In a share purchase agreement, a representation and warranty is a clause in which the seller promises that stated facts about the target company are true and accurate. Japan's Civil Code and Companies Act contain no provision on representations and warranties as such, so what a buyer can claim when one turns out to be untrue depends almost entirely on how the contract is drafted.
If the indemnity clause is vague, disputes arise over whether a claim lies under the Civil Code rules on non-performance or non-conformity. For buyers and sellers alike, setting the cap, threshold, claim period and disclosure schedule clearly is the most direct way to avoid post-closing disputes.
When this becomes an issue
- After the acquisition, unpaid overtime or a tax reassessment at the target comes to light and you want to claim against the seller.
- Your head office wants to use its standard English-language SPA template for a deal governed by Japanese law.
- As seller, you are worried about being asked to indemnify matters you already disclosed in due diligence.
- The buyer knew of a problem from due diligence but claims a breach of warranty after closing.
Representations, covenants and indemnities
A share purchase agreement contains several clauses with related functions. Separating their roles makes the negotiating points easier to see.
| Clause | What it promises | Typical consequence of breach |
|---|---|---|
| Representations and warranties | That facts about the target or the seller are true and accurate as of a given time | Indemnification under the indemnity clause; before closing, the buyer need not close (condition not satisfied) |
| Covenants | That a party will or will not do something between signing and closing, or after closing | Claim for performance, damages, indemnification |
| Indemnification | The scope, duration and maximum amount of compensation for loss caused by breach of a representation or covenant | The clause that decides the "exit" for representations and covenants |
| Specific indemnity | Compensation for a particular issue found in due diligence, separately from the warranties | Lets the buyer recover even for a problem it knew about |
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Try for free →The Japanese law position: the contract decides
No statutory rule, so drafting is everything
Parties may freely determine the content of a contract within the limits of the law (Civil Code, Article 521(2)). Representations, warranties and indemnities are agreements that rest on this freedom of contract.
What counts as a breach, and what must be paid for it, is therefore determined by the wording of the contract rather than by statute. Importing English or US drafting conventions wholesale leaves open how a Japanese court will read that wording under Japanese law.
Without an indemnity clause, what is the basis for a claim?
Where there is no indemnity clause, or it does not cover the point, the buyer must build its claim on the general rules of the Civil Code.
| Basis | Rule | Typical point of dispute |
|---|---|---|
| Damages for non-performance (Article 415) | Where an obligor fails to perform in accordance with the purpose of the obligation, the obligee may claim damages | Whether "the facts are true" is an obligation at all; the seller's defence that the failure is not attributable to it (proviso to Article 415(1)) |
| Liability for non-conformity (Articles 562 to 564) | Where the delivered subject matter does not conform to the contract in kind, quality or quantity: cure, price reduction, damages or cancellation | Whether a problem in the target's business is a non-conformity of the shares sold |
| Rescission for mistake (Article 95) | A declaration may be rescinded where, among other things, the party's understanding of circumstances on which it based the transaction was untrue, it had been indicated that those circumstances formed the basis of the transaction, and the mistake was material | Rescission unwinds the whole contract, which is often unrealistic in M&A |
| Rescission for fraud (Article 96) | A declaration induced by fraud may be rescinded | The party seeking rescission must show that the seller committed fraud |
Important
Scope of loss: differences from English and US templates
Damages for non-performance are, in principle, for the loss that would ordinarily arise (Civil Code, Article 416(1)). Loss arising from special circumstances may be claimed where the parties should have foreseen those circumstances (Article 416(2)).
The common template exclusion of "consequential damages" does not necessarily map onto Japan's distinction between ordinary and special loss under Article 416. In a contract governed by Japanese law, it is safer to list the heads of loss that are covered, such as lost profits, loss suffered by the target company and legal fees.
Parties may also agree in advance on the amount of damages for non-performance (Article 420(1)). A penalty is presumed to be such a liquidated damages amount (Article 420(3)).
Facts the seller knew but did not disclose
In a sale, even where the seller has agreed not to be liable for non-conformity (Civil Code, Article 562(1), main text) and similar warranty liability, it cannot escape that liability for facts it knew of but did not disclose (Article 572).
The statute does not make clear whether this rule reaches a "sole and exclusive remedy" clause or a cap in a share purchase agreement. Even so, where the seller knowingly concealed a problem, the principle behind this rule and rescission for fraud (Article 96) can become points of dispute.
Caution
What the indemnity clause should settle
Main negotiating points
Indemnity negotiations work through the following items. Amounts and periods are negotiated deal by deal; there is no fixed market standard.
| Item | What it decides | Buyer's interest | Seller's interest |
|---|---|---|---|
| Cap | Maximum total indemnity | Higher, or certain warranties carved out of the cap | Lower, a portion of the price |
| Basket / de minimis | No claim until a threshold is exceeded; small claims not counted | Lower | Higher |
| Survival (claim period) | How long after closing claims may be made | Longer, especially for tax and employment | Shorter |
| Knowledge qualifier | Whether limited to "to the seller's knowledge", and whose knowledge | No qualifier, or a broad group | Qualified |
| Materiality qualifier | Whether limited to "in all material respects" | No qualifier | Qualified |
| Disclosure schedule | Matters disclosed as exceptions to the warranties | Specific; avoid catch-all wording | Broad, including general disclosure |
| Buyer's knowledge (sandbagging) | Whether the buyer may claim for a breach it knew of | Expressly yes | Expressly no |
Key point
Claim periods and limitation
If the contract sets no claim period, a claim is extinguished by prescription if not exercised within five years from when the creditor knew it could exercise the right, or ten years from when it could be exercised (Civil Code, Article 166(1)).
For non-conformity in kind or quality in a sale, the buyer loses its remedies unless it notifies the seller within one year of learning of the non-conformity (Article 566, main text). This does not apply where the seller knew of the non-conformity at delivery or was unaware of it through gross negligence (proviso). Setting the claim period and the notice procedure in the indemnity clause reduces argument over which rule applies.
How representations and warranties play out, from signing to after closing
- 1
Due diligence
Review finance, tax, employment, contracts, licences and litigation to identify issues
- 2
Negotiate the scope
Agree what the seller represents, any knowledge or materiality qualifiers, and the reference times (signing and closing)
- 3
Prepare the disclosure schedule
The seller sets out specific exceptions to the warranties
- 4
Confirm at closing
Check, through conditions precedent or a closing certificate, that the warranties remain true and accurate at closing
- 5
Notify any breach
Follow the notice procedure and deadline in the indemnity clause, stating the basis and estimated amount in writing
Cross-border deals: governing law
The formation and effect of a juridical act are governed by the law chosen by the parties at the time of the act (Act on General Rules for Application of Laws, Article 7). Absent a choice, they are governed by the law of the place with which the act is most closely connected (Article 8(1)). The parties may later change the governing law, although a change that would harm a third party's rights cannot be asserted against that third party (Article 9).
An overseas buyer acquiring a Japanese company may agree to Japanese governing law. In that case the English-language warranties and indemnities are then interpreted under Japanese law. Where both English and Japanese versions are prepared, decide which prevails.
A foreign investor acquiring shares in a Japanese company may also need to file a prior notification or post-transaction report under the Foreign Exchange and Foreign Trade Act (see our column on inward direct investment).
What you can do now
- Check whether your SPA template sets out the consequences of a breach of warranty in the indemnity clause.
- Check how the definition of indemnifiable "loss" relates to ordinary and special loss under Article 416 of the Civil Code.
- Confirm that the cap, threshold, claim period and notice procedure are stated in figures and steps.
- List the issues found in due diligence and decide whether each will be handled by a specific indemnity or a price adjustment.
- As seller, prepare to describe known issues specifically in the disclosure schedule.
- Decide the governing law and which language version prevails.
When to consult a lawyer
- Before signing a letter of intent. The direction on warranty scope and the cap may be set at this stage.
- When an English-language SPA draft arrives from an overseas counterparty.
- When due diligence uncovers a significant issue and you need to negotiate a price adjustment or specific indemnity.
- When unpaid liabilities or regulatory action at the target come to light after closing. The notice deadline in the indemnity clause may be approaching.
For choosing a deal structure, see "Acquiring a Japanese Company: Share Purchase or Business Transfer". For how to enter Japan and the governing law of local contracts, see "Entering Japan as a Foreign Company".
We advise on contract negotiation and due diligence for acquisitions and sales of Japanese companies, in English and Japanese. See "M&A and Corporate" and "International & Cross-Border".
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