Hello. This is attorney Shin Jun-seon from the Law Firm Cheongchul.

In M&A practice, with the increase in corporate acquisitions using the LBO (Leveraged Buy-Out), cases have emerged where issues of whether a breach of trust crime has been established arise during the process of borrowing funds for acquisition by providing the assets of the target company as collateral. Recently, in a case of a merger using the LBO method, the CEO of the target company was sentenced to prison for breach of trust (HiMart), and the party involved became a topic of great interest as he fled the country at that time. Thus, while LBO has the advantage of enabling large scale acquisitions with little capital, special caution is needed as the occurring process of providing the target company’s assets as collateral raises issues regarding the establishment of breach of trust crimes by directors.

[Question]

Does a breach of trust crime occur when acquiring a company using the LBO method?

[Answer]

1. Concept of LBO

LBO is an M&A technique for raising acquisition funds by directly or indirectly collateralizing the assets of the target company. Major types include methods where the acquirer provides and borrows against the assets of the target company, and merger methods by establishing a special purpose corporation (SPC) to borrow before merging with the target company. In the latter case, unless the financial situation of the acquiring company is not poor compared to the former, the establishment of business breach of trust is trending towards being denied.

2. Flow of major precedents related to LBO

By examining the representative cases where business breach of trust due to LBO was an issue, we can identify the main criteria used in case law.

(1)   The acquisition case of Hanil Polyester by Dongyang Major (Supreme Court 2009Do6634)

• Established a special purpose corporation (SPC) to raise borrowed funds and then acquired Hanil Polyester

• After merging SPC and Hanil Polyester into Dongyang Major, paid back the borrowed funds using Hanil Polyester's cash

• Court’s judgment and criteria: Not guilty, as it was judged that the acquirer’s economic capacity was sufficient and did not cause substantial harm to the target company; however, if the acquirer’s financial structure is poor and unilateral asset depletion is clearly anticipated, it can be considered to be breach of trust (among the reasons for the first instance judgment).

• 
  

(2)   The 2012 Onse Telecommunications acquisition case (Supreme Court 2012Do9148)

• Provided the target company’s assets as collateral to secure acquisition funding

• Court's judgment and criteria: Not guilty, as the acquirer contributed a significant portion of its own funds and when the acquirer fully acquired the target's shares, the economic interests aligned, meaning that the target company's loss would soon become the acquirer's loss. Later, it's worth noting that the target company’s financial structure actually improved.

• In determining the intent of breach of trust, the risks of business management decisions of the enterprise must be interpreted strictly, and merely because a loss occurred does not impose liability (Supreme Court 2004. 7. 22. Judgment 2002Do4229).

• 
  

(3)   The HiMart acquisition case (Supreme Court 2016Do10654)

• A Hong Kong private equity fund acquired HiMart through SPC (HiMart Holdings)

• Provided HiMart’s assets as collateral to secure acquisition funding

• Court's judgement and criteria: Guilty (confirmed 5-year sentence); when the acquirer borrows money from financial institutions and provides the funds of the target company as collateral, the target company bears the risk of losing collateral, so the acquirer is only allowed to provide corresponding compensation for the burden (Supreme Court 2015. 4. 23. Judgment 2014Do17703). If the SPC cannot repay the loan, HiMart bears the risk of asset loss and there is a lack of compensation for that burden.

3. Factors denying the establishment of breach of trust

From the flow of precedents, including the above cases, it is highly probable that breach of trust will not be established in LBOs when the following factors are present.

(1) Appropriate borrowing ratios and economic capacity

• Some lower courts assessed that the funds separately contributed by the acquirer accounted for 46% of the total acquisition price, evaluating it as a 'significant percentage' and denying the establishment of breach of trust {Seoul High Court 2012. 7. 5. Judgment 2012No268 (appeal dismissed)}

• Considering the acquirer's economic capacity, it was determined that no damage was inflicted on the target company" (Dongyang Major case)

• 
  

(2) Possibility of enhancing corporate value

• "Notably, the financial structure of the target company can improve" (Onse Telecommunications case)

  
  

(3) Rationality of management judgment

• "Make careful decisions with the belief that they align with the company’s interests" (Onse Telecommunications case)

  
  

(4) Appropriate compensation

• "Will not provide company assets as collateral arbitrarily without any compensation" (HiMart case)

Moreover, practically, complying with internal procedures such as board resolutions regarding collateral provision can act as a factor negating the establishment of breach of trust, and whether substantial damage occurred can also be a contentious issue.

4. Actual working case examples

In the cases Shin Jun-seon represented, he claimed and proved the following circumstances to the investigative agency, resulting in a non-prosecution decision regarding the collateral provision actions taken during the LBO acquisition process.

• Only about 25% of the total acquisition price was borrowed through collateral provision

• Both the acquiring company and the target company proceeded with collateral provision after board resolutions

• A personal joint guarantee by the CEO of the acquiring company was additionally provided for the borrowed funds

• The provision of collateral was temporary and later revoked, meaning no substantial damage occurred

• The collateral provision was inevitably made according to the financial institution’s requirements

• The actions taken by the parties at that time were conducted according to reasonable business management judgment

5. Implications

Based on the above analysis of case law and practical experiences, to avoid the establishment of breach of trust in LBO style acquisitions, the following matters must be thoroughly examined.

(1)   Review of the appropriateness of borrowed money and collateral

• The borrowing ratio through collateral provision should not be excessive in relation to the total acquisition price

• Confirm whether the acquirer’s financial status and payment ability are sufficient

• The necessity and inevitability of collateral provision should be recognized

  
  

(2)   Ensuring appropriate compensation

• Design compensation in correspondence to the risks borne by the target company

• Detail the plans for improving the financial structure of the target company

• Prepare plans for enhancing corporate value, such as synergy effects

  
  

(3)   Ensuring procedural legality

• Comply with internal decision-making procedures like board resolutions

• Secure prior consent from major shareholders

• Document the discussions with financial institutions

  
  

(4)   Establish specific management plans

• Examine the specificity and feasibility of the repayment plan for the borrowed funds

• Formulate specific measures to prevent any loss to the target company

• Establish concrete plans for the operation of the company post-acquisition

As described above, while LBO style corporate acquisitions are not inherently illegal, the process of providing the target company’s assets as collateral can raise issues regarding the breach of trust liability of directors. Especially recent cases like HiMart show that courts are applying strict standards for collateral provision for the assets of the target company, so meticulous attention is necessary from the transaction structure design phase.

In actual working cases, the emphasis on the fact that the borrowing ratio was low compared to the total acquisition price and inclusion of a joint guarantee by the CEO of the acquiring company resulted in a non-prosecution decision regarding business breach of trust for leveraged buy-outs.

Companies or executives reviewing LBO transactions must design a legal transaction structure that satisfies the above judgment criteria in advance to prepare for potential criminal liability.

Attorney Shin Jun-seon has extensive advisory and litigation experience in various corporate criminal cases, so please feel free to contact us if you need legal advice on this matter.

The Law Firm Cheongchul consists of attorneys from the corporate legal teams of leading law firms in Korea, such as Kim & Chang, Gleam, Pacific, Sejong, and Yulchon, and attorneys specialized in relevant fields will form a team to respond, rather than just one attorney. Cheongchul provides legal consulting that goes beyond solving specific issues to offer comprehensive solutions for the overall business, ultimately aiming to achieve what the client desires. If you need assistance in achieving your goals, do not hesitate to contact Cheongchul.