• 2023.05.23
  • M&A

Mitigating Takeover Risk through Due Diligence

Importance of Due Diligence

When considering M&A, it is important to understand the type of company being acquired. Due diligence is the process of having an expert verify the status of the target company.
There are three main types of due diligence: business, accounting, and legal. For the business aspect, we examine what kind of business is being conducted, who the customers are, the environment surrounding the business, its future potential, whether the business plan is appropriate, and so on. The business is usually not required to be audited by a professional since the buyer is expected to have a good understanding of the business. Accounting due diligence is an audit of the accounting aspects and is usually performed by a certified public accountant or tax accountant. The main task is to verify that the balance sheet and income statement are consistent with each of the related ledgers. In addition, the auditor will also check for proper depreciation, clear distinction between cash receipts and disbursements from directors and officers, and whether there are any transactions that could be disallowed by the tax office.

Legal Due Diligence

Legal due diligence is the process of confirming that there are no problems from a legal standpoint. The following is a brief overview of how legal due diligence is performed and the issues involved.


M&A can be conducted through stock transfers or business transfers, but in the majority of cases, the stock transfer method is likely to be used. This is because M&A is for the purpose of transferring control, and share transfers are extremely simple in terms of procedures, such as not requiring the consent of the counterparty company with which the company has entered into an agreement, and are also advantageous from a tax perspective. Therefore, since the buyer pays for the shares through M&A, it is extremely important to confirm that the shares to be sold are validly issued and that the transferor is a genuine shareholder.

Existence of estate division and other procedural issues

In the case of shares for which share certificates have been issued, it is possible to acquire the shares in good faith by receiving the share certificates, but under normal circumstances, if the transferor is not the genuine shareholder, even after receiving the transfer of shares, there is possibility that the genuine owner of the shares will claim that he/she is the genuine owner of the shares in the future. For example, when received a transfer of shares from Mr. A, even if Mr. A originally inherited the shares from his father, Mr. B, and Mr. A thought that he had properly acquired the shares through a division of the estate, Mr. A’s brother, Mr. C, and mother, Ms. D, may argue that the division of the estate agreement was invalid and that Mr. A did not acquire the shares effectively. If the agreement on the division of property was invalid or the agreement on the division of property itself was not made in the inheritance of Mr. B, the acquisition of shares by Mr. A would be invalid, and the transferee who received the shares from Mr. A would not be able to acquire the shares validly. The transferee of the shares would have no choice but to demand that Mr. A return the purchase price already paid, but if Mr. A was without funds at that time, or if he could no longer be contacted, he would not be able to receive the return of the transfer price either. In the event of inheritance of a shareholder, the company must confirm the identity of the heirs by means of a copy of the family register and a chart of heirs, as well as confirming that the heirs who applied for the transfer of ownership really inherited the shares by means of a written agreement on division of property and a certificate of seal registration of all the heirs.

Validity of share issuance procedures

The same will also be relevant to whether the subscription of shares at the time of incorporation of the company and the issuance of new shares by way of third-party allotment were appropriate. Therefore, as a transferee of shares, it is not enough to rely on the entries in the shareholders’ register at that time, but it is also necessary to check whether each transaction was valid from the time the shares were issued.
For example, if X underwrote the shares at the time of Party A’s incorporation, Y inherited the shares held by X, and Z acquired the shares from Y, it is necessary to confirm whether X’s underwriting of the shares was valid, whether the underwriting price was paid by X, whether the inheritance by Y was valid, whether the estate was divided with the consent of all heirs, and whether Y alone inherited the shares. With regard to the transfer of shares from Y to Z, it is necessary to confirm whether a valid share transfer agreement has been drawn up, whether the payment for the transfer of shares from Z to Y has been made, and whether the transfer of title to Z has been properly made in accordance with the law and the articles of incorporation.
Of course, there is a time limit when disputing the validity of the procedure for issuing new shares, so if that period has passed, even if there was a procedural defect in the procedure for issuing new shares, it may not be possible to claim that defect against a third party in the future. If there is a transfer of shares from Y to Z by delivery of share certificates, it is possible that Z may have acquired the shares in good faith but it remains necessary to check all the steps from the time of issuance to the transferor, including such possibilities.

Warranty representations by the transferor

On the other hand, there are cases where it is doubtful whether there is enough evidence to prove the transfer of rights for all the transactions that took place several decades ago, and in practice, we may have to limit our investigation to a certain scope. For example, if no claims have been made by anyone over a period of 10 years regarding the ownership of shares by Z, then even if there is a problem regarding the acquisition of shares by Z, the transaction may have to be conducted on the assumption that the shares are already owned by Z, since the acquisition is already time-barred. Therefore, there is a possibility that the scope of the investigation of the shares may have to be compromised, except in cases where the company has just been established, and in some cases, it is not always clear whether or not Z is the real shareholder, but by having the transferor make a warranty declaration, it may be possible to claim damages against the transferor in the unlikely event that Z is not the real shareholder.
In some cases we have handled cases where the validity of a division of the estate is disputed by the other heirs to shares acquired by the transferor in a division of the estate, the buyer acquired the shares with an understanding of such a situation.

Articles of Incorporation and Basic Regulations

When conducting legal due diligence, the first documents to be checked are the certified copy of the commercial register, the articles of incorporation, the rules of the board of directors, and the rules of the general meeting of shareholders, etc. However, for many small and medium-sized companies, the articles of incorporation are out of date and do not correspond to the current corporate law, or there are no rules regarding basic corporate matters such as the rules of the board of directors or the general meeting of shareholders.
However, in cases where control of the company is completely transferred, the sale and purchase are often conducted with insufficient regulations, on the assumption that the articles of incorporation will be amended later and the regulations will be addressed by the transferee after the transaction.

Minutes of board of directors meetings and shareholders’ meetings

Since many small and medium-sized companies are owner-managed, all matters are decided at the sole discretion of the owner, and often there are no board of directors meetings or general shareholders’ meetings ever held. Of course, the appointment and dismissal of directors and officers must be registered in the commercial register, and the articles of incorporation and minutes of shareholders’ meetings are required to be attached to applications for registration, company representatives often ask judicial scriveners to prepare minutes of board of directors meetings and shareholders’ meetings, even though they were not actually held.
According to the Companies Act, a company is required to hold a board of directors meeting at least once every three months, and an annual shareholders’ meeting at least once a year to approve financial statements and other matters.
Under normal circumstances, there should be no particular problem if the minutes of the shareholders’ meeting or the board of directors’ meeting are not maintained, but if, for example, the board of directors’ meeting at which new shares or stock acquisition rights are issued was not actually held, it cannot be said that there will be no problem with the issuance of new shares or stock acquisition rights in the future. Similarly, if a dispute over control of the company arises, it is not impossible to say that there is possibility of a dispute over whether the procedures for appointing and dismissing directors and officers in the past were properly carried out.
Therefore, if there is a possibility of M&A activity in a company, at least a minimum number of board of directors meetings and shareholders’ meetings should be properly held and recorded in the minutes. The legal due diligence will check whether the directors were properly notified of the board meeting (if not, whether the directors who should have been notified gave their consent not to do so), and whether the shareholders’ meeting, it is necessary to confirm whether or not a valid notice of meeting was given to all shareholders by a certain period of time prior to the meeting as stipulated in the articles of incorporation of the company.
On the other hand, even if the shareholders’ meeting or board of directors’ meeting in the past was not held effectively and properly, it does not mean that the M&A of the company in question will be immediately prohibited. A risk assessment will be conducted to estimate the matters that would have been resolved at the shareholders’ meeting or board of directors meeting, and to evaluate the magnitude of the risk by examining the possibility of procedural defects being claimed in the future by third parties or company insiders, in light of the contents of the resolutions.

Other agreements

The existence and content of contracts are also an important subject of legal audit. Regarding contracts, in addition to basic transaction agreements with business partners and individual sales contracts, various other contracts may be considered, such as sales agency agreements, real estate lease agreements, license agreements, and so on. In auditing contracts, it is important to first determine whether the contract exists. For example, there are many cases in which contracts with important business partners do not exist, and transactions have been conducted only with purchase orders and purchase order agreements.
Of course, not all contracts must exist, and here again, it is a matter of determining whether the absence of the contract contains the possibility of causing a dispute in the future. In a case we have handled in the past, a written agreement regarding a parking lot (100,000 yen monthly rent) did not exist, and the buyer’s attorney pointed out that the buyer was required to sign an agreement with the lessor before closing the M&A transaction. In this example, the buyer company was an American company, but the seller and buyer worked together to try to clear up as many issues that appeared during the legal due diligence process as possible before closing. This is a case where due diligence was utilized as a means to clear up issues.
The content of the contract is also an important audit matter. For example, if there is a lease agreement for a store and the term of the agreement is 10 years and the tenant is required to pay the entire rent for the remaining period in a lump sum if the agreement is terminated mid-term, the mid-term termination could result in a burden of tens to hundreds of millions of yen. Of course, if the lease agreement is for the head office and there is no possibility of mid-term termination, there will be few problems. However, in the case of a lease agreement for a store, when restructuring is planned to close a store with poor business performance, the amount of penalty due to termination will be extremely large and the store may not be able to be closed. The amount of the termination penalty would be so large that it would be impossible to close the store.
In one M&A case, we also had to check all the contracts with about 150 business partners, calculate whether there would be any mid-term cancellations from the other party and the amount of fees to be paid if the contracts were to continue, and project the minimum sales after the acquisition. In this case, we took the approach of projecting future revenues based on the contents of the contract.
In addition to the above, change of control clauses should be checked when checking contracts. For example, if a real estate lease agreement contains a clause that requires the lessor to report or consent to a change in controlling shareholder or other M&A activity (a “change of control clause”), it is necessary to report or obtain consent based on the agreement.

Disputes about the company

If a lawsuit has been filed against the company, or if the company is a party to a lawsuit against a third party, it is necessary to review all documents related to the lawsuit and determine the scope of the ripple effect of the lawsuit. A trial includes not only ordinary litigation, but also provisional attachments, preliminary injunctions, trial proceedings, appeals proceedings, and all other legal disputes. In addition to cases in which the company is a defendant, it is necessary to consider all lawsuits to which it is a party, even if it is a plaintiff, to determine what the cause of the dispute is and whether there is a possibility that similar issues will recur in the future.
In addition, even if the case has not gone to court, a dispute in the broad sense of the term also includes cases where a client has sent a certified letter demanding payment or a notice of termination of a business contract, and the other party does not want to approve the termination. For example, if the amount of unpaid overtime wages is as small as 300,000 yen, but the company does not properly manage the overtime and does not actually pay overtime wages, there is a possibility that similar claims will be made by other employees in the future.

Claims for payment of unpaid overtime

If one of the employees files a complaint with the Labor Standards Inspection Office and the Labor Standards Inspection Office conducts an investigation and issues a recommendation for correction, the company may be required to follow the instructions of the Labor Standards Inspection Office and pay two or three years’ (the statute of limitations for unpaid overtime until March 2020 is two years, but the statute of limitations for unpaid overtime after April 2020 is three years) worth of unpaid overtime as well as submit a written pledge to pay overtime in the future. For example, in a company with current administrative expenses of 500 million yen and operating profit of 50 million yen, if overtime compensation of 30 million yen is added, resulting in administrative expenses of 530 million yen and operating profit of 20 million yen, the value of the company will be completely different.
In the above case, even if the unpaid overtime wages for the person who is currently claiming is only 300,000 yen, the company as a whole could see an increase in administrative expenses of 30 million yen per year. If the corporate value is calculated as seven times operating income, a company with a corporate value of 350 million yen may end up with a corporate value of only 140 million yen.
Thus, the existence of a dispute could mean that there is a major business problem behind the dispute. Therefore, it is important to identify not only the dispute but also the business problem behind the dispute and to properly evaluate the business risk of the dispute.

Systemic problems

For example, suppose that a financial institution is being sued by the holder of a lost credit card who claims that the finder of the credit card withdrew money without permission and incurred a loss of 2 million yen. The financial institution would only risk 2 million yen in this case, but in the unlikely event that it loses the lawsuit and the court rules that the financial institution’s handling of the PIN of the credit card is inadequate, the financial institution may have to modify its entire system. In such a case, it is not inconceivable that the financial institution may have to modify its entire system. In this case, the system modification could cost several hundred million yen, so the above lawsuit only clarifies part of the problem. Of course, if it is determined that the financial institution has properly managed confidential customer information and that the financial institution was not negligent (the customer was personally responsible for the loss of his/her credit card and the discovery of his/her PIN), there is no risk as described above. Therefore, in the legal audit process, it is necessary to take an appropriate attitude to determine whether the claim could be a risk factor to the company based on laws and regulations and social common sense.
A similar issue often arises with system development claims by system development companies. For example, suppose that there was a problem with the developed system and a claim for damages was made for default. Even if the case itself was settled for 200 million yen, it is possible that the company’s sales and management did not have a proper understanding of the capabilities of the company’s developers, and that the company was not capable of developing a difficult system in the first place. In this case, even if the above trial has already been concluded, it is quite possible that a similar problem will occur in the future, and therefore, it is necessary to check the contents of the ongoing development contract and determine whether the current staff has sufficient development capability for it.

Litigation for refund of overpayment

Similar issues are also relevant to lawsuits for the payment of money. For example, at one time, many lawsuits were filed by consumer finance companies claiming overpayment. Although the Interest Rate Restriction Law limited the interest rate that a lender could charge to a certain range (e.g., 15%), the Money Lending Business Law did not clearly regulate the interest rate, and the Capital Subscription Law set the prohibited interest rate at 40%. It was not clear which law would be enforced.
Therefore, for several decades, it was often pointed out that there were problems with the collection methods of consumer finance companies, and many customers claimed violation of the Interest Rate Restriction Law in lawsuits for refund of loans from consumer finance companies. At that time, the courts did not have clear guidelines for judgment on this point and took the form of recommending settlement as much as possible. However, in cases where the parties could not reach an agreement, it seems that judgments were made to accept the consumer finance company’s claim on the grounds that it was stated in the contract.
On the other hand, since about a decade ago, as the demand for consumer finance has increased significantly due to the easing of monetary policy, the issue of collection methods of consumer finance companies has come to the forefront of public attention. The exchange of information among groups of lawyers working against consumer finance companies progressed, theories were refined, and gradually a social consensus was formed that the interest rates charged by consumer finance companies were too high. Subsequently, the Supreme Court ruled that loans in violation of the Interest Rate Restriction Law were invalid, and also ruled that customers could demand the return of interest that they had paid in the past in violation of the Interest Rate Restriction Law. This has led to a number of lawsuits filed by consumers against consumer finance companies nationwide for the return of overpayments.
Since the Supreme Court’s ruling has already been issued, it is natural to expect that consumer finance companies will be filed claims for the return of overpayments, so it will be necessary to point this out in the legal audits of consumer finance companies and clarify the scope of the risk (calculating how many hundreds of billions of yen the future claims from overpayment return lawsuits will be). It will be necessary to clarify the scope of the risk. Naturally, legal fees for lawsuits and administrative costs for managing overpayment claims will also be a significant amount of money, so it is necessary to mention the scope of such risks in the legal due diligence.
In this way, disputes involving a company must be examined not only in terms of the outcome, but also in terms of the reasons behind the dispute, and the potential risks involved must be properly evaluated. In most cases, legal issues are considered to be involved, but there are also issues inherent in changes in social awareness and the technology possessed by the company, so the evaluation of these issues can be complex. As an attorney conducting a legal audit, it may be necessary to seek the opinion of an expert in the relevant field on issues that the attorney is unable to determine on his or her own.