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When shareholders learn that a director is about to enter into a transaction that would cause the company serious harm, they usually think first of claiming damages after the transaction is done. However, the Commercial Act (상법) also provides a means of stopping the act itself before any harm occurs: the right to demand that a director cease an unlawful act (위법행위 유지청구권).

This article explains what this right is, what requirements must be met to exercise it, and what needs to be prepared alongside it when it is actually exercised.

[Contents]

1. A Right to Stop Harm Before It Happens

2. The Act Must Violate the Law or the Articles of Incorporation

3. A Risk of Irreparable Harm

4. Who Can Make the Demand, and With What Shareholding

5. How to Make the Demand, and What If the Act Has Already Been Carried Out

A Right to Stop Harm Before It Happens

Article 402 of the Commercial Act provides that 'where a director commits an act in violation of any Act or the articles of incorporation and this is likely to cause irreparable damage to the company, the auditor or a shareholder holding shares representing at least one hundredth of the total number of issued shares may, on behalf of the company, demand that the director cease that act.' Here, 'cease' (유지, 留止) means to stop an act that is about to be carried out.

Once a director's misconduct has caused the company harm, the director can be held liable for damages (Article 399(1) of the Commercial Act). However, damages are an after-the-fact remedy that makes up for harm already done with money, and if the director lacks sufficient assets to pay or the transferred assets are hard to recover, actual recovery is limited. The demand to cease is called a preventive remedy because it stops the act itself before such a result occurs.

The Act Must Violate the Law or the Articles of Incorporation

The first requirement is that the director's act must violate the law or the articles of incorporation. It is not enough that the terms of a transaction look unfavourable or that a business decision seems wrong; you must be able to point specifically to which statute or provision of the articles the act contravenes.

A typical example is a self-dealing transaction made without board approval. Article 398 of the Commercial Act provides that where a director or major shareholder, his or her spouse or lineal ascendants and descendants, or a company in which such persons hold 50% or more of the total issued voting shares, among others, wishes to transact with the company, the material facts of the transaction must first be disclosed to the board of directors and approved by at least two thirds of the directors, and the terms and procedure of the transaction must be fair.

In a case like the example given in the video, where the company's core real estate is to be transferred to a related party at a price far below market value, the starting points are whether the counterparty falls within the persons covered by Article 398, whether board approval was obtained, and whether the terms of the transaction are fair. The Commercial Act also provides that directors must faithfully perform their duties for the company and its shareholders in accordance with the law and the articles of incorporation (Article 382-3(1)), so a transaction that is markedly unfavourable to the company also raises an issue in relation to this duty.

A Risk of Irreparable Harm

The second requirement is that the act must be likely to cause 'irreparable damage' to the company. This refers to cases where it would be difficult to restore the original position even if monetary compensation were received after the harm occurred.

The video gave the following examples.

• Where the company's core real estate or technology assets are to be transferred to a related party at a price far below market value

• Where, once the contract is carried out, ownership passes to a third party and it becomes practically impossible to recover it

There is also a legal reason why assets become harder to recover once they pass to a third party. The Supreme Court held that a self-dealing transaction made without board approval is void as between the company and the director, but that for the company to assert that invalidity against a third party, it must prove that the third party knew of the lack of board approval or was grossly negligent in not knowing of it (Supreme Court Decision 2003Da64688, March 25, 2004). This means that once assets have passed to a third party unaware of the circumstances, the mere fact that the transaction was unlawful may not be enough to recover them.

In the end, the director's act in violation of the law or the articles, the risk of irreparable damage, and the shareholding requirement discussed next must all be met. The 1% shareholding and the irreparable damage that the video described as 'two requirements' both presuppose an act by the director that violates the law or the articles of incorporation.

Who Can Make the Demand, and With What Shareholding

The demand to cease may be made by the auditor or by a shareholder holding 1% or more of the total issued shares. Even if a single shareholder falls short of 1%, several shareholders may consider combining their holdings and exercising the right jointly.

Listed companies are subject to a special rule. A shareholder who has continuously held at least 50/100,000 (0.05%) of the total issued shares for six months may exercise the right, and for listed companies prescribed by Presidential Decree (those with capital of KRW 100 billion or more at the end of the latest business year) the threshold is lower still at 25/100,000 (0.025%) (Article 542-6(5)). Because this special rule does not affect exercise under the general provision (paragraph (10) of the same Article), a shareholder holding 1% or more may make the demand under the general provision even if the six-month holding period has not been met.

It should also be remembered that this demand is exercised not for the shareholder's own benefit but 'on behalf of the company.' This distinguishes it from the right to demand cessation of a new share issuance. Article 424 of the Commercial Act provides that where a company issues shares in violation of the law or the articles of incorporation, or by a markedly unfair method, and a shareholder is likely to suffer a disadvantage, that shareholder may demand that the company stop the issuance. The demand to stop a new share issuance is made against the company by the disadvantaged shareholder personally, so there is no shareholding threshold, whereas the demand that a director cease an unlawful act is made against the director on behalf of the company, so the 1% requirement applies.

How to Make the Demand, and What If the Act Has Already Been Carried Out

The Commercial Act does not prescribe a particular method for making the demand. It may be made directly to the director in writing or otherwise, or by filing a lawsuit with the court.

However, if the director goes ahead with the act despite receiving the demand, the demand alone cannot stop it. Where the transaction is imminent, applying to the court for a provisional injunction prohibiting the director's act should be considered as well. The Civil Execution Act (민사집행법) provides that, regarding a disputed legal relationship, a provisional disposition determining a temporary status may be granted where necessary to avoid substantial harm or to prevent imminent danger (Article 300(2)). In that case, materials are needed to make a prima facie showing of the violation of the law or the articles and of the risk of irreparable damage.

If the act has already been carried out and harm has occurred, it cannot be undone by a demand to cease, and the matter moves to holding the director liable for damages. A director who, intentionally or negligently, violates the law or the articles of incorporation is liable to compensate the company for the damage (Article 399(1)). If the company does not pursue that liability, a shareholder holding 1% or more may demand in writing, stating the reasons, that the company file suit, and if the company does not file suit within 30 days, the shareholder may bring a derivative suit directly on behalf of the company (Article 403).

In short, the demand to cease concerns not 'how to obtain compensation after harm occurs' but 'how to prevent harm before it occurs.' The starting point is to confirm, before the director's act is carried out, which statute or provision of the articles the act contravenes, what would be difficult to undo once it is carried out, and whether the shareholding needed to make the demand is in place.

Cheongchul Law Firm directly handles corporate law matters, including the exercise of minority shareholder rights, actions to hold directors liable and derivative suits, and management control disputes. If an unlawful transaction by a director is imminent, please contact us through our consultation booking page.

This post is intended to provide legal information and does not constitute legal advice on any specific matter. Conclusions may differ depending on the facts of each case, so please consult a professional.