Ruling confirms long-suspected risk of liability for directors and officers in approving use of target company assets as security for acquisition financing.
On November 9, 2006, Korea’s highest court affirmed the conviction of the CEO of a target company for criminal breach of fiduciary duty, for pledging the target’s assets post-acquisition as security for loans used in the acquisition by a special purpose company (SPC). The landmark decision by the Supreme Court, confirming what had long been a theoretical problem for leveraged buyouts (LBOs), may have ramifications for many potential deal structures seeking to utilize target assets.
The decision stems from the acquisition in 2001 of Shinhan Corporation ("Target") by an SPC set up by the defendant (a Mr. Kim) who would become Target’s CEO (or "representative director"). Target, a publicly listed construction company, had been in corporate reorganization. The SPC, headed by Kim, acquired the majority of the shares of Target, as well as reorganization claims of its creditors, with financing from institutional lenders. As collateral for these loans, the SPC pledged the Target shares and creditor claims so acquired.
Immediately after the acquisition, once installed as representative director of Target, Kim mortgaged and otherwise pledged most of Target’s assets to the SPC’s lenders. At the same time, the initial pledge over Target shares and reorganization claims was released. It seems Target fared better financially in the wake of the acquisition.
Indictment And Grounds
Kim as Target CEO was charged with breach of fiduciary duty (bae-im, also termed occupational breach of trust), for pledging Target assets as collateral for the SPC debt. Under relevant law , a company director, or officer, commits bae-im if he breaches his fiduciary duty in order to obtain a pecuniary benefit himself or to procure such a benefit for a third party, and thereby causes economic harm (or creates a risk of such harm) to his company.
Lower Court Findings Mixed
Following trial, the district court found Kim guilty of bae-im as charged, reasoning that the pledge of Target’s assets subjected it to the risk of forfeiting them, in case of default, without receiving any value in return for the pledge.
On appeal, the Seoul High Court reversed, finding no basis for criminal liability. The court concluded that Kim gained no personal benefit from the pledge. Rather, the loan proceeds so secured were used to acquire, and extinguish, reorganization claims, leading to an improvement in Target’s financial condition. In itself, the furnishing of Target assets as security, the court reasoned, does not necessarily mean an intention to cause harm. Prosecutors appealed to the Supreme Court.
Supreme Court Findings
Siding with the guilty verdict of the first court, the Supreme Court ruled1 that, in pledging target assets without procuring adequate compensation for Target in return, Kim breached his fiduciary duty to Target for personal gain, or gain of a third party, causing Target economic harm.
In its decision of November 9, the court observed that, in this LBO context, a target company as pledgor must bear economic burdens associated with the pledge, and the risk of forfeiting assets in case of default by the acquiror. Hence, the court said, the pledge would only have been permissible if the acquiror had furnished adequate consideration for Target in exchange. Not having done so, the SPC derived a pecuniary gain based on the value of the collateral, and caused Target harm.
In passing, the court observed that Kim should at least have buffered Target against risks of foreclosure by, for example, maintaining the initial pledge over Target shares and/or some claims against Target. However, the precise significance of this was left unclear.
Unlike the intermediate court, the Supreme Court dismissed the evident post-LBO improvement in Target’s condition and Kim’s alleged efforts to that end. Instead, the court focused on Kim’s intent at the time of the pledge: The purpose was to aid the SPC and himself, not the Target, by furnishing leverage for the acquisition, without intending to compensate Target for the pledge. Add to this the harm to the Target (economic burden and risk of forfeiture), and the elements of the crime are complete. Subsequent actions by Kim cannot cancel out his criminal intent at the time of the pledge, the court held.
Kim could not be exonerated through ratification by SPC as the controlling Target shareholder, the court noted, because the duty in question is owed to the company itself, Target, not its shareholders.
Implications And Questions
It has been widely understood that a pledge of target company assets to secure acquisition financing may involve risks of criminal, as well as civil, liability for breach of fiduciary duty on the part of directors or officers who approve the pledge. In a sense, the Supreme Court decision is not a surprise, reaffirming the caution that must be exercised in any proposal to use target company assets to finance an LBO.
The decision gives some shape to the necessary analysis. Pledging of target company assets in the LBO context is not necessarily, in itself, a criminal breach of fiduciary duties. Rather, according to the decision, such a pledge may be lawful if "adequate" consideration is procured for the target company, or, perhaps, if there is enough of an intent to benefit the target company.
Further, the decision seems to imply that criminal intent, or resulting harm, may be deemed mitigated if a sufficient separate security package is furnished in addition to target company assets, or other steps taken, so as to narrow the risks for the target.
At the same time, the decision invites much speculation. What might constitute "adequate" consideration for a pledge of target assets? What form might it take, and how would the value of it be assessed, as compared to the putative harm of the pledge? How might an adequate degree of beneficent intent be shown? What might be the precise advantage of a mixed security package, including collateral other than target assets?
Also worth considering is to what extent the ruling can be viewed as fact-specific. A Supreme Court decision is authoritative guidance for lower courts in later cases. But there may have been aggravating facts here, extrinsic to the core LBO structure. Among other things, the defendant Kim was, until installed at the Target, head of the SPC and evidently a large investor in it, as well as the individual driving force behind the acquisition.
Hence in several ways it is uncertain how broadly, or narrowly, the court’s reasoning should be read. Could the court’s reasoning cover alternative structures arriving at similar results? Could it extend to transactions other than direct pledges of assets?
In any case, the decision—and the questions it raises—will merit careful attention in the structuring of leveraged acquisitions in Korea.
1. Supreme Court Decision in Case No. 2004-Do-7027.
This update is intended as a summary news report only, and not as advice. For legal advice, please inquire with your contact at Bae, Kim & Lee, or the following attorneys of our firm:
Keun Byung Lee
Hee Gang Shin
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