South Korea: Structuring LBOs in Korea: proceed with caution

Author: | Published: 1 Sep 2012
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During the last several years, foreign investors seeking to finance acquisitions in Korea through leveraged buyouts (LBOs) have been advised to exercise caution in structuring their transactions. Structures commonly used in some other jurisdictions may expose investors to serious liabilities under Korean laws. The issue arises from the fiduciary duty owed by corporate directors of a target company who participate in decisions approving the merger agreement and/or convening shareholders' meeting for the purpose of obtaining shareholder approval for such merger. In particular, collateralisation of the acquired company's assets in LBO-type transactions for the benefit of the buyer have been viewed as a breach of fiduciary duty for the director of the target approving such transaction, even if the buyer had acquired 100% of the equity of the target company. The investors who agreed with the preparation and implementation of such structure may also be held jointly liable for the directors' breach of fiduciary duty. On the other hand, certain structures involving a push-down of acquisition loans to a target have been upheld by the Korean courts.

Fiduciary duty and LBOs

Under Korean law, directors may be subject to civil and criminal liability for breach of fiduciary duty if they act with the intent to either benefit themselves or a particular third party. "Third party" in this context includes the shareholders of the company since the prevailing view is that the fiduciary duty of directors runs to the company itself rather than the shareholders of the company. Thus, under the single shareholder corporation doctrine, even the sole shareholder of a wholly-owned subsidiary may be subject to liability for breach of fiduciary duty if such shareholder acts, in its capacity as a director of the subsidiary, for the shareholder's own interest at the expenses of its subsidiary. It should be noted that a person who is not formally a member of the board may still be deemed a director (with the requisite fiduciary duties), if such person has influence over one or more directors, does business under the name of a director, or conducts company business by using a title denoting authority, such as honorary chairman, chairman, president, vice-president, executive director, managing director, director, and so on. A person who is not a director or a de facto director may also be found criminally liable for aiding and abetting the criminal breach of a director's fiduciary duty.

With respect to the criminal intent element required for a finding of a criminal breach of fiduciary duty, the Korean Supreme Court has held that a fiduciary does not necessarily need to act solely for his own or a third party's interest to be held liable for breach of fiduciary duty. So long as the fiduciary's act primarily served such fiduciary's own or a third party's interest, the fact that such act also served the principal's interest is immaterial. In terms of damages, there is no need to prove actual damages to the company, and directors may be subject to civil and/or criminal liability in cases where there is merely the potential risk of damage to the company. In this regard, the Supreme Court has held that any actions of directors to improve the condition of the target company after the fact, or the directors' good faith intent to take such actions, would not serve to cure actions that are otherwise in breach of their fiduciary duty.

The Shinhan Corporation decision

The Korean Supreme Court addressed the above issues in the LBO context for the first time in 2006 (Case No. 2004Do7027), in a transaction where the target provided its assets as collateral security in support of the indebtedness incurred by the buyer for the acquisition of the target's shares. The case involved an acquisition by an individual entrepreneur of a financially distressed, mid-sized construction firm, which had been undergoing a court-administered reorganisation proceeding. The buyer formed a special purposes vehicle (SPV), which in turn borrowed funds from financial institutions to finance the acquisition of the target. The SPV's loans were secured by shares and the non-performing loans payable by the target, both of which were acquired by the SPV at the closing of the acquisition. The SPV used the loan proceeds to purchase the target's non-performing debt obligations from its creditors, as well as new shares of the target representing a controlling share of the target's total share capital. Upon closing, the buyer was appointed the target's representative director, and then caused the target to establish first-priority security interest on certain of its major assets, including real properties and bank deposits, to replace the pledges previously made over the target's shares and non-performing loans.

The prosecutor's office brought criminal charges against the buyer on these grounds alleging that the buyer had breached his fiduciary duty to the target. The prosecution argued that by directing the target to provide its own assets as collateral for the indebtedness of the SPV, the buyer had caused the target to incur the risk that such assets would be enforced by the lenders in the event of the SPV's default under its loan obligations, thereby causing the target to suffer potential damages. The district court agreed.

On appeal, the Seoul High Court overturned the district court ruling, finding that there was insufficient showing of criminal intent on the part of the buyer. Specifically, the appellate court rejected the argument that causing the target to provide security for indebtedness incurred in relation to the acquisition of its own shares should constitute a per se breach of fiduciary duty. In doing so, the appellate court reasoned that "use of an LBO structure – in and of itself – should not be deemed to have resulted in harm to the target with corresponding benefits to the acquirer. Even if the acquirer caused potential damage to the target by providing the target's assets as collateral for the LBO financing, it does not necessarily indicate that the acquirer had any criminal intent since the target itself may have benefited from the transaction such as the discharge of existing liabilities."

On further appeal, however, the Korean Supreme Court found that the target had suffered harm in providing the collateral since it assumed the risk of losing its valuable assets upon default by the acquisition vehicle, stating:

"In a leveraged buyout where the acquirer finances the acquisition through borrowings and subsequently provides the assets of the target as collateral, the target will necessarily assume the risk of losing its assets in the event of a default by the acquirer. Therefore, such provision of collateral solely for the benefit of acquirer should not be permitted unless the acquirer provides the target appropriate consideration such as compensation that is commensurate with the risk assumed by the target. If the acquirer has caused the target to provide its assets as collateral without any consideration, it would be reasonable to find that the acquirer himself (or a third party) has received pecuniary gain in an amount equal to the value of the collateral, and that the target incurred damages in the same amount".

In making its ruling, the Supreme Court rejected the appellate court's finding that the target's exposure was not substantive or that the acquisition had helped reduce the target's credit exposure. The Court concluded that the target had not received "appropriate consideration," despite the fact that the repayment of the target's underlying debt was primarily funded from the capital injection made by the SPV through the SPV's loans, because the loans were originally taken out to secure the funds necessary for the buyer to purchase the shares and control the target.

The 2006 decision in Shinhan Corporation drew a lot of concern and sparked debate. While there was general consensus that the ruling was specific to the facts of the case and that the outcome may have been different under other circumstances, e.g., if the buyer had put more of his own capital in the acquisition or took more risk and aligned his interest with the interest of the target, some commentators criticised the ruling for taking too narrow an approach in assessing the benefits of the transaction to the target. Specifically, they pointed out that the provision of collateral was part of the acquisition that rescued the target from insolvency and ultimately led to the successful turnaround of the business, and argued that the Court should have given further weight to such facts and looked at the transaction as a whole. Other commentators criticised the Court's confirmation of the single shareholder corporation doctrine, arguing that directors owe a fiduciary duty to the shareholders only, subject to certain limited exceptions, and that the distinction between a corporation and their owners is unnecessary.

The Tong Yang Major decision

Subsequently in 2010, in a high-profile criminal proceeding before the Supreme Court in which Kim & Chang was the defence counsel, the Supreme Court ruled in favour of the defendants, affirming the lower courts' rulings that the type of LBO structure at issue in the case did not bring economic harm to the target and thus did not provide grounds for finding breach of fiduciary duty.

The Tong Yang Major case arose from the 2007 acquisition of Hanil Synthetic Fiber by Tong Yang Major through Tong Yang Major Industry, a subsidiary of Tong Yang Major formed for the purpose of acquiring the target. In connection with the acquisition, the SPV incurred debts to finance the transaction that were ultimately pushed down to the target level through a merger of the SPV into the buyer, followed by a merger of the target into the buyer. The target's cash reserves were used to repay a substantial portion of the SPV's debts immediately after the mergers.

The prosecution argued that the mergers and the subsequent use of the target's cash for repayment of the loans constituted a criminal breach of the directors' fiduciary duties since the structure allowed the buyer to realise monetary gains from the transaction, while causing the target to suffer economic harm. The trial court was not convinced, however, and ruled in favour of the defendants on grounds that the prosecution had failed to establish economic harm to the target.

On appeal, the appellate court affirmed the trial court's decision. It emphasised three points.

The first was the fact that the buyer had provided its own equity and collateral in financing the acquisition (among other things, the buyer, the SPV and their affiliates provided a pledge over their own assets as well as the target's shares held by them, and the buyer provided a guarantee for certain debts of SPV).

Secondly, the buyer's compliance with the statutory requirements (including procedural requirements) of a merger to protect the interests of the shareholders and the creditors of the target (including supermajority approval, appraisal rights for dissenting shareholders and creditor protection measures).

Third, the fact that the buyer's acquisition of the target was not merely aimed at exploiting the target's cash reserves but to acquire and operate the target's business upon consummation of the acquisition. The appellate court's reasoning and conclusion were subsequently affirmed by the Supreme Court which noted, among other things, that the mere fact an LBO has occurred does not, in and of itself, give rise to criminal liability for breach of fiduciary duty. The Supreme Court emphasised that courts should examine the specific actions taken by the directors during the LBO process, on a case-by-case basis, to determine whether there was, indeed, a breach of fiduciary duty.

The Onse Telecom decision

A recent Seoul High Court decision (rendered on July 5 2012) in which the Court vacated the lower court judgment that found a representative director of a target guilty of fiduciary duty provides some guidance as to the level of consideration that the acquirer needs to provide to the target in order to satisfy the "appropriate consideration" standard specified by the Supreme Court in the 2006 Shinhan Corporation case.

In that case, the representative director had taken the lead in the 2006 takeover by the acquisition vehicle established by Onse Telecom (now Onse Telecom Corporation, having undergone reorganisation proceedings at the time of the takeover). Citing the Supreme Court ruling in the 2006 Shinhan Corporation decision, the lower court in Onse Telecom ruled that the use of the assets of the acquired company as collateral in an acquisition financing context constituted a breach of fiduciary duty even if the acquiring company had acquired 100% of the equity of the acquired company. Further, the lower court found a breach of fiduciary duty with regard to the early redemption by the acquired company of bonds with warrants, which it had previously issued to the acquiring company as a part of the consideration for the acquisition, to enable the acquiring company to prepay its acquisition loan, citing the acquired company's loss of the benefit that could have been earned from not repaying such bonds until maturity and the loss of opportunity for capital inflows upon the bondholder's exercise of the warrants.

The Seoul High Court overruled on appeal, distinguishing the facts of the case from prior cases, and finding that there was no breach of fiduciary duty since the transaction also benefited the acquired target company. In doing so, it is noteworthy that the High Court considered the following benefits conferred to the acquired company in determining the breach of fiduciary duty issue (in the lower court, such factors had been considered in the penalty assessment phase only, that is, after the lower court had already concluded that there was a breach of fiduciary duty).

Specifically, the High Court focused on the fact that a considerable portion of the purchase price (approximately 46%) for new stocks was financed through the acquiring company's own funds raised by equity and unsecured convertible bond issuances by the acquiring company.

It also looked at the fact that the acquiring company and the acquired company became, in substance, a single economic entity through the acquisition of 100% equity interest of the acquired company and the fact that the reduction in leverage ratio of the acquired company from 435% to 54% improved its financial position, thereby increasing its management efficiency. Its final area of focus was the fact that the acquired company through a back-end merger with the acquiring company became a listed company.

The Seoul High Court also acquitted the representative director of charges related to the early repayment of bonds with warrants by the acquired company, citing that the repayment of bonds with warrants had reduced the leverage ratio of the acquired company, thereby improving its financial structure and decreasing its interest expense; and the early repayment of such bonds cannot be deemed to constitute an overall loss to the acquired company since the bonds with warrants were originally issued as an intermediate financing tool to be used towards repayment of bankruptcy claims, and that both objectives were achieved by the time of prepayment.

In finding that the target had obtained corresponding benefits, even though there was no direct payment to the target for the collateralisation of its assets, the High Court decision may be seen as providing guidance regarding the extent and scope of consideration that the acquirer needs to provide in order for the investor to avoid liabilities for breach of fiduciary duty. Furthermore, the court viewed the acquiring company as the ultimate bearer of the burden or loss to be borne by the target whose assets had been used as collateral, and recognised that the acquiring company and the target had in substance become a single entity through the acquisition of a 100% interest in the target's equity. This may be seen as a departure from previous decisions which regarded the corporation and its shareholders as separate and independent corporate persons.

The Onse Telecom decision has been further appealed to the Supreme Court by the Prosecutor's Office and it will be interesting to see if and to what extent the Supreme Court will reconsider the positions it previously took in the 2006 Shinhan Corporation decision.

Practical considerations

Given the limited nature of specific guidance provided in court cases as to how the substantive aspects of a director's fiduciary duty are to be satisfied, investors are advised to exercise caution in structuring LBO-type transactions. At a minimum, investors should consider whether there are certain incidental gains to the target, such as improvement of the balance sheet (for example, increase of the assets and the shareholder's equity due to the proposed merger) or tax benefits (such as deductible interest payments). They should also consider whether the directors of the target can to show that they took all reasonable steps available to make sure that their decision was well-informed and considered.

In this regard, investors should consider following a number of steps so as to reduce potential risks. The first is to ensure the directors of the target are different from the directors of buyer to enable the target's board to reach independent decisions. Secondly, they should obtain advice or an opinion from outside financial expert(s) with respect to the financial impact of the proposed merger on the target. Third, they should present the outside financial expert's advice or opinion to the board of directors and give the directors sufficient time to review those materials. The fourth step is to ensure the board carefully reviews the pros and cons of the proposed merger before reaching a conclusion that the proposed merger is not detrimental to the target. Finally, investors should keep good records of the directors' careful deliberations and discussions of those pros and cons.

In conclusion, while it is clear that LBO merger transaction would not automatically involve a violation of the fiduciary duties of the target's directors, until there are clear Supreme Court decisions in this area, proceeding with a transaction structure based on the simple belief that the deal would also bring business benefits the target would be quite risky. This is still the case even if such belief were based on certain economic rationale. The complexity in this area of the law underscores the need to carefully examine the potential legal risks associated with LBO financing in Korea.

Jin Yeong Chung
 

Kim & Chang
39 Sajik-ro 8-gil
(Seyang Bldg., Naeja-dong), Jongno-gu
Seoul 110-720
Korea

T: +82-2-3703-1108
F: +82-2-737-9091~3
E: jychung@kimchang.com
W: www.kimchang.com

Jin Yeong Chung leads the firm’s cross-border litigation and insolvency and restructuring practice groups. For more than 22 years, he has successfully represented various foreign and domestic clients. His advocacy for a foreign investor in ICC arbitration against the governmental deposit insurance corporation led to an award of about W3 trillion ($2.8 billion). He has served on a number of governmental committees and has lectured since 2001 on financial transactions at the Judicial Research and Training Institute, the only educational and training institution which everyone who passes the Korean Bar Exam is required to attend before joining the bench or the bar.

Chung received his LLB from Seoul National University, College of Law in 1984, and his LLM from Yale Law School in 1994. Before joining the firm, he served as a Judge Advocate in the Republic of Korea Air Force from 1986 to 1989. He is a member of the Korean and New York Bars.

Sungjean Seo
 

Kim & Chang
39 Sajik-ro 8-gil
(Seyang Bldg., Naeja-dong), Jongno-gu
Seoul 110-720
Korea

T: +82-2-3703-1214
F: +82-2-737-9091~3
E: sjseo@kimchang.com
W: www.kimchang.com

Sungjean Seo is a foreign attorney in the firm’s international arbitration and cross-border litigation practice group. She concentrates her practice on representing Korean and international clients in international arbitrations and advising clients in connection with cross-border litigation. She has advised Korean conglomerates, foreign private equity firms, and US, European and Japanese companies in disputes arising out of various commercial contexts, including joint ventures, share purchase agreements, distributorship relationships, and supply of technical equipment. Before joining Kim & Chang, Seo practised for several years in New York with Milbank Tweed Hadley & McCloy and Rogers & Wells (now Clifford Chance), concentrating in the areas of complex cross-border finance, securities offerings and asset securitisation.


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