Legal Effectiveness of the Letter of Intent in M&A Agreements

The type of contract related to M&A transactions varies depending on the negotiation stage between the buyer and the seller.

In this article, we will explain the basic agreement that is often concluded at the negotiation stage by companies considering M&A transactions, both as buyers and sellers.

What is a Basic Agreement?

A Basic Agreement is also known as a Memorandum, Letter of Intent (LOI), or Memorandum of Understanding (MOU).

The types of M&A transactions and the necessary contracts vary from case to case, and consequently, the content stipulated in the Basic Agreement also changes. Broadly speaking, there are methods such as share acquisition, business transfer, and organizational restructuring. Share acquisition includes methods such as share transfer through bilateral transactions, share transfer through public tender offer, and third-party allotment. Organizational restructuring includes methods such as mergers, share exchanges, share transfers, and company splits. In addition, there are methods that combine company splits and share transfers, and methods that combine public tender offers and share exchanges.

As such, M&A transactions are quite diverse, and the content of the Basic Agreement, which serves as a bridge to the final contract, also changes according to the scheme.

The significance of the Basic Agreement lies in encouraging the contracting parties to negotiate towards the conclusion of the final contract, forming agreement on important points of discussion, clarifying the content of the transaction, and granting exclusive negotiation rights, among other things.

Generally, it is created on the premise of content changes because it stipulates matters that have been tentatively agreed upon at the stage where due diligence (referred to mainly as “DD” in this article) of the target company has not been conducted. Therefore, it is common for various clauses not to have legal binding force, except for some clauses.

Provisions of the Basic Agreement

The main provisions of the basic agreement generally include the content of the transaction, exclusive negotiation rights, representations and warranties, and cooperation with due diligence. We will explain each clause based on the assumption of a basic agreement for a share transfer contract in the final contract.

Transaction Details

Article 1 (Contract Conditions)
1. Party A and Party B have agreed to negotiate in good faith to conclude a share transfer agreement (hereinafter referred to as the “Final Agreement”) in which Party A transfers all of the issued shares (hereinafter referred to as the “Subject Shares”) of the target company (Party C) that Party A owns to Party B, and Party B accepts this transfer from Party A.
2. The total transfer price of the Subject Shares is set at XX yen. However, the official total transfer price of the Subject Shares will be determined at the time of the Final Agreement.

This clause defines the details of the transaction, such as the subject of the transaction, the scheme content (methods of M&A such as share transfers, mergers, company splits, etc.), and the transaction price.

The content stipulated in the basic agreement may vary depending on the stage of negotiation, and it may be based on the premise of content changes due to negotiations after conclusion, or it may be stipulated in content close to the final agreement.

Especially for the purchase price, it is often stipulated without agreeing in a legally binding form, and for the final purchase price, it is often stipulated that the official price will be determined at the time of the final agreement, or that it can be revised in certain cases (for example, if new significant circumstances that affect the purchase price are discovered after the DD is implemented).

Validity Period

Article 2 (Validity Period)
The validity period of this agreement shall be from the date of this agreement until the 〇th day of the 〇th month of the Reiwa 〇th year (Gregorian calendar year: 〇〇〇〇). However, if the parties agree in writing to extend the validity period of this agreement, it shall be in accordance with that agreement.

This sets the period during which the basic agreement is recognized as effective. Generally, it is often set for about 3 to 6 months.

Exclusive Negotiation Rights

Article 3 (Exclusive Negotiation Rights)
1 From today until ● year ● month ● day, Party A guarantees that it will not conduct any negotiations, agreements, or contracts with third parties other than Party B regarding transactions similar to this transaction.
2 Notwithstanding the provisions of the preceding paragraph, if Party A receives a proposal from a third party regarding a transaction similar to this transaction, and it is reasonably judged that not responding to the proposal would likely violate the duty of care of Party A’s directors, Party A can negotiate with the third party by paying a penalty of 〇〇 million yen to Party B.

In a basic agreement, the selling company may grant exclusive negotiation rights to the prospective buying company. Conversely, it is possible for the buyer to stipulate this, or to provide information to other prospective buying companies. The content stipulated varies depending on the power relationship between the two parties.

From the buyer’s perspective, due diligence (DD), management interviews, etc. that follow will be conducted intensively for a certain period of time, so it will take a considerable amount of time and money to scrutinize the selling company. To minimize the risk of the seller moving on to negotiations with other prospective buyers, the buyer often demands exclusive negotiation rights that are advantageous to them.

On the other hand, from the seller’s perspective, they often hope to negotiate with the prospective buying company that offers the most favorable terms, and are cautious about granting exclusive negotiation rights. Therefore, even if exclusive negotiation rights are stipulated in the basic agreement, a period of about 3 to 6 months may be granted at the request of the seller.

Furthermore, as a clause advantageous to the seller, an exception to the exclusive negotiation rights may be stipulated in order to seek a selling opportunity to a more optimal prospective buyer. This is to ensure the opportunity for the seller to select the best selling destination and to avoid a breach of the duty of care by the seller’s directors. Such a clause is also called a fiduciary out clause.

From the buyer’s perspective, if the exception clause is applied easily, the time and money spent on DD and other activities may be wasted. Therefore, in preparation for the seller applying the exception, it may be stipulated that the seller has an obligation to pay a certain amount of money (penalty) to the buyer when applying the exception clause.

Representations and Warranties

Article 4 (Representations and Warranties)
The Party A represents and warrants to the Party B that, as of the date of this Agreement, the following statements are true and accurate:
(1) Representations and Warranties concerning the Seller (Party A)
A. Party A is a corporation duly organized and validly existing under the laws of Japan.
B. Party A is not insolvent, no bankruptcy proceedings have been initiated against Party A, and there is no cause for such proceedings.
C. Party A legally and validly holds all the shares in question.
D. Party A is not involved with antisocial forces. There are no transactions, payments, benefits, or any other relationships or interactions, either directly or indirectly, between Party A and antisocial forces. There are no officers or employees belonging to antisocial forces in Party A.
(2) Representations and Warranties concerning the Target Company (Party C)
A. Party C is a corporation duly organized and validly existing under the laws of Japan.
B. Party C is not insolvent, no bankruptcy proceedings have been initiated against Party C, and there is no cause for such proceedings.
C. The total number of shares that Party C can issue is X shares, and the total number of issued shares is X shares. All of these shares are common shares that have been legally and validly issued. Party C has not issued or granted any shares or the like other than these shares, and no third party has any rights to them.
D. Party C has fulfilled all its obligations to pay remuneration or wages, money, etc. to its officers or employees, and there are no unpaid remunerations or wages.
E. There are no lawsuits pending against Party C by third parties, and there is no risk of such lawsuits.
F. Party C is not involved with antisocial forces. There are no transactions, payments, benefits, or any other relationships or interactions, either directly or indirectly, between Party C and antisocial forces. There are no officers or employees belonging to antisocial forces in Party C.

This refers to the clause where one party represents and warrants to the other party that certain matters are true and accurate at a certain point in time.

Representations and warranties are often more detailed at the final contract stage of a share transfer agreement, etc., based on due diligence (DD). In addition to the above items, they cover a wide range of content, including intellectual property rights, financial documents, real estate, movable property, intellectual property rights, assets, claims, concluded contracts, personnel and labor, public rents and taxes, pensions, insurance, etc. Although they may not be described at the time of concluding the basic agreement, it is common to include them from the stage of concluding the basic agreement, including the clause on cooperation in DD, in order to expect proactive disclosure of information from the other party.

Cooperation in Due Diligence

Article 5 (Due Diligence)
Party B shall be able to conduct an investigation (hereinafter referred to as “Due Diligence”) by Party B and attorneys, certified public accountants, and other similar persons appointed by Party B, for a period of ○ months from the date of conclusion of this basic agreement. Party A and Party C shall cooperate to the extent that it does not interfere with business operations.

This clause defines the scope of Due Diligence and the content of the obligation to cooperate.

Types of Due Diligence include Business DD, Financial DD, and Legal DD, but there may also be HR DD, IT DD, and Environmental DD. Both the seller and the buyer conduct Due Diligence, but it is generally assumed in the basic agreement, as in Article 5 above, that the buyer conducts Due Diligence on the seller.

As a buyer, the goal is to achieve effective and accurate results by investing money and conducting Due Diligence within a limited period, and the cooperation of the seller is essential for this. Therefore, it is common for the seller’s obligation to cooperate in Due Diligence to be stipulated in the basic agreement, as mentioned above.

However, if the seller is proactive in transactions with the buyer, the significance of stipulating such an obligation is low. Also, it is irrational to demand disclosure of information by using the obligation to cooperate in Due Diligence as a shield even when negotiations between the seller and the buyer have broken down. Therefore, the obligation to cooperate in Due Diligence is sometimes considered to have no legal binding force. When the obligation to cooperate in Due Diligence is stipulated in the basic agreement as having legal binding force, the seller will negotiate to limit the scope of that obligation.

Duty of Care in Management

Article 6 (Duty of Care in Management)
1. Party A and Party C shall, until the final contract is concluded, perform their duties and manage their properties with the care of a prudent manager.
2. Party A and Party C shall not engage in the following acts or any other acts that significantly affect the management of Party C. However, this does not apply if there is prior written consent from Party B.
(1) Transfer, disposal, or establishment of lease rights of significant assets
(2) Capital increase or decrease
(3) Changes in the composition of officers
(4) Execution of large new borrowings or other debt-bearing acts
(5) Facility investment exceeding X ten thousand yen
(6) Other acts that cause significant changes in the financial condition and future profit and loss situation

This stipulates that the seller has a high duty of care to prevent the value of the target company from being impaired.

This clause is established to protect the buyer’s position so that the value of the target company is not impaired during the negotiation period.

Legal Binding Force

Article 7 (Legal Binding Force)
This agreement, excluding Article ○, Article ○, and Article ○, shall not have legal binding force.

This clause is to clearly identify the provisions of the basic agreement that have legal binding force.

Since the basic agreement is a provisional agreement made at the stage before due diligence (DD) is conducted leading up to the final contract, it is usually considered to not have legal binding force. However, there are some clauses where it is desirable to have legal binding force. Depending on the specific case, it is important in future negotiations to define the scope to which legal binding force applies between the parties.

Confidentiality

In addition to the items we have discussed so far, there may be provisions regarding confidentiality. These are often established if a confidentiality agreement has not been signed prior to the conclusion of the basic agreement.

Regarding the confidentiality clause, it is possible to sign a confidentiality agreement before concluding the basic agreement, and in such cases, there is less need to include it in the basic agreement. However, even if a confidentiality agreement has already been signed, if you want to keep the fact of the basic agreement’s conclusion confidential, you will need to redefine it in the basic agreement to broaden the scope of confidential information.

For detailed information about confidentiality agreements, please refer to the article below.

https://monolith.law/corporate/checkpoints-nondisclosure-agreement[ja]

Summary

The contracts and transaction types concluded in M&A deals vary depending on the case, and the terms of the basic agreement are also diverse.

Furthermore, more specialized and extensive experience is required to devise expressions depending on the timing of exchanging the basic agreement.

To avoid future troubles, we recommend consulting with a specialist lawyer and carefully drafting the agreement.