SOUTH KOREA
This article covers legal and regulatory aspects governing distressed mergers and acquisitions (“M&A”) and corporate restructuring in South Korea.
Contributed by
Yoon & Yang LLC
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Due to the outbreak of the novel coronavirus (“COVID-19”), there has been a decline in consumer confidence and global trade, which has hampered the performance of companies worldwide. Korea is no exception. However, during the first half of 2020, there has been an unprecedented surge in activity in the restructuring and distressed M&A market in Korea which has gone largely unnoticed following the Korean government’s implementation of an emergency corporate finance policy, the finance industry’s extension of maturity dates for loans and pre-emptive asset sales by companies. Nevertheless, a record number of 522 companies filed for bankruptcy in the first half of this year, according to the National Court Administration.
As COVID-19 continues to spread, companies are expected to steadily file for bankruptcy beginning in the second half of this year. Banks regularly conduct credit risk assessments on companies they work with (between August and November for 2020), and the performance reports for the first quarter and the first half of 2020 are expected to reflect the net operating losses incurred by businesses due to COVID-19.
Credit risk assessments classify companies into the following categories: (i) companies operating normally (Grade A), (ii) companies with a high likelihood of showing signs of insolvency (Grade B) (iii), and companies with signs of insolvency (Grade C & D)[1]. For Grade B companies, maturity dates for loans may be extended and new financing may be provided. Distressed companies with Grades C or D, however, must undergo restructuring through either out-of-court workouts or debtor rehabilitation proceedings. If companies with signs of insolvency fail to take such steps, then the principal creditor bank[2] for such companies must take action under the direction of the Financial Services Commission.
With the expectation that the corporate restructuring market will be active beginning in the second half of this year due to COVID-19, this article will provide an overview of corporate restructuring in Korea and discuss potential M&A options available to companies subject to restructuring.
2. Overview of Corporate Restructuring in Korea
Corporate restructuring in Korea is largely divided into public and private restructuring: (i) for public restructurings, the Debtor Rehabilitation and Bankruptcy Act (“DRBA”) sets forth the applicable rehabilitation procedures, and (ii) for private restructurings, the CRPA sets forth the applicable joint management procedures (“workouts”).
Alternatively, financial creditors may enter into voluntary agreements for the restructuring of debtors. However, this article will not address such restructuring option because these are voluntary agreements that will vary depending on the agreement of the parties involved. In general, private restructuring agreements under the CRPA apply mutatis mutandis to certain debt that is out-of-scope for voluntary agreements; however, workouts under the CRPA and workouts according to voluntary agreements do not differ considerably in terms of process and subject matter.
2.1. Rehabilitation Proceedings (Public Restructuring)
Debtor rehabilitation proceedings take place under the management and direction of the court in accordance with the DRBA.
Procedural Overview
1) A debtor may file an application for rehabilitation proceedings with the court when: (a) it cannot repay debt that becomes due without causing serious disruption to the continuation of its business, or (b) there is a danger that the debtor will become insolvent (e.g., excess debt).
2) Once the court commences rehabilitation proceedings, it appoints a receiver, and the receiver is granted exclusive authority to manage and dispose of the debtor’s assets. The court typically appoints an existing representative director of the debtor as the receiver (Debtor in Possession, DIP) unless such representative director is disqualified (e.g., is substantially responsible for the debtor’s financial distress because such person has: (a) misappropriated or embezzled assets of the debtor, or (b) breached fiduciary duties owed to the debtor).
3) Over the course of the rehabilitation proceeding, the court-appointed receiver manages the debtor’s business affairs under the supervision of the court.
4) The court approves a rehabilitation plan that modifies the rights of creditors and shareholders and sets out the liabilities that will remain the responsibility of the debtor.
5) If the court finds that the debtor can implement its rehabilitation plan without difficulty, the court may terminate the rehabilitation proceeding early, and the company will resume operating normally.
Key Features
- Laying the groundwork for rehabilitation through compulsory adjustments to debt (e.g., exemptions from certain liabilities as further explained below).
- Exemption from the enforcement of domestic and international claims arising from causes existing prior to the implementation of the rehabilitation plan (including, commercial and financial claims as well as claims for damages, collectively, “rehabilitation claims”). Employee wages and certain taxes, which are considered priority claims under the DRBA, are excluded and are payable as they become due.
- Payment of secured rehabilitation claims according to the rehabilitation plan, which modifies the rights of creditors (e.g., partial cash repayment, partial debt to equity conversion, and exemption of the remainder). The approved rehabilitation plan also establishes the manner of repayment (e.g., cash repayments in annual installments within ten (10) years). The rehabilitation claims that are not filed within the designated period will be cancelled (exempted).
- The decision to approve the rehabilitation plan requires the consent of no less than: (a) three fourths (3/4) of the total claim amount for creditors with secured rehabilitation claims, (b) two thirds (2/3) of the total claim amount of creditors with rehabilitation claims generally, and (c) half (1/2) of the total voting rights of the shareholders/equityholders (except the consent of the shareholders/equityholders is not required if the total amount of liabilities exceed the total amount of assets at the commencement of rehabilitation proceedings).
Advantages
- Rehabilitation proceedings significantly reduce the financial burden of the debtor by adjusting all indebtedness (including commercial claims), while out-of-court workouts are limited to financial claims.
- Where the structure of claims or contractual liabilities is complex and varied, the contingencies that may arise from toxic contracts may be eliminated in the rehabilitation proceedings.
Disadvantages
- As the essence of restructuring proceedings is debt adjustment, it does not provide additional funding to the distressed company.
- International credibility may be undermined due to the stigma attached to “bankruptcy,” which may result in employee departures and the termination of business relationships when rehabilitation proceedings commence.
2.2. Out-of-Court Workouts (Private Restructuring)
A private restructuring is a corporate restructuring led by financial creditors pursuant to restructuring agreement amongst the financial creditors and the debtor.
Procedural Overview
1) When a bank’s credit risk assessment indicates that a company has signs of insolvency (experiencing difficulties meeting its debt obligations in the normal course of business, i.e., inability to repay loans to creditors without additional cash inflow; Grade C or below in the credit risk assessment), a notice of such assessment is sent to the company (“distressed company”).
2) The distressed company applies for a workout plan with the principal creditor bank (within three (3) months from the date the notice is sent to the distressed company), and the principal creditor bank sends notice calling for a meeting of the financial creditors who have extended credit to the distressed company (“Council,” and each member of the Council, a “financial creditor”) within fourteen (14) days of such application.
3) Each financial creditor files its claims[3] with the Council within five (5) days from the date of the notice calling for a meeting of the Council.
4) The Council decides in favor of the workout plan by the consent of financial creditors representing no less than three fourths (3/4) of the amount of the filed claims (“collective amount of claims”). (Requirements for decisions of the Council are discussed below.)
5) Upon conclusion of diligence on the assets and liabilities of the distressed company, the Council approves a restructuring agreement. Within one (1) month from the date of the Council’s decision in favor of the workout plan, the Council and the distressed company enter into a restructuring agreement.
6) The workout plan commences upon an agreement to perform the restructuring agreement (debt adjustment, new extensions of credit, self-rehabilitation plan, etc.).
7) The workout plan may be terminated by the Council’s decision upon the determination that (a) the company is no longer bearing signs of insolvency, (b) the terms of the restructuring agreement have been fulfilled, or (c) an event of termination provided under the restructuring agreement has occurred. If a court orders rehabilitation proceedings or commences bankruptcy proceedings on a company in workout, the workout plan is suspended and the proceedings under the DRBA commence.
Key Features
- Improvement in the capital structure of the debtor by making adjustments to debt (such as debt to equity conversion); and the provision of new funds to normalize operations.
- Typically, the Council defers the repayment of the principal balance of existing loans, adjusts interest rates, or may convert debt into equity where necessary. In addition, it is customary for the Council to provide financial support by either providing new funds or extending the maturity period for existing debt.
- In general, a decision of the Council can be made with the consent of no less than three fourths of the collective amount of claims, which encourages swift restructuring.
Advantages
- A flexible and swift restructuring process can be undertaken by agreement amongst the creditors.
- If a distressed company secures liquidity by obtaining new funds from creditors, it may maintain stable business operations.
Disadvantages
- The claims adjusted in out-of-court workouts are limited to financial claims.
- There may be conflicting interests amongst the financial creditors that are difficult to reconcile.
3. M&A for Companies in Rehabilitation
M&A activity for companies in rehabilitation proceedings commences upon the approval of the rehabilitation plan. As the acquisition price is typically used to pay the applicable rehabilitation claims under the rehabilitation plan in lump sum, M&A is a useful means for companies in rehabilitation proceedings to repay the balance of its rehabilitation claims and quickly achieve rehabilitation.
Furthermore, the acquirer is not burdened by additional contingent liabilities as it acquires the target company after the company’s existing liabilities have been extinguished.
3.1. Overview of Timing and Procedure for M&A of Companies in Rehabilitation
This type of M&A can be largely classified into: (i) M&A before the approval of the rehabilitation plan but after the commencement of the rehabilitation proceedings, and (ii) M&A after the approval of the rehabilitation plan.
In the former case, the proposed M&A activity is included in the overall rehabilitation plan, which is then approved by the court and carried out accordingly (DRBA, Articles 55(1) and 200).
In the latter case, the company in rehabilitation expects to fulfill its rehabilitation plan when the rehabilitation plan was approved, but it experiences difficulties and resorts to M&A. In this scenario, M&A activity commences upon the court’s approval of a modified rehabilitation plan that includes the debtor’s plans for M&A activity.
3.2. Recent Practices in Bankruptcy Court
The number of early terminations of rehabilitation proceedings have increased as courts have become aware that helping debtors escape the stigma of bankruptcy and its related disadvantages under the Korean financial system (e.g., impact on credit rating and limitations on new loans) assists debtors with their financial recovery. Since 2011, the Seoul Bankruptcy Court has been increasingly utilizing early termination[4] as its default model (so-called Fast-Track model), and therefore, M&A activity after approval of the rehabilitation plan has dramatically declined.
It is not uncommon for debtors in the Seoul Bankruptcy Court to commence M&A within the timeframe for approval of a draft rehabilitation plan (within one year from the date of commencement for rehabilitation proceedings, up to a maximum of eighteen months). As a result, there have been an increasing number of cases where the court approves a draft rehabilitation plan that contemplates that early M&A activity will commence when an appropriate candidate for acquisition surfaces, debtor would be sold to the appropriate third party acquirer, and the proceeds would be distributed to the creditors.
3.3. Notes of Caution for Current Practice Trends
As the Seoul Bankruptcy Court increasingly promotes M&A activity for distressed companies before approval of the rehabilitation plan as well as early rehabilitation, many distressed M&A transactions have closed prior to the resolution of disputes between the debtor and the creditors regarding the nature and/or amount of claims.
While the rehabilitation claims are repaid as provided in the rehabilitation plan such as “partial modification (reduction) of rights, partial debt to equity conversion (including consolidation or retirement of shares after conversion), and exemption of the remainder,” priority claims as defined under Article 179 of the DRBA and other regulations must be repaid in full, including claims arising from the costs incurred from the rehabilitation proceedings and from causes after the commencement of the rehabilitation proceedings. Priority claims must be repaid and this does not change even if they are classified as rehabilitation claims under the rehabilitation plan. The full amount of priority claims may be demanded even if they are omitted from the rehabilitation plan or described as rehabilitation claims (Supreme Court, 2004Da3512, 2529 decision rendered on Aug. 20, 2004).
Accordingly, the acquirer must pay attention to the classification of the claims during due diligence and consider the potential for contingent liabilities arising from claims that are later found to be priority claims.
4. M&A for Companies in Workout
In a typical workout program, M&A activity is approved by a decision of the Council and led by the principal creditor bank. When M&A activity is approved by the Council, the principal creditor bank is entrusted by the Council to carry out certain key functions such as appointing advisors and receiving letters of intent to acquire the distressed company.
4.1. Overview of M&A Procedure for Companies in Workout
M&A activity for companies in workout begins with a discussion of the appointment of advisor as well as the purpose, scope, and timeline for the contemplated M&A activity. It proceeds with due diligence of the target company, establishment of the sale strategy, and the drafting of the Information Memorandum (IM) for the target company. In addition, the characteristics of potential investors should be classified based on the needs of the interested parties (shareholders, target company, and creditors), and a search for investors should commence. This is followed by receipt and assessment of the letters of intent for the proposed acquisition, and responses must be provided to preliminary due diligence requests of potential acquirers. Ultimately, a preferred bidder must be selected, responses must be provided to the preferred bidder’s detailed due diligence requests, and the terms and conditions of the agreement must be negotiated and executed.
In the meantime, debt to equity conversion for pre-M&A creditors takes place in order to either improve the capital structure of the distressed company or to help facilitate the M&A transaction. The shares thus issued by converting debt to equity can be acquired as is by the acquirer or used to assist the acquirer in stabilizing and managing the distressed company through a reduction of the number of shares through a consolidation of shares or retirement of shares, in each case without refund to shareholders, before the acquisition. A distressed company that improves its capital structure with a debt to equity conversion for its creditors then secures liquidity with the acquirer’s investment capital and sets the groundwork for returning to normal business operations.
4.2. M&A Through Acquisition of Stock in Debt to Equity Conversions
M&A for a company in workout can be conducted by purchasing the stocks converted from debt to equity beneficially owned by the creditors of such company. For this type of M&A activity, the “Guide for the Management and Sale of Capital Stock Acquired by the Creditor Financial Institutions by way of Debt-to-Equity Swap” (“KFB Guide”) drafted by the Korea Federation of Banks may be referenced.[5]
According to the KFB Guide: (i) the shareholders of the stocks from debt to equity conversions form the “Council on the Sale of Stock by the Creditor Financial Institutions” in order to promote the joint sale of such converted equity interests (a separate “Shareholders Council” may be formed as well, provided that the Council jointly administers the sale for companies in workout (KFB Guide, Articles 5, 6); (ii) the default method of sale is a competitive bidding process through the advisor with public notice (Article 8(1)); (iii) joint sale by the creditors is preferred over individual sales in order to maximize the value of the sale (Article 8(2)); (iv) the sale and disposal of the converted equity interests owned by the creditors may be restricted or jointly managed until the sale is completed to facilitate an efficient sale process (Article 8(3)); (v) when selecting the preferred bidder, the purchase price must be given the highest consideration, and preference may be given to strategic investors over financial investors (Article 10); and (vi) for the determination of the purchase price, the value of the target company (intrinsic value as well as earnings value, and the stock price for a listed company) must be considered while factoring in control premiums and capital gains (Article 11).
This method can be used when the acquisition of converted equity interests beneficially owned by creditors would result in a change-of-control in management.
4.3. M&A Through Third-Party Capital Increase
As in a typical M&A, a company in workout can also utilize the M&A through issuance of new equity interests to a third party. However, it is rare to proceed with the M&A transaction solely through a capital increase with issuances to a third party investor. The usual practice is to precede or accompany such capital increase with the reduction of the number of existing shares or a debt to equity conversion for the creditors in order to offer stability for the acquirer and enhance the company’s capital structure. Recently, there has been an increase in this type of M&A activity.
4.4. Notes of Caution for M&A of Companies in Workout
According to recent trends in the distressed M&A market, capital reduction of the number of existing shares, conversion of debt to equity for creditors, and third-party capital investments are expected to be frequently utilized in combination. However, this type of M&A activity requires the support and cooperation of the target company’s existing major shareholders and creditors.
In particular, M&A for companies in workout is initiated by the decision of the Council, which necessitates cooperation among financial creditors and may present certain challenges given their competing interests. Therefore, an acquirer must collaborate with the principal creditor bank to present acquisition terms that can satisfy all of the creditors involved.
Acquirers pursuing distressed M&A in Korea are well advised to review the applicable restructuring processes and procedures, and to identify their respective advantages and disadvantages prior to formulating an acquisition strategy. For instance, court approval is required to consummate transactions involving targets in rehabilitation proceedings, and priority claims that are misclassified as rehabilitation claims may result in unexpected contingent liabilities. On the other hand, to consummate a transaction with a target company in workout requires the cooperation of the principal creditor bank and its other creditors, as well as the cooperation of its existing shareholders to effectuate a reduction in the number of outstanding shares, which may help align the interests of the shareholders and creditors of the target company.
In the second half of 2020, a significant number of companies are expected to become vulnerable due to external factors such as COVID-19. Because it is socially and economically preferable for companies to restructure instead of declaring bankruptcy, more corporate restructuring and distressed M&A transactions are anticipated where all interested parties including the acquirer, creditors, and existing shareholders of a distressed company can all be content.
[1] Companies that, according to their credit risk assessments by their principal creditor banks, are experiencing difficulties meeting their repayment obligations in the normal course of business, i.e., repayment of loans to creditors, without additional cash inflow from outside sources in addition to ordinary loans (Corporate Restructuring Promotion Act (“CRPA”), Article 2(7)).
[2] The principal creditor bank of the relevant company (or a bank that provided the greatest amount of credit in the absence of such principal creditor bank) (CRPA, Article 2(5)).
[3] Includes all claims that can be exercised against a company with respect to any line of credit provided to the company or to a third party (CRPA, Article 2(1)).
[4] The DRBA leaves the door open for companies to rehabilitate and return to normal operations by allowing the court to terminate the restructuring plan early, even before full repayment of its debts under its rehabilitation plan in the event that repayments commence and the court finds that the company would have no difficulty carrying out the rehabilitation plan (DRBA, Article 283(1)). This is typically called “early termination (Seoul Bankruptcy Court Practice Guide No. 251).”
[5] The Guide was drafted by the Korea Federation of Banks for the transparent sale of stocks acquired by creditors in a debt to equity conversion during corporate restructuring, and it requires that such stocks jointly sold.
Authors:
Partner, Yoon & Yang LLC
Sangman Kim is a partner at Yoon & Yang specializes in M&A, private equity, joint ventures establishment, domestic and foreign investment, workout, and corporate restructuring such as bankruptcy and rehabilitation.
Sung Uk Park
Senior Foreign Attorney, Yoon & Yang LLC
Seoul, South Korea
T: +82 2 6182 8325
Sung Uk Park is a US qualified senior foreign attorney at Yoon & Yang, specializing in M&A, private equity, entertainment and leisure, foreign direct investment and international transactions.
S. Janet Lee
Foreign Attorney, Yoon & Yang LLC
Seoul, South Korea
T: +82 2 6182 8393
S. Janet Lee is a US qualified foreign attorney at Yoon & Yang and her practice areas include global M&A, general corporate governance, private equity, joint ventures, takeover defense and securing stakeholder interests in contested situations.
Seong Ju Lee
Associate, Yoon & Yang LLC
Seoul, South Korea
T: +82 2 6182 8349
Seong Ju Lee is an associate attorney at Yoon & Yang, and his practice areas include corporate restructuring, workout, bankruptcy, M&A, corporate law and financial regulations and compliance.