Legal Issues of Leveraged Buyouts (LBO) and Breach of Trust in South Korea: Analysis of Key Court Decisions

1. The Concept and Basic Structure of LBO

LBO (Leveraged Buyout) refers to a technique in M&A transactions where acquisition funds are raised by directly or indirectly using the target company’s assets as collateral and then acquiring that company. In other words, it is a method of borrowing funds to acquire a company by using the target company’s assets as collateral or by planning to repay the debt with the assets of the acquired company.

The general procedure of an LBO is as follows:

1. The acquirer establishes a Special Purpose Company (SPC)
2. The SPC borrows acquisition funds from financial institutions
3. The SPC acquires shares of the target company with the borrowed funds
4. After acquisition, the debt is repaid using the assets or cash flow of the target company

LBOs are mainly used in the following situations:
– When an acquirer with insufficient financial resources attempts a large-scale acquisition
– When private equity funds use leverage to increase investment returns
– For strategic acquisitions for corporate restructuring or business diversification

However, this structure can place an excessive debt burden on the acquired company, increasing management risks and potentially harming the interests of existing shareholders or creditors, which has made it a subject of legal controversy in South Korea.

2. Legal Issues and Breach of Trust Concerns in LBO

The core legal issue with LBOs arises when the target company provides assets as collateral or bears debt repayment obligations for the benefit of the acquirer rather than for its own benefit. Since such actions may cause harm to the company and its stakeholders (shareholders, creditors, etc.), the possibility of criminal breach of trust becomes a key issue.

Relationship Between LBO and Breach of Trust

Situations where breach of trust becomes an issue in LBO transactions mainly include:

1. Directors or executives of the target company providing company assets as collateral for the benefit of the acquirer
2. The acquirer, after gaining management control, using the target company’s assets to repay their own borrowings
3. Actions that harm the target company through mergers or asset extraction

Breach of trust is established under Article 355(2) of the Criminal Act when “a person who handles another’s business gains property benefits or has a third person gain them by breaching his duty, thereby causing loss to the person whose business he handles.” Occupational breach of trust (Article 356) provides for a more severe punishment.

Relationship with Commercial Law Regulations

The current Commercial Act does not directly regulate LBOs. However, for listed companies, there are provisions (Article 542-9 of the Commercial Act) restricting transactions with major shareholders and interested parties, prohibiting companies from lending funds, providing guarantees or collateral for the repayment or security of acquisition funds raised by major shareholders, with violations being punishable (Article 624-2 of the Commercial Act).

Additionally, the prohibition on self-dealing by directors (Article 398 of the Commercial Act) can also serve as a regulatory provision for LBO actions. According to this provision, self-dealing without board approval may be invalid, and an LBO could be viewed as an indirect form of self-dealing where the company provides collateral for the benefit of the major shareholder, who is the acquirer.

3. Various Types of LBO

LBOs can be classified into four main types according to their implementation methods, and court precedents on the establishment of breach of trust vary by type.

Collateral-Provision Type LBO

Definition: This is a type where the acquiring company maintains the separate legal entities of the Special Purpose Company (SPC), which is the acquisition entity, and the target company, and raises acquisition funds by using the target company’s assets (deposit assets, real estate assets, etc.) as collateral for the SPC’s acquisition loans.

Characteristics:
– Receiving cooperation from major shareholders and CEOs of the target company to take over management
– Providing assets of the acquired company as collateral to secure acquisition funds from the position of CEO after the acquisition
– In many cases, the acquirers’ intention to acquire the company is clearly for utilizing only the assets of the target company rather than normal business operations

Court Case: Shinhan Case (Supreme Court Decision 2004Do7027, November 9, 2006)

In this case, to acquire Shinhan Corporation, which was undergoing corporate reorganization, the defendant established an SPC and borrowed 35 billion won from Dongyang Hyundai Finance, setting up a pledge on the new shares that the SPC would acquire by participating in Shinhan’s capital increase, and separately providing reorganization claims and secured reorganization rights totaling about 62 billion won against Shinhan to Hanmi Bank as collateral.

Court’s Position: The Supreme Court recognized breach of trust. The gist of the judgment is as follows:

1. Providing collateral solely for the acquirer cannot be permitted without limit and may only be allowed if the target company receives appropriate consideration such as compensation for the risk of providing collateral
2. If the acquirer has the target company provide its property as collateral without providing any consideration to the target company, it can be seen that the acquirer or a third party gains property benefits corresponding to the collateral value and causes property loss to the target company
3. Even for a company undergoing reorganization, the potential interests of shareholders and creditors should be protected, so this does not affect the judgment on breach of trust

This judgment is significant in clearly establishing that breach of trust can be established for collateral provision without appropriate consideration to the target company in a collateral-provision type LBO.

Merger Type LBO

Definition: This is a type where the acquirer establishes an SPC, has it borrow funds to acquire the target company through share acquisition, and then merges the target company with the SPC, with the surviving company repaying the existing loan debt.

Characteristics:
– Transferring the burden of acquisition funds borrowed by the SPC to the target company through merger
– Legally conducted through merger procedures, so legal risks may be lower than the collateral-provision type
– Shareholder and creditor protection mechanisms under the Commercial Act’s merger procedures are in operation

Court Case: Hanilhapsom Case (Supreme Court Decision 2009Do6634, April 15, 2010)

In this case, to acquire Hanilhapsom, which was undergoing corporate reorganization, the acquirer together with its affiliates invested about 100 billion won to establish an SPC, which then borrowed 466.7 billion won from financial institutions to finance the acquisition and acquired Hanilhapsom for 500 billion won. Subsequently, the SPC was absorbed by the acquirer, and then the acquirer absorbed Hanilhapsom. After the merger, the surviving entity, the acquirer, used 180 billion won of funds held by Hanilhapsom to repay 260 billion won of debt borrowed for the acquisition of Hanilhapsom.

Court’s Position: The Supreme Court denied the establishment of breach of trust in this case. The gist of the judgment is as follows:

1. It cannot be determined uniformly that breach of trust is established or not established for those who led corporate acquisitions through leveraged buyouts, and judgments must be made individually
2. Unlike methods that directly provide the assets of the target company as collateral, if there are no defects in the substance or procedure of the merger, it is difficult to see that the company suffered a loss
3. Through a merger, the acquiring company and the target company become personally united and their assets become inseparably integrated, making it difficult to assess damage to the target company

This judgment suggests that it is difficult to recognize breach of trust in merger-type LBOs conducted through legal merger procedures.

Asset Extraction Type LBO

Definition: This is a type where, after the SPC acquires the target company, it maintains its position as the largest shareholder without merging and recovers investment capital through methods specified in the Commercial Act (mainly paid-in capital reduction).

Characteristics:
– A method of recovering funds through legal capital reduction procedures
– Compliance with procedures specified in the Commercial Act (special resolution of the shareholders’ meeting, creditor protection procedures, etc.)
– The company’s financial structure may deteriorate due to fund recovery through capital reduction

Court Case: Daesun Distilling Case (Supreme Court Decision 2011Do524, June 13, 2013)

In this case, the issue was whether the act of acquirers recovering funds through paid-in capital reduction and dividend distribution after acquiring Daesun Distilling through an SPC constituted breach of trust.

Court’s Position: The Supreme Court denied the establishment of breach of trust. The gist of the judgment is as follows:

1. Paid-in capital reduction and dividend distribution are results of exercising shareholder rights guaranteed by law and there are no procedural defects
2. Considering the capital reduction reimbursement and distributable profits, it cannot be said that the company suffered property loss by allowing shareholders to gain improper benefits
3. A company’s paid-in capital reduction or dividend distribution conducted in accordance with legal procedures cannot in itself be considered an act that causes harm to company creditors

A similar judgment was rendered in the Dong-A Construction case (Supreme Court Decision 2011Do1544, December 22, 2011).

These judgments show that it is difficult to establish breach of trust for fund recovery actions conducted in compliance with procedures specified in the Commercial Act in asset extraction type LBOs.

Hybrid Type LBO

Definition: This is a type where there is a collateral provision act by the target company, and subsequently, the SPC merges with the target company (including asset extraction after merger).

Characteristics:
– A form combining characteristics of the collateral-provision type and merger type
– A complex structure that raises and repays acquisition funds through collateral provision and merger
– Various legal issues are mixed and appear

Court Case: Onse Telecom Case (Supreme Court Decision 2012Do9148, March 12, 2015)

In this case, the existing shares of Onse Telecom, which was undergoing corporate reorganization, were all redeemed, and the acquirer acquired 100% of new shares from a capital increase and bonds with warrants (BW). Subsequently, Onse Telecom provided its assets as collateral for the acquirer’s existing loan debt for raising acquisition funds, and took out a loan using its headquarters building as collateral to repay the BW held by the acquirer early, allowing the acquirer to repay short-term loan debt with those funds. The acquirer then absorbed Onse Telecom.

Court’s Position: The Supreme Court denied the establishment of breach of trust in this case. The gist of the judgment is as follows:

1. When judging whether corporate executives had the intent of breach of trust in relation to management decisions, strict interpretation standards should be maintained
2. Business management inherently involves risk, and losses may occur even if a manager makes decisions carefully and in good faith without intent to gain personal benefit
3. The intent of breach of trust should only be recognized when, in light of all circumstances such as the circumstances and motives that led to the management decision, the content of the business, the economic situation of the company, the probability of loss and the probability of profit, it is recognized as an intentional act with awareness of gaining property benefits for oneself or a third party and causing damage to the principal
4. Responsibility cannot be assigned solely based on the result of damage occurring or on the grounds of negligence

This judgment is significant in applying the business judgment rule to the judgment of breach of trust intent in hybrid-type LBOs and presenting strict criteria.

4. Requirements and Criteria for Breach of Trust

To determine whether breach of trust is established in relation to LBOs, the constituent requirements of breach of trust must be examined in detail.

A Person Who Handles Another’s Business

The subject of breach of trust is ‘a person who handles another’s business.’ In the context of LBOs, the following issues arise:

1. Position of the Acquirer: The acquirer may be recognized as ‘a person who handles another’s business’ if they are in a position to manage the assets of the target company or, even without an official position, have effectively taken control of management.

2. Target of Directors’ Obligations: Company directors owe duties of care and loyalty to the company, so they are ‘persons who handle another’s (the company’s) business.’ The interests of shareholders and the interests of the corporation may not always align, and precedents take the position of viewing the company as ‘another.’

3. Special Cases: In the case of collateral-provision type LBOs, the acquirer has been recognized as the subject of breach of trust, but the recognition may vary in other types of LBOs.

Breach of Duty

A breach of trust act refers to a person who handles another’s business acting in violation of their duty. ‘Acting in violation of duty’ means not performing actions expected by law, contract, or good faith principles, or doing prohibited actions.

In relation to LBOs, the acquirer bears the following duties:
1. The duty to prohibit self-dealing under the Commercial Act
2. The duty of care as a good manager
3. The duty of loyalty

Violation of these duties may constitute a breach of duty under criminal law. However, the determination of duty violation may vary by LBO type:

1. Collateral-Provision Type LBO: The act of providing the target company’s assets as collateral for the acquirer’s loan may in principle be viewed as a breach of duty, but a different judgment is possible if appropriate consideration is provided to the target company.

2. Merger Type LBO: If done through legal merger procedures, it may be difficult to view it as a breach of duty.

3. Asset Extraction Type LBO: If methods and procedures specified in the Commercial Act (paid-in capital reduction, dividends, etc.) are followed, it may be difficult to view it as a breach of duty.

Occurrence of Property Damage

For breach of trust to be established, the actor or a third party must gain property benefits and property damage must occur to the principal. The core issue in LBOs is whether property damage has occurred to the target company.

Precedents view the concept of damage as including not only realized damage but also the concrete risk of actual damage occurring, and ‘risk of property damage occurring’ means a concrete risk equivalent to damage occurring to the principal from an economic perspective.

The criteria for judging damage occurrence by LBO type are as follows:

1. Collateral-Provision Type LBO: When providing real estate, etc., as collateral, property damage may be recognized as the risk of asset loss occurs. The loss of the possibility to utilize the collateral value due to collateral provision itself can be evaluated as actual damage.

2. Merger Type LBO: There is a problem in evaluating damage as the company becomes personally unified and assets become inseparably integrated through the merger. If the merger went through legal procedures and the merger ratio was reasonably determined, it is difficult to recognize damage occurrence.

3. Asset Extraction Type LBO: In the case of distributing profits earned from business activities or taking the form of legal paid-in capital reduction, if methods and procedures specified in the Commercial Act were followed, it may be seen as not a breach of duty. However, even if there are no procedural defects, there may be room to view it as damage if there is a significant difference in light of capital maintenance and loyalty principles.

Intent of Breach of Trust

For breach of trust to be established, there must be awareness of ‘acting in violation of duty’ and awareness of ‘causing property damage to the principal.’ There also needs to be awareness of ‘gaining property benefits for oneself or a third party.’

When judging the intent of breach of trust in relation to LBOs, ‘management judgment’ becomes an important consideration:

1. Precedent Criteria for Judging Executive Intent: The Supreme Court comprehensively considers the circumstances and motives of the judgment, the content of the business, the company’s economic situation, and the probability of loss and profit occurrence when judging an executive’s intent. Particularly in the circumstances and motives of the judgment, the presence of improper solicitation or personal intentions, such as conflicts of interest, plays an important role.

2. Intent Judgment by Type:
– Collateral-Provision Type LBO: The act of providing collateral for the acquirer’s debt unrelated to the target company is likely to have recognition and intent regarding the acquirer’s benefit gain and damage to the target company, making it easier to recognize the intent of breach of trust.
– Asset Extraction Type/Merger Type LBO: It may be difficult to recognize awareness or intent of damage based solely on objective facts (increase in debt, decrease in capital, etc.) due to difficulties in judging damage or risk occurrence from paid-in capital reduction or mergers. In these types, management judgment plays an important role in determining breach of trust intent.

5. Business Judgment Rule and Breach of Trust

One of the important issues in judging breach of trust related to LBOs is the application of the ‘Business Judgment Rule,’ which originated in U.S. corporate law.

Significance of the Business Judgment Rule

The Business Judgment Rule is a principle that does not hold managers accountable even if their decisions result in damage to the company, as long as they made decisions for the best interest of the company, diligently and prudently based on reasonably available information. This theory has developed from the consideration that business management inherently involves risk-taking, and judging solely based on results retrospectively could dampen entrepreneurial spirit.

Business Judgment Rule in Korean Precedents

While Korean precedents do not directly cite the term ‘Business Judgment Rule’ from U.S. law, the Supreme Court importantly considered the concept of ‘management judgment’ when judging the intent of breach of trust in the Onse Telecom case (Supreme Court Decision 2012Do9148, March 12, 2015).

The Supreme Court stated, “Business management inherently involves risk, and losses may occur even if a manager makes decisions carefully and in good faith without intent to gain personal benefit. Applying relaxed interpretation standards for intent and imposing criminal liability for occupational breach of trust in such cases would violate the principle of nulla poena sine lege and risk dampening corporate economic activities.”

Therefore, “The intent of breach of trust should only be recognized when, in light of all circumstances such as the circumstances and motives that led to the management decision, the content of the business, the economic situation of the company, the probability of loss and the probability of profit, it is recognized as an intentional act with awareness (including potential awareness) of gaining property benefits for oneself or a third party and causing damage to the principal.”

6. Conclusion: Legal Risk Management Strategies for LBO

The following are strategies to minimize the risk of breach of trust in LBO transactions:

1. Providing Reasonable Consideration to the Target Company

Particularly important in collateral-provision type LBOs is for the target company to receive appropriate consideration corresponding to the risk of providing collateral. In the Shinhan case, the Supreme Court recognized breach of trust for collateral provision actions without consideration to the target company. Therefore, the following measures can be considered:

– Using part of the acquisition funds for capital enhancement or debt repayment of the target company
– Paying appropriate fees (commissions) for collateral provision
– Preparing management improvement measures such as enhancing the credit rating of the target company

2. Compliance with Legal Procedures

It is important to strictly adhere to procedures specified in the Commercial Act in LBO transactions:

– In merger-type LBOs, ensuring the appropriateness of the merger ratio and complying with shareholder and creditor protection procedures
– In asset extraction-type LBOs, meeting the legal requirements for paid-in capital reduction or dividend distribution
– Adhering to necessary decision-making procedures such as board approval and shareholders’ meeting resolutions
– Complying with regulations on directors’ self-dealing (Article 398 of the Commercial Act)

3. Establishing Transparent Decision-Making Processes

Transparency and prudence in the decision-making process are important for the application of the business judgment rule:

– Seeking opinions from independent external experts (accountants, lawyers, financial advisors, etc.)
– Review and approval by disinterested outside directors
– Maintaining detailed records of the decision-making process and rationale
– Reviewing and documenting the economic rationality of the transaction

4. Avoiding Pursuit of Personal Interests

It is important to clearly establish that the purpose of the LBO transaction is to enhance corporate value rather than to appropriate the target company’s assets, and to prepare evidence that there was no intent to pursue personal interests:

– Establishing and implementing post-acquisition management improvement plans
– Detailing post-merger integration (PMI) plans
– Establishing mechanisms to prevent conflicts of interest between the acquirer and management
– Ensuring the rationality of investment recovery plans

Conclusion

While LBO is an important M&A technique that enables acquirers with insufficient financial resources to undertake large-scale corporate acquisitions, it carries the risk of imposing excessive debt burdens on the target company. Therefore, legal review to minimize the risk of breach of trust is essential when structuring LBO transactions.

Court precedents judge the establishment of breach of trust differently according to the type of LBO, applying strict criteria particularly to collateral-provision type LBOs. On the other hand, they tend to deny the establishment of breach of trust for merger-type and asset extraction-type LBOs when they comply with procedures under the Commercial Act.

Additionally, recent precedents apply strict criteria to the judgment of breach of trust intent considering the specificity of management judgment, so when planning LBO transactions, it is important to secure the economic rationality of the transaction and the transparency of the decision-making process.