As a general rule, the Korean Commercial Code (KCC) forbids a company from acquiring its own shares (treasury shares) in accordance with principles of capital adequacy. One of the exceptions to this rule is the acquisition thereof through prescribed methods under the Securities and Exchange Act. Treasury shares acquired through this method do not have voting rights while in the possession of the company, yet despite that, they are recognized as a defence mechanism against hostile takeovers.
In a hostile takeover situation, the target company sells its treasury shares to a friendly third party and, in doing so, revives the voting rights associated with the shares. This way the target company is able steer shareholder voting in its favour. In addition, acquisition of treasury shares leads to a decrease in the number of shares exchanged in the market and a subsequent increase in share value, which may exert pressure on the acquiring company with respect to the capital it needs for the takeover. Further, the target company may obtain large-scale loans or use a substantial amount of its existing capital to acquire treasury shares, which may be detrimental to the acquiring company’s purpose for the takeover.
In an actual case involving a hostile takeover, a company tried to sell its treasury shares to its controlling shareholder in order to defend itself from a third party. At one point, the courts had ruled that such disposition is lawful, but recently they reversed their position.
Case precedent holding that the disposition of treasury shares in a hostile takeover situation is lawful
Sovereign Fund’s hostile takeover bid for SK Group
In 2004, Sovereign made a hostile-takeover bid for SK Corporation, which is the holding company of SK Group. In response, SK sold 9.67% of its 10.41% treasury shares to its friendly shareholders, including the creditor banks of SK Group. Sovereign, arguing that such disposition was unlawful, filed for a provisional disposition with the court, requesting that the votes associated with the sold treasury shares be enjoined from being exercised.
The court held in favor of SK, stating that the board resolution to dispose of the subject treasury shares in response to the hostiletakeover bid cannot be considered invalid. Moreover, if SK’s acquisition of the subject treasury shares was lawful, then the disposition thereof cannot be said to be unlawful. The court also held that, in cases where a company disposed of its treasury shares for the purpose of helping existing management or the majority shareholder to unjustifiably keep control of the company, and in doing so harmed the interests of the company and other shareholders, such disposition may be unlawful. However, before such disposition is determined to be unlawful, it must first be established that the acquisition itself was unlawful. The court found that the board’s decision to dispose of the treasury shares in response to the hostile takeover bid fell within the scope of business judgement.
From the time of this court decision to its decision involving Daelim Trading discussed below, it was believed that a company was allowed to sell its treasury shares to a friendly party for the purpose of defending itself against a hostile takeover bid.
Dispute involving Daelim Trading’s management rights
In this case, a company owning 17.18% of its shares sold these shares to its majority shareholder when a dispute arose between the majority shareholder and the second-largest shareholder. In response, the second-largest shareholder filed a claim to nullify the treasury share purchase agreement, arguing that the above disposition was unlawful, and also filed a claim for provisional disposition to enjoin the voting rights associated with the treasury shares sold to the majority shareholder.
The court held that, the act by a company of disposing its treasury shares has an important impact on the rights and position of the shareholders depending on their shareholdings. In particular, if in a case where treasury shares are only sold to certain designated shareholders, then the resulting decrease in the shareholding of the existing shareholders would be tantamount to having issued new shares to third parties. As such, the restrictions imposed by the KCC on the issuance of new shares to third parties must also be applied in the case of selling treasury shares to certain designated shareholders and the disposition of treasury shares must not be used as a method to circumvent the restrictions. In this context, the court held that this case was one in which the disposition of treasury shares had an important impact on the interests of other major shareholders as well as on management and control rights of the company. Therefore, the share purchase agreement was deemed invalid and the treasury shares acquired thereby did not have any associated voting rights. (The KCC provides that new shares shall be issued to existing shareholders in proportion to their shareholdings, except in cases where certain necessities of the company, including financial reorganization or acquisition of certain technology, cannot be satisfied by the above issuance. In such situations, new shares may be issued to third parties.)
The Daelim Trading decision saw that, although disposition of treasury shares is different from the issuance of new shares in that the former does not increase the overall capital, the restrictions, which protect the interests of the existing shareholders, should also be applied in the case of disposing of treasury shares. Also, as with the issuance of new shares, existing shareholders should be provided with the opportunity to purchase treasury shares, and the act of selling treasury shares to a designated party without providing such opportunity would have an important impact on the interests of the existing shareholders as well as on management rights of the company. Based on this opinion, the court held that the subject disposition of treasury shares was invalid.
The Daelim Trading decision has been criticized for overly emphasizing the principle of shareholder equality, and critics have also argued that if the logic therein is conclusively upheld, then the disposition of treasury shares would no longer be a viable defensive mechanism against hostile takeovers.
Is the sale of treasury shares to third parties is lawful?
Currently, there are no laws that govern the issue of whether treasury shares may be sold to third parties in a hostile takeover situation. Due to this absence, in the past it was held that the above disposition was lawful in principle, and the only issue of concern was the fiduciary duty of directors. However, as discussed in connection with the Daelim Trading case, a new interpretation has arisen which argues that the disposition of treasury shares must be restricted similarly to the issuance of new shares to third parties.
However, issuing new shares and selling treasury shares are two different acts, thus it would not be reasonable to apply in its entirety the restrictions upon the latter. Ultimately, the main concern appears to be whether such act is a violation of a director’s fiduciary duty. (Recently, the Ministry of Justice has been undertaking efforts to amend the KCC. The original draft amendment had provided that in case of selling treasury shares, the existing shareholders may acquire them in proportion to their shareholdings, which is identical to the court decision in the Daelim Trading case above, but such clause has now been deleted.)
Legal commentaries are of the view that the directors of a target company may defend against a hostile takeover if such bid harms the company and if the expenses incurred to defend the company or the value of lost opportunities in connection thereof are less than the harm caused by the hostile takeover. It appears that this logic would be applicable in the case of selling treasury shares. If a certain disposition of treasury shares to shareholders or third parties can be seen as falling within the scope of the board’s business judgment, then the question of whether such disposition was lawful would be determined by the fiduciary-duty standard, i.e. the business judgment rule. According to the business judgment rule, the acts of the directors must be based on reasonable and justifiable grounds showing that there is reason to believe that the hostile takeover will harm the company. In addition, there must be objective grounds to show that the expenses required to defend against the hostile takeover are less than the harm caused by the hostile takeover. In order to meet the above requirements, the directors would have to procure ample objective and reasonable materials, solely based upon which they would have to decide their actions and from the company’s point of view.
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