What Is Legal Due Diligence (Legal DD)? Key Points on Its Purpose, Investigation Items, Process, Timeline and Reflection in the Contract

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

Once an acquisition target has been settled and the signing of a letter of intent comes into view, the buyer's management and legal staff begin concrete deliberations. The main question to decide is how far legal due diligence should go. The purpose of legal DD is not to read every document of the target company without limit. Within a limited investigation period, the buyer decides whether it may proceed with the acquisition and whether the price or transaction terms need to be revised. On that basis, the proper role of legal DD is to identify accurately which clauses should be included in the definitive agreement (SPA).

Legal due diligence (legal DD) is a procedure in which, in M&A, the buyer investigates the legal issues and risks hidden in the target company or target business. Specialists closely examine whether the target company operates its business in compliance with laws and contracts and whether there are defects in its rights and obligations. It is defined as a procedure for identifying in advance losses that may arise in the future and obstacles to business operations.

Its area of responsibility differs from that of financial DD, tax DD and business DD, but the findings in legal DD are directly linked to the purchase price and contract terms. Because they also affect post-closing integration work, legal DD forms a single process carried out in coordination with each of the other specialists. If you would like to check the scope and overall picture of our support from the basic agreement (LOI) through legal DD, SPA negotiations and closing, please see M&A Support.

The Purpose of Legal Due Diligence and the Matters to Be Decided

The purpose of legal DD is not limited to simply pointing out the target company's violations of law or deficiencies in its internal rules. Its main purpose is to prevent the buyer from bearing unexpected legal liability or the risk of business suspension after executing the acquisition, and to reflect such risks appropriately in the investment decision and the contract terms. If a material legal risk materializes after the acquisition has been executed, the investment recovery plan the buyer had envisaged may become difficult to achieve. It is necessary to identify risks in advance and to agree on who will bear each risk and by what method.

The results of legal DD are mainly used for the following four decisions.

• Whether to execute the acquisition and the selection of the transaction scheme
• Calculation of the transfer consideration and reflection in price adjustment clauses
• Reflection in the conditions precedent, representations and warranties, and special indemnities in the SPA
• Identification of corrective matters and covenants to be carried over after closing

If permits and licenses necessary for the business cannot be succeeded to, or if core intellectual property rights do not belong to the company, the business value initially envisaged may be impaired. The same applies where a contract with an important business partner contains a change of control clause and there is a risk that the contract will be terminated. When a material issue is found, the buyer considers abandoning the transaction itself and also discusses redesigning the transaction scheme.

Even for risks that do not warrant stopping the transaction, a discovered fact does not necessarily lead automatically and directly to a price reduction or indemnification. The risks must be sorted according to their nature. The buyer considers whether to treat a matter as a corrective item to be addressed before closing or to deduct it from the purchase price. Alternatively, the buyer determines whether to make it subject to indemnification for breach of representations and warranties or to remedy it on its own after the acquisition, and translates that determination into the contract terms.

Core Investigation Items That Determine Whether the Transaction Succeeds

The matters to be investigated in legal DD are wide-ranging, but not all items carry equal weight. There are core issues that concern the legal foundation of the target company itself and determine whether the acquisition can proceed and on what terms. Specifically, there are three: the ownership of the shares and the transfer procedures, business continuity and contractual positions, and labor-related and other off-balance-sheet liabilities.

In practice, the main documents to be checked when verifying the core issues are as follows.

• Articles of incorporation, the commercial register, the shareholder register, the procedures for issuing shares and stock acquisition rights, and minutes of shareholders' meetings and board of directors meetings
• Business permits and licenses, the status of compliance management, and documents relating to past administrative investigations, guidance and dispositions
• Major business contracts, loan agreements with financial institutions, business alliance agreements, and contracts containing change of control clauses
• Work rules, contractual relationships with officers, employees and outsourcing contractors, and materials relating to unpaid wages and other labor matters
• Documents relating to pending litigation, serious customer complaints, contingent liabilities and guarantees of third-party obligations

Ownership of the Shares and Transfer Procedures

In a share transfer scheme, the most fundamental issue is whether the seller lawfully and validly holds the shares of the target company and whether the buyer can acquire full rights to them. If there are deficiencies in the shareholder register or in past share issuance and transfer procedures, the ownership of the shares the buyer acquires may itself be disputed.

The main text of Article 128, Paragraph 1 of the Companies Act provides: "The transfer of shares of a company issuing share certificates does not become effective unless the share certificates for those shares are delivered." In a company issuing share certificates, whose articles of incorporation provide that share certificates will be issued, a transfer of shares does not take effect merely because the seller and the buyer have entered into an agreement to transfer the shares. Actual delivery of the share certificates is a requirement for the transfer to take effect. In legal DD, the articles of incorporation and the commercial register are used to confirm whether the company is a company issuing share certificates. If share certificates were not actually issued even though the company is a company issuing share certificates, or if they have been lost, there is room for a finding that the transfer has not taken effect.

Article 130, Paragraph 1 of the Companies Act provides: "The transfer of shares may not be asserted against the stock company or other third parties unless the name and address of the person who acquired the shares are stated or recorded in the shareholder register." Under Paragraph 2 of the same Article, for a company issuing share certificates, "the stock company or other third parties" is read as "the stock company." In a company not issuing share certificates, entry in the shareholder register is the requirement for asserting the transfer against the company and third parties, while in a company issuing share certificates it is understood to be the requirement for asserting the transfer against the company. If the procedure for updating the shareholder register has not been properly carried out, the buyer, in principle, cannot exercise the rights of a shareholder against the company.

Article 136 of the Companies Act allows a shareholder holding shares with restrictions on transfer to request approval. When the shareholder intends to transfer shares to another person, the shareholder may request that the company decide whether or not to approve the acquisition by that other person. Article 139, Paragraph 1 of the Companies Act provides: "For a stock company to decide whether or not to give the approval under Article 136 or Article 137, paragraph (1), a resolution of a shareholders' meeting (or of the board of directors, for a company with a board of directors) is required; provided, however, that this does not apply if it is otherwise provided for in the articles of incorporation." Where a transfer of shares with restrictions on transfer has not gone through the company's approval procedure, the transfer is understood to be valid between the parties to the transfer. However, it is understood to have no effect in relation to the company.

To confirm these statutory requirements, legal DD obtains the target company's articles of incorporation, commercial register and shareholder register. The minutes of shareholders' meetings and board of directors meetings relating to share issuances, procedures for issuing stock acquisition rights, capital increases, acquisitions of treasury shares and past transfers between shareholders, from incorporation to the present, are cross-checked in chronological order. If the company is a company issuing share certificates, the physical share certificates and documents confirming their issuance status are closely examined. It is necessary to investigate comprehensively whether there are nominee shares, shareholders whose whereabouts are unknown, or missing minutes.

Business Continuity and Contractual Positions

Whether the buyer can continue the target company's business as intended after the acquisition is also a core issue that affects the conclusion. Factors that threaten business continuity include issues of succession to permits and licenses, change of control clauses in major contracts, and the procedures for transferring contractual positions.

As for business permits and licenses, the provisions and procedures for succession differ depending on the underlying industry-specific law. It is necessary to check the governing laws and regulations for each permit or license, including whether there is a provision allowing succession through a merger, company split or business transfer. In a share transfer, the target company itself, as the holder of the permit or license, does not change, but some industry-specific laws require notifications or similar filings for changes in shareholders or officers. Failure to make a required notification may lead to administrative guidance or dispositions, so the legal procedures are identified in advance.

Whether major business contracts contain a change of control clause (COC clause) is also a core subject of review. This clause applies when there is a change in the shareholder composition or control of the contracting party (the target company). It is a provision that requires the target company to obtain the counterparty's prior consent or give notice to the counterparty, or that gives the counterparty a right to terminate the contract. If, as a result of executing the acquisition, major business partners terminate their contracts, the revenue base of the business will be significantly impaired. If a loan agreement with a financial institution contains a change of control clause, there is also a risk that the acquisition will cause the loss of the benefit of time and that repayment of the entire loan in a lump sum will be demanded.

Where contractual relationships are succeeded to in a scheme such as a business transfer, Article 539-2 of the Civil Code applies. Article 539-2 of the Civil Code provides: "If one of the parties to a contract agrees with a third party to transfer the contractual position, and the other party to the contract consents to the transfer, the contractual position is transferred to the third party." The consent of the other party to the contract is indispensable for the transfer of a contractual position, and contracts for which the other party's consent cannot be obtained are excluded from the scope of succession.

To verify this continuity, legal DD closely examines the originals or copies of business permits and licenses and documents relating to past administrative investigations, guidance and dispositions. Sales contracts, service agreements, business alliance agreements, lease agreements with major business partners and loan agreements with financial institutions are reviewed, and the wording of change of control clauses, anti-assignment clauses and termination events is checked individually.

Labor-Related and Other Off-Balance-Sheet Liabilities

Contingent liabilities and unrecognized liabilities that are not recorded in the financial statements (off-balance-sheet liabilities) create a risk of imposing unexpected economic burdens on the buyer after the acquisition. One of the off-balance-sheet liabilities frequently found in legal DD is labor-related liabilities for unpaid wages, in particular unpaid overtime pay.

Article 37, Paragraph 1 of the Labor Standards Act sets out the employer's obligations where it extends working hours or has employees work on days off. The employer must pay premium wages for work during those hours or on those days, calculated at a rate equal to or higher than the prescribed premium rate. If there are legal deficiencies in the target company's fixed overtime pay system or in its treatment of managers and supervisors, there is room for a finding that premium wages commensurate with working hours have not been properly paid.

Regarding the period for claiming unpaid wages, Article 115 of the Labor Standards Act provides that the extinctive prescription period for wage claims is "five years from the time when they become exercisable." Under Article 143, Paragraph 3 of the same Act, for the time being, claims for wages other than retirement allowances are subject to a 3-year period (claims for retirement allowances are subject to a 5-year period). Under this provision, claims for unpaid premium wages covering the past 3 years accumulate as potential liabilities. If the target company has a large number of employees, the amount payable going back over the prescription period (3 years for the time being) can be substantial.

Off-balance-sheet liabilities other than labor-related ones include pending litigation, serious customer complaints, contingent liabilities and guarantees of obligations for third parties. If the target company has provided a joint and several guarantee for another company's borrowings, it bears the risk of suddenly being required to pay if the principal obligor's financial condition deteriorates.

To investigate these matters, legal DD obtains the work rules, wage rules, notices of working conditions and filed Article 36 agreements. Objective attendance records such as time cards and PC logs are compared against the wage ledger for verification. Complaints and hearing records relating to litigation, customer complaint reports, and documents relating to contingent liabilities and guarantees of third-party obligations are carefully checked.

Where Legal Risks Lie in Peripheral Investigation Items

In addition to the core issues, the ownership of intellectual property and IT-related rights, the handling of personal information, and past and present disputes are also subject to investigation in legal DD. These may not immediately determine whether the transaction succeeds, but they are peripheral issues that cannot be taken lightly because they affect the competitiveness and public trust of the business.

Ownership of Intellectual Property and IT-Related Rights

For companies whose core business is internally developed software or services, the question is whether the intellectual property rights reliably belong to the company. Where system development has been outsourced to external contractors or sole proprietors, it is checked whether the development outsourcing agreement clearly states to whom the copyrights and the right to obtain patents belong. If no rights transfer clause has been clearly provided for with the contractor, there is a risk that the intellectual property rights in the system remain with the contractor.

The terms of use for the services the company provides also need to be reviewed. It is examined whether amendment procedures have been properly carried out, whether clauses unfavorable to users are legally valid, and whether the company has secured the authority to use the data it has acquired. This is confirmed by reviewing intellectual property registration certificates and application documents, system development outsourcing agreements, and personal information and data usage terms.

Disclosure of Data under the Act on the Protection of Personal Information

In the course of an M&A investigation, when personal data held by the target company is disclosed to the buyer, the rules under the APPI must be complied with.

Article 27, Paragraph 1 of the APPI restricts the provision of personal data to third parties by business operators handling personal information. Except in cases such as where the provision is based on laws and regulations, personal data must not be provided to a third party without obtaining the principal's consent in advance. However, Article 27, Paragraph 5, Item 2 of the same Act provides that, "where personal data is provided in connection with the succession of a business due to a merger or other reasons," the person receiving the data does not fall under a third party.

The Personal Information Protection Commission's "Guidelines for the Act on the Protection of Personal Information (General Rules)", section 3-6-3, also refers to the negotiation stage before a contract is concluded. It states that a case where a company, in response to an investigation by the other party, provides its own personal data to the other company also falls under this provision. In that case, the providing company must enter into a contract necessary to have the other company comply with security control measures. That contract is required to set out matters such as the purpose of use, the method of handling, the measures to be taken if a leak or similar incident occurs, and the measures to be taken if the negotiations fail.

Accordingly, the confidentiality agreement entered into before legal DD begins needs to set out the purpose of use and security control measures required by these guidelines. When the target company's customer information or employee information is disclosed in the data room, appropriate information management measures, such as masking names and contact details, are taken.

Pending Disputes and Handling of Complaints

Pending litigation, mediation and other proceedings to which the target company is a party not only impose a financial burden if the case is lost but also lead to a decline in the public trust of the business. Even for complaints that have not reached the stage of litigation, the possibility that they will develop into serious disputes in the future and the room for liability for damages to arise are examined. Through litigation documents, notices from counterparties, internal complaint records and the like, the actual state of the disputes and the expected losses are ascertained.

Differences in Legal Effects and Procedures Depending on the Transaction Scheme

When issues are found in legal DD, there may be discussions about cutting off the risks by changing the acquisition scheme. However, changing the scheme from a share transfer to a business transfer or a company split does not necessarily resolve issues relating to permits and licenses or contracts immediately. Because the statutory requirements and the rules for succession to rights and obligations differ for each scheme, it is necessary to understand the differences between the methods.

A share transfer is a method of purchasing shares from the shareholders of the target company. Only control of the company itself is transferred, and the target company's legal personality, assets, liabilities, contractual relationships, and permits and licenses remain as they are. While the procedure is relatively simple, the buyer also comprehensively takes over the risks of potential off-balance-sheet liabilities and past violations of law held by the target company. Procedures such as the delivery of share certificates in a company issuing share certificates and approval of transfers of shares with restrictions on transfer are strictly required.

A business transfer is a method of purchasing all or part of the business conducted by the target company through an individual sale and purchase agreement. Because the buyer can select the business assets and contractual relationships it wishes to take over, it can, in principle, avoid taking over unnecessary liabilities and off-balance-sheet liabilities. However, under Article 467, Paragraph 1 of the Companies Act, certain business transfers require approval of the agreement by a resolution of a shareholders' meeting by the day before the effective date. This covers transfers such as a transfer of the entire business. A transfer of an important part of the business (excluding a transfer in which the book value of the assets transferred does not exceed one-fifth of the total assets (or, if a lower proportion is provided for in the articles of incorporation, that proportion)) also falls within its scope. This shareholders' meeting resolution is a special resolution under Article 309, Paragraph 2, Item 11 of the Companies Act.

In addition, for the transfer of contractual positions, individual consent must be obtained from the other party to each contract in accordance with Article 539-2 of the Civil Code. Contractual relationships for which consent cannot be obtained cannot be succeeded to, and contracts with major business partners may come to an end. Permits and licenses are also not automatically taken over through a business transfer; a new acquisition or the succession procedure provided for in the industry-specific law is required.

A company split is a reorganization method in which a stock company causes another company to succeed, after the split, to all or part of the rights and obligations it holds in connection with its business. Article 759, Paragraph 1 of the Companies Act provides: "A stock company succeeding in an absorption-type company split succeeds to the rights and obligations of the splitting company in the absorption-type company split on the effective date, in accordance with the provisions of the absorption-type company split agreement." Because a company split is a method of universal succession, it is understood that, in principle, consent from individual contract counterparties is not required. However, the treatment of permits and licenses and the effect of contract clauses need to be examined separately. Please confirm whether succession is possible and what procedures apply for each candidate scheme.

Investigation Procedures, Timeline and Costs

To complete legal DD smoothly, it is necessary to understand the standard investigation procedure and to clarify the role that the buyer and the target company should each play at each stage. In addition, the time and cost of the investigation depend on the size of the target company and the design of the investigation scope.

The standard process for legal DD begins with entering into a confidentiality agreement. The buyer and the target company enter into a confidentiality agreement that sets out information management clauses compliant with the guidelines under the APPI. Next, the buyer's legal staff or attorneys send a disclosure document list (document request list) to the target company. Demanding the submission of all documents without limit from the initial stage places an excessive burden on the target company's front-line staff and causes delays in the disclosure of important documents. After understanding in advance publicly available information, such as the commercial register and website, and the outline of the business, a disclosure request list with priorities set for each transaction is designed.

The target company then uploads documents to an online virtual data room or similar platform, and the buyer begins reviewing and examining them. Where documents are not disclosed, it is confirmed whether "no relevant facts exist" or whether "the facts exist but no documents have been prepared or retained." It is important to make clear in the report the scope that remains unverified. In parallel with the document review, a question-and-answer (Q&A) sheet summarizing questions and additional items to be confirmed is sent to the target company, and written answers are requested.

Once confirmation in writing has progressed, interviews are conducted with the target company's management and with staff in charge of legal affairs, general affairs, labor matters and the like. Actual business flows, organizational culture and the background of potential disputes, which are difficult to grasp from documents alone, are confirmed directly. In transactions where documents are disclosed in stages, verification proceeds as documents are disclosed. If a serious concern that could affect the transaction decision is found, it is shared with the client early through an interim report. Finally, a report covering the investigation results and the legal assessment is compiled, and the work moves on to reflecting the findings in the SPA (definitive agreement).

In addition to the transaction amount, the scope of the investigation and the volume of work affect the timeline and cost of legal DD. Specifically, the actual work hours vary depending on the number of group companies subject to the investigation, the geographic spread of business locations, the total volume of disclosed documents, and the number of past years covered by the investigation. The timeline and cost also vary depending on whether the scope of the investigation is a focused review limited to key issues or an investigation of the entire organization.

When requesting an estimate, please provide an outline of the target company's business, the transaction scheme being considered, and your desired schedule. If this information is shared, it becomes easier to compare whether to conduct a focused review limited to key issues or an investigation of the entire organization. There is also an article that organizes published fee examples and points to check in estimates. For details, please see M&A Attorney Fees: Fees for Legal DD, SPAs and Closing.

The main purpose of legal DD conducted by the buyer is to identify the potential risks assumed through the acquisition and to reflect them in the investment decision and the protective clauses of the SPA. There are also matters that a buyer should focus on when acquiring a startup. The points of focus are discussed in detail in Buy-Side Legal DD Checklist.

On the other hand, there are also cases where sellers conduct sell-side DD (vendor DD) to identify their own issues and deficiencies in documents before being pointed out by buyers. Preparation on the seller's side is explained in Legal DD to Prepare Before Becoming a Seller. By organizing the shareholder register, issuance resolutions and major contracts in advance, the seller can understand the issues the buyer is likely to point out and consider in advance how to respond in terms of the sale conditions. Maintaining a contract register in ordinary times and keeping records of how decisions were reached, which speeds up the initial response to an acquisition review, are also useful. The procedure is also explained in detail in Steps for a Target Company to Prepare in Advance for Legal DD.

Reflecting Findings in Transaction Terms and Designing Contract Clauses

The outcome of legal DD is not simply receiving a report summarizing the risks. It is important to translate the legal risks discovered into specific clauses of the definitive agreement (SPA) appropriately and to secure the buyer's business value and legal position. If legal DD and contract drafting proceed separately, the risks identified through the investigation may not be reflected in the contract clauses.

Findings in legal DD are allocated, according to their severity, to abandoning the transaction or redesigning the scheme, to corrective matters to be addressed before closing (conditions precedent), or to reflection in the price. If a legal issue discovered makes the continuation of the business fundamentally impossible, the buyer considers abandoning the acquisition itself or switching to another scheme such as a business transfer. For curable defects, the seller's resolution of the defect by the execution date is made a condition precedent (CP) to the buyer's obligation to pay the purchase price. Where the amount of a future monetary loss is fixed or can be reasonably calculated, it is either deducted directly from the original transfer consideration or deducted from the consideration through a price adjustment clause.

Future risks and post-acquisition actions are allocated to representations and warranties, special indemnities, and post-closing covenants. The seller is made to represent and warrant the absence of certain legal facts and compliance with laws and regulations, and is made liable for damages in the event of a breach. For losses arising from specific known matters, a special indemnity clause (specific indemnity clause) is provided, under which the seller indemnifies separately from indemnification for breach of representations and warranties. In many cases, the claim period and the cap are also set separately from those for representations and warranties. Furthermore, obligations for the target company to establish a certain compliance system or to continue certain procedures after the acquisition is completed are set as covenants.

The practical responses are made concrete by applying this allocation to specific examples of the three core issues.

If deficiencies are found in the ownership of the shares and the transfer procedures, they are addressed as corrective matters before closing if the defect is curable. The fact that share certificates were not issued in a company issuing share certificates, or that a resolution approving a transfer (by the shareholders' meeting or the board of directors) is missing, is dealt with individually. The valid issuance and delivery of share certificates by the closing date is made a condition precedent. Obtaining a lawful resolution approving the transfer (by the shareholders' meeting or the board of directors) and updating the shareholder register are also set as conditions precedent to the buyer's performance of its obligations. This allows payment of the purchase price to be withheld until the transfer of rights to the shares has been fully confirmed. If the ownership of the shares cannot be lawfully cured because past capital increase procedures are invalid or there are material gaps in the shareholder register, abandoning the transaction or redesigning the scheme is chosen.

If major contracts contain a change of control clause, steps are taken to prevent termination of the contracts as a result of the acquisition. Obtaining prior consent regarding the change of control from the relevant business partners by the closing date is set as an obligation of the seller and as a condition precedent to closing for the buyer. It is necessary to include a clause reserving to the buyer a right to terminate if the counterparty's consent cannot be obtained. If it is agreed that consent will be obtained after closing, an obligation to use efforts to obtain consent is imposed as a covenant. The risk is allocated by providing a special indemnity clause under which the seller bears the damages if consent cannot be obtained and the contract is terminated.

If labor liabilities such as unpaid overtime pay for the past 3 years are found, they are addressed in light of the prescription period under Article 143, Paragraph 3 of the Labor Standards Act. If the unpaid amount can be specifically calculated, the estimated amount is either deducted directly from the purchase price or reflected in a price adjustment clause. On the other hand, if there is a dispute over matters such as whether employees qualify as managers and supervisors and the amount of loss cannot be fixed in advance, the seller is made to represent and warrant compliance with labor laws. A special indemnity clause is set under which the seller indemnifies when employees make claims in the future and a payment obligation actually arises. Furthermore, overhauling the target company's labor management system after the acquisition is completed is set as a post-closing covenant.

It is also necessary to check the overall basic design of the SPA and how its clauses interact. This is explained in detail in Indemnification, Price Adjustment and Closing in an SPA (Share Purchase Agreement). The overall picture of reflecting findings in contract clauses is discussed in The Structure and Key Provisions of an SPA (Share Purchase Agreement).

Frequently asked questions

What is legal due diligence?

It is a procedure in which, in M&A, the buyer investigates the legal issues and risks hidden in the target company or target business. Specialists closely examine whether the target company complies with laws and contracts and whether there are defects in its rights and obligations, and the procedure is carried out so that the results can be reflected in whether to proceed with the acquisition, the purchase price, and the clauses of the definitive agreement.

Which investigation items are given particular weight in legal DD?

The core issues that determine whether the acquisition can proceed and on what terms are three: the ownership of the shares and the transfer procedures, business continuity including permits and licenses and change of control clauses, and labor-related and other off-balance-sheet liabilities, starting with unpaid overtime pay. Their legality and whether rights can be transferred are examined with particular focus.

What determines the timeline and cost of legal DD?

They vary depending on the number of group companies subject to the investigation, the geographic spread of business locations, the total volume of disclosed documents, and the number of past years covered by the investigation. The timeline and cost also depend on the design of the investigation scope, namely whether it is a focused review limited to key issues or an investigation of the entire organization.

What should be done if legal risks are found in legal DD?

They are reflected in the definitive agreement according to the nature of the risk. For material issues, abandoning the transaction or redesigning the scheme is considered, and curable defects are made conditions precedent to closing. Losses that can be fixed are deducted from the price, and representations and warranties and special indemnity clauses are set for uncertain future damages.