M&A Tips for Japanese Companies

M&A transactions in the UK, especially for small to medium-sized unlisted companies, generally follow a similar process to those in Japan. This includes the buyer expressing interest and agreeing on key terms, conducting various due diligence (including legal due diligence), negotiating and signing the definitive agreement, satisfying conditions precedent then completing the transaction, and post-merger integration (PMI). This article highlights some English systems and practices that might surprise Japanese buyers at each step.

Legal Due Diligence (DD) 

The points to consider in legal due diligence (DD) are broadly similar, but there are some notable differences. For example, in the UK, there’s a regulation called TUPE (Transfer of Undertakings (Protection of Employment) Regulations). When a business is “transferred,” the employees involved are automatically transferred to the new business owner by law. This applies not only to business transfers but also to outsourcing situations. For instance, if a company outsources its IT operations, the employees working on those operations at the company will be transferred to the service company which will provide the outsourced services. If the target company has previously transferred employees under TUPE, there may be employees with different employment terms. 

Another example is, in Japan, employers are legally required to pay overtime wages for work that exceeds statutory working hours. In contrast, in the UK, while there is a minimum wage, there is no legal requirement to pay overtime wages. Although the UK has a maximum limit on weekly working hours, this can be waived with the employee’s consent. Higher-paid employees are less likely to face minimum wage issues, and the maximum working hours limit is often waived. On the other hand, modestly paid workers are less likely to work overtime without being compensated. Therefore, the risk of “working overtime without compensation” is generally less of a concern in the UK compared to Japan.

Negotiating The Definitive Agreement

In the UK, it’s generally assumed that the risk of the target company’s business passes to the buyer at the signing of the share purchase agreement, which significantly influences the typical transaction terms.

For example, in the UK, deal certainty is highly valued. Conditions precedent are usually limited to legal requirements like merger control clearance. It’s rare to see Material Adverse Change (MAC) clauses, which make the absence of significant adverse events a condition precedent. It’s also uncommon for the accuracy of the seller’s warranties about the target company’s business to be a condition precedent. Typically, the buyer’s remedies for breaches of these warranties are limited to damages, and a breach of any warranties would not allow the buyer to terminate the share purchase agreement. The seller’s liability for breaches of warranties is often subject to certain limitations. For example, the buyer’s claims for damages are usually not allowed until the cumulative amount of the seller’s liability reaches a certain threshold (the “basket” clause), often set at 0.5-1.0% of the purchase price. The cap on the seller’s liability for warranties regarding the target company’s business is often set at 10-30% of the purchase price.

It’s common not to repeat the seller’s warranties about the target company’s business at the time of completion. If such warranties are repeated, the seller is often allowed to exclude liability through further disclosures. Therefore, the buyer’s protection between signing and completion relies heavily on covenants regarding the operation of the target company during that period.

When it comes to purchase price adjustment mechanisms, the “locked box” method is quite common. This method sets the price based on financial statements as at a reference date, and only any leakages from that date to the completion date are compensated by the seller. However, the “completion accounts” mechanism is also frequently used.

Conditions Precedent

As mentioned earlier, in the UK, conditions precedent to completing a transaction are often limited to legal requirements. One unique aspect in the UK is the National Security and Investment Act 2021 (NSIA). Under the NSIA, if the target company operates in one of 17 sensitive sectors and more than 25% of its shares are being sold, prior notification to the government is required. These sectors include advanced materials, robotics, AI, nuclear, communications, and computing hardware. Even if prior notification isn’t required, the government can review the transaction post-completion and impose corrective measures if national security risks are identified. Therefore, parties may choose to notify the government voluntarily to avoid future interference. The NSIA notification can be made before signing the share purchase agreement, allowing parties to obtain clearance in advance and exclude it from conditions precedent.

On top of NSIA clearance, approval from competition authorities or regulators may be required. Even when acquiring a UK company, if the target company and its subsidiaries operate outside the UK, approvals from foreign authorities may also be necessary.

Completion of a Transaction

The buyer will not immediately become a shareholder upon completion of a transaction due to a UK tax called stamp duty. A 0.5% tax is charged on any transfer of shares in a UK company. The process involves the buyer paying the stamp duty to the tax authorities, sending the Stock Transfer Form received from the seller to the tax authorities, and, after receiving the stamp, requesting the target company to update the shareholder register. Only then does the buyer officially become a shareholder. This process creates a slight time lag. During this period, the buyer exercises shareholder rights based on the power of attorney granted from the seller. If the buyer needs to become a shareholder immediately, there are structures to achieve this, although they incur additional costs.

Post-M&A Integration (PMI) 

Here are some common questions Japanese companies have about post-M&A integration (PMI).

No Concept of “Merger” 

In Japan, companies can merge into a single entity, but the UK doesn’t have an equivalent system. To achieve similar results, you need to transfer the business, which legally means transferring individual assets. In a merger, the assets, contracts, and liabilities of the disappearing entity automatically transfer to the surviving entity by law. In the UK, you must follow the necessary procedures for transferring each asset, similar to business transfers in Japan. 

If a Japanese company has a subsidiary in the UK and wants to merge it with a target company after purchasing its shares (rather than structuring it as an asset sale by the subsidiary), it must first acquire the target company’s shares, then transfer the business between the existing subsidiary and the acquired entity, and finally liquidate one of the entities. 

Director Residency Requirements

Under UK company law, there is no requirement for directors to reside in the UK.  This means that a Japanese resident can be appointed as a director of a UK entity after an acquisition. However, the residency of the directors may affect the determination of the company’s tax residency.

Inflexibility of Job Descriptions 

In Japan, employers can change employees’ job titles and duties relatively flexibly. However, in the UK, “job-based” employment is common, and the scope for changing an employee’s job title or duties is usually limited. Unilateral changes by the employer could be seen as constructive dismissal, potentially leading to lawsuits from employees. Legal issues may arise if the buyer’s group company sends personnel to the target company affecting the existing employees’ duties.

W&I Insurance

W&I insurance plays a vital role in M&A transactions, especially in the UK. Particularly for Japanese companies acquiring UK targets, understanding the nuances of W&I insurance is essential. This section provides an overview of W&I insurance in the UK.

It’s important to note that due to Japanese insurance regulations, if a buyer acquires a UK business through a Japanese entity (rather than setting up a UK vehicle for the acquisition), the insurance must be arranged in Japan.

What is W&I Insurance?

Warranty and Indemnity (W&I) insurance covers financial losses from breaches of warranties in a share purchase agreement. There are two types: sell-side and buy-side. Sell-side insurance covers the seller’s losses if the buyer makes a claim. Buy-side insurance, which is more common in the UK, covers the buyer’s losses. When a buy-side policy is used, the seller’s liability is often set at a nominal amount (e.g., £1) and buy-side insurance typically waives the insurer’s right of subrogation against the seller.

Terms of W&I Insurance

Key terms include the premium, excess/retention, de minimis, and exclusions. The premium is calculated based on the enterprise value, typically covering 10-30% of the enterprise value. Excess/retention sets the threshold below which no claims can be made, usually around 0.5% of the enterprise value. De minimis sets the minimum loss amount for a valid claim. Any areas which were not properly due diligenced by external advisers will be excluded (so purchasing a W&I insurance policy cannot replace legal due diligence) and excludes known risks. Certain risks, like pension deficits, are automatically excluded, while others, such as environmental issues like contamination, are often excluded but on a case-by-case basis. Separate policies may be needed for known risks, such as tax risks or title defects in a property.

W&I Insurance Process

The process starts with the buyer contracting an insurance broker, who obtains quotes from multiple insurers and provides a report. The buyer selects an insurer and begins the formal underwriting process. During underwriting, the insurer reviews due diligence data, transaction documents, and due diligence reports, and the buyer (and their advisors) answers any questions from the insurer. An underwriting call is held to confirm the quality of the due diligence and ensure that the warranties were adequately negotiated between the seller and the buyer.

Navigating UK M&A

While the M&A process in the UK shares many similarities with that in Japan, there are distinct practices and systems in the UK that Japanese buyers should be aware of. From due diligence to post-M&A integration, each step presents unique challenges and opportunities, requiring holistic and strategic approaches. It’s crucial to appoint an experienced legal adviser who understands both the UK landscape and the Japanese background. By being well-prepared and informed about these differences, Japanese buyers can navigate the UK M&A landscape more effectively and achieve successful outcomes.