What Are Key Person Clauses and Retention? Closing Conditions and Measures to Keep People

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

In M&A negotiations, a buyer will sometimes say, "We want a key person clause covering the target company's CTO." Behind such a request, it is worth checking whether there is a misunderstanding that simply putting a key person clause into the contract will ensure the CTO stays with the company after the acquisition.

A key person clause as a closing condition is just one way of using a key person clause. It is a provision that, where the continued appointment or employment of a specific officer or employee is essential to running the target company's business, makes that a condition precedent to the buyer's performance of its obligations. Conditions precedent are a mechanism for the seller and buyer to decide whether to carry out the transaction; they have no direct effect in preventing the resignation or departure of the individual, who is not a party to the contract. To have the key person remain with the company after the acquisition, a separate retention design must be put in place through compensation, authority, contract terms and the like.

A key person clause as a condition precedent and retention through post-acquisition treatment and authority are separate frameworks with different purposes and means. The former is a means of allocating risk between the parties in deciding whether to carry out the transaction; the latter is a set of measures that works on the individual's own free will after the acquisition. It is important to distinguish in advance between what can be bound by contract and what is a matter of allocating risk between the parties.

Separating Deal Terms from People Measures

When a key person clause is made a condition precedent to closing, what it addresses is the existence of objective facts, such as "the employment or appointment of a specific officer or employee continuing until the closing date" or "a contract relating to the person's post-closing appointment having been executed." If the condition precedent is not satisfied, whether to refuse to carry out the transaction or to waive the condition and proceed is determined in light of whose benefit the condition is for and the waiver and termination provisions in the contract. Whether the seller breached a best-efforts obligation it promised and whether the condition was in fact satisfied should also be considered separately. In either case, the clause functions only in deciding whether to carry out the transaction; it does not bind the key person's own decision whether to leave the company.

Post-acquisition retention, by contrast, is an effort to reach agreement with the key person. Changes in compensation or position, grants of shares or stock options, and revisions of contract terms are basically carried out on the basis of individual agreement with the person. That said, there are also cases based on frameworks other than individual agreement, such as lawful assignments under the employer's personnel authority, or changes to working conditions through a reasonable amendment of the work rules meeting the requirements of Articles 9 and 10 of the Labor Contracts Act, as against Article 8 of that Act, under which changes are in principle made by agreement. No matter how detailed the key person clause in the share purchase agreement (SPA) between the seller and buyer, it cannot bypass agreement with the individual concerned or the required legal procedures. From the start of M&A negotiations, the design of closing conditions and post-acquisition retention measures must proceed in parallel as separate workstreams.

Identifying Key Persons and Designing Conditions Precedent

Identifying key persons requires more than just listing names. It is the work of confirming who is single-handedly carrying which tasks needed to continue the business. Sales staff who hold the relationship of trust with particular customers, engineers who understand the design philosophy of core systems, managers who are the named holders of licenses or the contact for government authorities, the representative who handles financing, and the manager who oversees internal labor management are examples of key persons from the perspective of business continuity. In due diligence, look not only at job titles on the organization chart but also at the contacts named in contracts and the names on licenses. Also check how technical materials are stored and the communications with customers, and identify where operations would stall if a particular person left.

There are several types of closing condition design: a type that conditions closing on a specific individual remaining in office or employment until the closing date, a type that conditions it on the execution of a post-closing contract, a type that conditions it on there being no prospect of resignation or departure, and a type that conditions it not on particular individuals but on the continued employment of a certain percentage of employees. For companies where personal relationships account for most of the enterprise value, or where professionals are highly mobile, a method based on the percentage of employees remaining can also be considered. When using the continued tenure of specific officers or the percentage of employees remaining as the standard, clearly state in the contract the scope of persons covered, the reference date, and who determines expected departures and by what standard.

Placing a key person clause also carries its own risk: the designated officer or employee may use their own departure as a bargaining chip and affect whether the deal succeeds. Wary of facing unreasonable demands such as pay increases, sellers sometimes deliberately refuse to include a key person clause. Moreover, a seller cannot forcibly stop an employee from leaving voluntarily. When the percentage of employees remaining is made a condition, turning turnover risk that the seller cannot control directly into a condition precedent places too heavy a burden on the seller. For this reason, balance is struck through designs that limit obtaining the necessary consents to a best-efforts obligation of the seller, or that include an exception clause deeming the condition satisfied if, even when the percentage falls below a certain level, equivalent personnel are hired and the business is not impaired.

Post-Acquisition Retention Measures

Even after the conditions precedent are satisfied and the transaction is completed, whether the key person continues to stay with the company is a separate issue. Post-acquisition measures to keep people include revising base salary and bonuses, retention bonuses based on length of service, grants of shares or share options, guarantees of authority, and switching to a service agreement for a fixed period.

Measures that involve re-contracting individually are founded on agreement with the person and must also take into account corporate decision requirements under the Companies Act and the rules on changing working conditions. Explaining to the individual the terms decided between the parties to the SPA and obtaining the necessary agreement is what makes the measures effective. Also note that even if the arrangement is formally called a service agreement, the person does not lose their rights as a worker if there is in fact a relationship of direction and control or a degree of restraint. In addition, when including a clawback clause requiring repayment of a retention bonus, excessive restraint that circumvents the purpose of Article 16 of the Labor Standards Act, which prohibits penalties and liquidated damages, may be invalid. That said, whether the conditions of a bonus are permissible is determined case by case based on its substantive purpose and the reasonableness of the amount.

Design retention measures with an eye not only on treatment immediately after the deal but on terms several years ahead, so that they continue to function through the post-deal integration work. As discussed in Indemnity, Price Adjustment and Closing in an SPA (Share Purchase Agreement), conditions precedent, covenants and indemnity are linked within the overall framework of the contract, and the key person clause is also positioned within that interconnection.

Legal Limits on Resignation, Removal and Non-Competition

The rules on resignation and removal differ greatly depending on the legal status of the person regarded as a key person.

A worker under an employment contract without a fixed term may give notice of termination at any time, and employment ends when two weeks have passed after the notice (Article 627, paragraph 1 of the Civil Code; fixed-term employment is subject to separate rules, such as Article 628 of the Civil Code). Dismissal by the company, on the other hand, is invalid as an abuse of rights if it lacks objectively reasonable grounds and is not considered appropriate in light of social norms (Article 16 of the Labor Contracts Act). While the worker's freedom to resign is strongly protected, the company faces strict restrictions on unilaterally ending the relationship. Even if the company asks the person to sign an employment contract, it is not permitted to force labor against the person's will by means of unjust restraint (Article 5 of the Labor Standards Act), and in light of the purpose of the freedom to choose one's occupation (Article 22, paragraph 1 of the Constitution), the freedom to resign itself cannot be taken away by contract.

The relationship between a director and the company is governed by the provisions on mandate (Article 330 of the Companies Act), so under the principles of mandate a director may resign at any time (Article 651, paragraph 1 of the Civil Code). However, liability for damages may arise, for example, for resigning at a time unfavorable to the company (paragraph 2 of the same Article), and when the number of officers required by the articles of incorporation or by law is not met, the rights and obligations of an officer may remain until a new officer takes office (Article 346 of the Companies Act). The company, for its part, may remove a director at any time by resolution of the shareholders' meeting (Article 339, paragraph 1 of the Companies Act), but for a removal without justifiable grounds, the removed director may claim damages (paragraph 2 of the same Article). The procedural details are explained in When Does a Director's Term Expire?.

The obligations the seller owes under the SPA are considered in accordance with the contract. When the seller is also an officer or employee, each capacity is analyzed separately. In the event of a breach of covenants or a non-compete clause, not only damages and indemnity but also an injunction based on a valid agreement may be granted. Nor can a post-employment non-compete obligation be uniformly classified as valid or invalid; it is determined by comprehensively considering the company's legitimate interests to be protected, the person's position, the duration, the geographic area, the breadth of the covered business, whether there is compensation, and other factors. The details of these factors are covered in A Non-Compete Clause Is Not Better Simply Because It Is Drafted Broadly.

Handover Arrangements That Reduce Dependence on Key Persons

No matter how carefully closing conditions and retention measures are prepared, an operating structure that relies entirely on particular individuals will not change by itself. Since these are means of preparing for the risk that the person ultimately leaves, handovers that reduce dependence on particular individuals need to be advanced in advance.

The following are matters to confirm before PMI (post-merger integration) gets fully underway:

• Arrangements for handing over contract contacts, deal histories and relationships with major customers
• The location of source code, design documents and technical specifications, and the distribution of access rights
• The status of license holders, filed matters and contacts for government authorities
• The distribution of administrator privileges for various systems and cloud services
• The extent to which work procedures have been documented and manuals prepared
• The status of selecting successor candidates and development plans

Advance these preparations in parallel with retention measures from the pre-closing stage. If you try to tackle them all at once after the transaction is completed, you may not be in time before the person leaves. A design that relies on only one of conditions precedent or retention measures will leave the company facing the difficulty of continuing the business when the person departs. Our SPA services, including conditions precedent and retention provisions, are described on M&A Support.

Frequently asked questions

Can a key person clause prevent a key person from leaving?

No. A key person clause is a mechanism that makes the continued appointment or employment of officers and employees of the target company a condition precedent to closing, and it allocates the risk of departure between the parties. It has the effect that the buyer may refuse to close if the condition precedent is not satisfied, but it has no power to stop the person's resignation or departure itself. To have the person stay after the acquisition, retention measures such as compensation and position must be designed separately through agreement with the person.

How does the legal treatment of removing a director differ from that of an employee?

An employee under an employment contract without a fixed term may give notice of resignation at any time under Article 627, Paragraph 1 of the Civil Code, whereas dismissal by the company is strictly restricted by the doctrine of abuse of the right to dismiss under Article 16 of the Labor Contracts Act. A director is subject to the provisions on mandate under Article 330 of the Companies Act and may therefore resign at any time under Article 651, Paragraph 1 of the Civil Code. The company may also remove a director at any time under Article 339, Paragraph 1 of the Companies Act, but removal without justifiable grounds carries the risk of a claim for damages under Paragraph 2 of the same Article.

Can a post-employment non-compete obligation prevent a key person from being poached or going independent?

It cannot necessarily prevent this in all cases. The validity of a post-employment non-compete obligation is judged individually in light of factors such as the company interests to be protected, the person's position, the duration, geographic limits, the scope of prohibited activities and compensatory measures. A broadly drafted clause is not necessarily a strong one; it needs to be designed according to the person's position and the interests to be protected.