The leveraged buyouts are not always legal

An all-Korean transaction using the leveraged buyout method was declared illegal, in some instances, by the Supreme Court on Nov. 9. Although such transactions are fairly common around the globe, in Korea they are rare. The recent ruling did not outright ban LBOs, and needs to be understood in the broader context of LBO transactions.

LBOs are takeovers of another company with funds borrowed using the acquiring - or quite often acquired - company's assets as collateral. In the United States and Japan, many takeover cases have been reported using the LBO method of funding. The method has added advantages in that it increases financial returns and it has tax advantages. Sometimes the debt is repaid from the acquired company's cash flow or by selling off its assets.

However, an LBO transaction which took place in mid-2001 presented a tricky issue to Korean courts in a criminal case where the CEO of the acquiring company, who had became the CEO of the acquired company after the acquisition, was indicted for misappropriation of the target's assets for the benefit of the acquiring company. Although the defendant was acquitted by an appeals court, the Supreme Court reviewed the case more closely and subsequently returned the case to an appeals court for further review.

To sum up the facts, the defendant, the CEO of the acquiring company, had borrowed 35 billion won ($30 million) to acquire the target company, which was under court reorganization proceedings. At first, he used new shares issued by the acquired company as collateral but, immediately after being appointed as CEO of the acquired company, he replaced the secured assets with real property owned by the acquired company. The defendant also borrowed another 32 billion won using the acquiring company's accounts receivables as collateral, but again replaced that with a deposit in a bank account of the target.

First of all, the Supreme Court noted that collateralizing the acquired company's assets in an LBO situation would expose the target to a real risk of loss if the principal debtor, i.e., the acquirer, did not repay the borrowed money to the banks and that, as a result, it should not be permissible without limits unless "proper consideration" is given to the target in return for the risk borne by the target. Despite the defendant's argument that he used all the borrowed money for the acquired company's restructuring - not for personal gain - the Court held that in the absence of balancing benefits provided to the acquired company, the defendant caused a significant risk to the acquired company and benefited the acquiring company or himself in violation of his duty as director of the target.

On the one hand, the ruling is predictable since it appears in line with many precedents where directors have been found in breach of fiduciary duty when actual losses or the substantial risk of losses have been caused. On the other hand, the holding was declared under the specific pattern of facts that, as the Supreme Court pointed out, "proper consideration" for the risk to the acquired company was not given.

This case clearly shows that even a globally common M&A technique may be subject to unexpected legal issues in particular situations and needs to be carefully reviewed in light of the existing legal principles and precedents in the relevant jurisdiction.

Cho Chi-hyoung is a partner and an attorney-at-law at Hwang Mok Park P.C., one of Korea's leading law firms. HMP may be contacted at info@hmplaw.com or (02) 772-2700 - Ed.

By Cho Chi-hyoung