Avoiding Japan’s legal traps − Common mistakes in a (mostly) civil country


Those who live here know Japan to be a civil country. Yet foreigners conducting business with Japanese firms can still find themselves in costly legal disputes. Beacon Reports highlights some common mistakes made by those who fail to understand Japan’s legal system and how to avoid them.

Japan operates predominately under civil law. The UK and US however, follow common law. (Read The Economist magazine’s explanation describing the difference between the two here.) In short, the Europeans developed a civil law in which every law is explicitly written. The British on the other hand, saw no logic in writing a new law to cover every eventuality. They developed a common law that evolved from precedents set by prior court rulings (also known as case law).

Japan’s legal system became a hybrid of civil and case law during the 1990s to accommodate increased foreign direct investment necessitated by economic reality. Awareness of US legal principles increased as those that had studied law overseas returned home to practice as judges and attorneys. Then common law concepts like indemnification, covenants, representations and warranties were introduced and more broadly accepted. But as often occurs in Japan, Western ideas were adapted rather than adopted. Where the courts incorporate overseas concepts into Japanese law, often they are ‘localized’ to fit existing ideas of justice.

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Under the hybrid system, conventional civil law is supplemented by case law which interprets and develops new laws where the existing legislation is silent. In practice there is often little documentary evidence of prior court rulings for the courts to draw upon. In these instances a judge will either revert to using Japan’s Civil Code or base a decision on the judges own sense of right or wrong.

Foreigners wishing to do business here in the manner they are accustomed too should further note that the Japanese are not keen on writing lengthy contracts. Business in Japan is more about building and preserving personal relationships. Where a contract between parties exists, material terms and conditions are typically in ‘short form’, leaving much room for interpretation and future negotiation.

For all these reasons, foreigners not familiar with Japanese law or business practice can find themselves in a costly legal dispute. A court could rule the opposite to what that party had intended. Foreigners for instance, may believe that Japanese courts will look only to ensure that the parties to a contract have fulfilled an agreement’s terms and conditions rather than look beyond that which is expressly stated. They would be wrong!

US courts typically only consider ‘procedural’ issues. For example, did the company follow the terms and conditions of the contract or did they not? In Japan, however, the courts will also consider the rationale behind the parties’ actions. If the judge feels the decision taken (or not taken) was unjustified, the court may ignore the written terms and conditions when reaching its judgment.

Let’s look at a practical example of that: Assume a buyer enters into an agreement with a seller. In the buy-sell agreement, the seller makes representations about the condition of the asset being sold and also warranties their accurateness. Let’s also assume that after the signing, but before the closing, the condition of the asset deteriorates. The buyer goes ahead with the purchase without adjusting the price, either because (a) it never learned about the new harmful information (perhaps due to a defect in its due diligence review) or (b) the buyer learned about the deterioration but chose to ignore it. Should the buyer then seek compensation from the seller in a Japanese court of law, a judge could dismiss the buyer’s claim.

In defense the seller can claim the buyer was grossly negligent for not having conducted proper due diligence during the period between the signing and the closing. Alternatively the seller can argue the buyer learned about the new circumstances, perhaps by conducting due diligence, but chose to do nothing about it. In either case the seller most likely will be released from liability under the representations and warranties it made because the buyer knew, or should have known the asset was negatively affected. Thus the buyer can be penalized for performing or not performing due diligence!

To highlight a common scenario, let’s assume that after the signing and before the closing in an acquisition, the seller sends the buyer a long email. Many matters are covered, including mention of what appears to be a benign issue. The buyer takes no notice of it and goes ahead with the purchase. Afterwards, disaster strikes. The buyer has bought a lemon and sues the seller who had given representations and warranties. In this situation, the courts could support the seller’s claim that the buyer was negligent for not having followed up on the information received. The courts could find in favor of the defendant.

The genesis of this seemingly strange ruling comes from Japan’s Civil Code. When you buy a car for instance, if the buyer knows it has a defect, under Japanese law he cannot claim for damage afterwards even if the representations and warranties state otherwise. Again, Japanese courts don’t only consider procedural issues − they also take the party’s rationale and knowledge into consideration.

Don’t get caught into that legal trap! Under Japanese law a buyer can opt out from the Civil Code by inserting an appropriately worded clause in the buy-sale agreement. The clause should state that any due diligence conducted by the buyer will not limit or negate the representations and warranties made by the seller. That way, if the buyer gains knowledge through its own efforts outside the contract from its advisors or even from the seller, that information can’t be used against it.

In one Osaka District Court case involving the purchase of a company, the seller gave representations and warranties that the firm being purchased had no threatened tax disputes against it. The closing transpired without any hiccups. Approximately two years later, the target company was investigated by the local tax office and assessed a large, yet to be paid, corporate tax bill that had accrued before the buyer’s acquisition. In this instance, the buyer had no idea that a prior tax liability existed. They were never told. The buyer reached a settlement with the tax office and paid the back taxes. Then the buyer sued the seller for breaching the buy-sell agreement’s representations and warranties.

The court however, found with the defendant. It turned out that the seller had given the buyer’s attorneys information about the potential tax liability, but their attorneys had failed to pass that information on. Because the buyer’s attorneys knew about it beforehand, the courts said that the buyer should have known about it as well.

That legal trap could have been avoided had the buy-sell agreement contained a clause making the ‘disclosure schedules’ (which form part of the agreement) the only accepted way to update the representations and warranties. New information sent by email, telephone or through the buyer’s advisers would then not have been deemed delivered to the buyer.

How much compensation for damage can or should the buyer ask for? Under Japanese law, absent any contractual provision to the contrary, a plaintiff is required to prove the amount of damage suffered. The buyer should therefore always seek to include a contractual provision that stipulates a penalty amount to be paid in the event of a breach.

A properly crafted penalty clause would allow the buyer to collect the penalty amount without having to prove the actual amount of damages. Further, a penalty clause would allow the buyer to collect additional damages if the buyer can demonstrate that actual damage surpasses the penalty amount.

A final suggestion: Always include an ‘entire agreement’ clause in every Japanese contract. In common law countries courts will typically ignore previous agreements including those made by email or by telephone. Under Japan’s Civil Code however, the courts can use their own judgment in these matters. Here, prior agreements made outside the main written contract are de rigueur and can impact the validity of that main agreement failing the inclusion of a clause stating otherwise. Be safe rather than sorry by including an appropriately worded ‘entire agreement’ clause in your Japanese contracts to reduce the risk of a judicial re-write.

Stephen Bohrer

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