is a partner at Anderson Mori and Tomotsune and chief representative of its Beijing Office