Justice Ministry Leads Bill Encouraging Foreign Speculative Capital’s “Eat-and-Run” Tactics

Multiple Derivative Suits and Separate Election of Audit Committee Members on the Verge of Passing the National Assembly

Obsessed with Making Bills That Stifle Rather Than Support Business Activity

Last month, the National Assembly and the Ministry of Justice poured out partial amendments to the Commercial Act. In particular, two major provisions in the Ministry of Justice’s advance legislative notice for the Revised Commercial Act—the multiple derivative suit system and the separate election of audit committee members—have also been reflected in bills proposed by the ruling party in the National Assembly, making their passage highly likely. Major business organizations, including the Federation of Korean Industries (FKI), the Korea Employers Federation (KEF), the Korea Federation of SMEs, the Korea Federation of Middle Market Enterprises, the Korea Listed Companies Association, and the KOSDAQ Listed Companies Association, all oppose these Ministry of Justice proposals. The Korea Chamber of Commerce and Industry (KCCI) also opposes the separate election of audit committee members and has suggested a revised position on multiple derivative suits, proposing that they apply only to parent companies owning more than 99% of a subsidiary’s shares.

The multiple derivative suit system would allow not only minority shareholders of a company, who may currently file a derivative suit on behalf of the company against directors or other officers, but also minority shareholders of a parent company holding more than 50% of a subsidiary’s shares to bring such suits. For example, a shareholder owning 1% of the parent company’s shares could directly sue a director of the subsidiary for damages caused to the subsidiary by neglect of duty. At present, only shareholders of the subsidiary may bring such suits. Shareholders of the parent company may only file a derivative suit against directors or officers of the parent company for damages to the parent company arising from the parent company’s failure, as a shareholder of the subsidiary, to adequately pursue such legal action.

Originally, the derivative suit system was intended to recover damages suffered by the company. It is therefore a management oversight mechanism permitted only to minority shareholders of that company when the company itself neglects to pursue recovery. Accordingly, even in the United States and Japan, where parent company shareholders are granted such standing, it is allowed only as an exception for shareholders of wholly owned parent companies—companies owning 100% of a subsidiary’s shares—or fully controlling parent companies, where derivative suits by the subsidiary’s own shareholders cannot be expected.

If, as in the Ministry of Justice’s proposal, minority shareholders of a parent company owning more than 50% of a subsidiary are granted standing to bring derivative suits against officers of the subsidiary, it would open the door for domestic and foreign speculative funds interested only in short-term profits to become minority shareholders of parent companies and abuse that right against officers of numerous subsidiaries. Even if the subsidiary’s own minority shareholders do not want such action, these investors could use derivative suits as a pretext to demand large dividends from the subsidiary or pressure it over the appointment of directors, thereby undermining the subsidiary’s management and ultimately harming the subsidiary’s shareholders as well. This would run counter to the stated purpose of introducing the multiple derivative suit system—to fill gaps in oversight of subsidiary management.

Currently, large listed companies with total assets of 2 trillion won or more are required to adopt an audit committee system, under which at least three audit committee members are elected at the shareholders’ meeting, instead of the traditional auditor system. Since audit committee members are chosen from among the directors, directors are first elected by majority vote at the shareholders’ meeting without restrictions on voting rights, and then audit committee members are selected from among those elected directors under voting restrictions. In this process, the largest shareholder and its specially related persons may not exercise voting rights for shares exceeding 3% when electing an audit committee member who is not an outside director, and all shareholders may not exercise voting rights for shares exceeding 3% when electing an audit committee member who is an outside director.

The separate election system for audit committee members aims to enhance their independence by electing, at the director election stage of the shareholders’ meeting, directors who will serve as audit committee members separately from other directors, thereby making the above 3% voting cap applicable from the initial election of directors.

The audit committee system was originally borrowed from the United States, but in the U.S., audit committee members are selected by the board of directors, so there is no room to restrict shareholders’ voting rights; the independence of auditing is secured instead through the outside director system and external audit arrangements. In Korea, not only must at least two-thirds of the audit committee consist of outside directors, with an outside director serving as chair, and a strengthened external audit system already in place, but there is also a rule—unprecedented internationally—limiting voting rights attached to shareholdings exceeding 3% when electing an auditor or audit committee member.

Even so, restricting voting rights attached to shares exceeding 3% from the very stage of electing directors who will serve on the audit committee infringes on the essence of shareholder rights, which is participation in corporate management based on majority capital rule, and violates the economic freedom of enterprise guaranteed by the Constitution. In particular, by creating institutional conditions under which foreign speculative capital, which can spread large sums of money across diversified investments, can easily elect directors who become audit committee members, the system risks being used to protect speculative capital’s interests and to leak corporate information, ultimately harming the company’s interests.

In addition, the Ministry of Justice’s amendment also includes relaxed requirements for exercising minority shareholder rights in listed companies. Currently, for listed companies, the exercise of various minority shareholder rights, including the right to bring derivative suits, requires not only ownership of a certain percentage of shares but also continuous holding of those shares for six months. The proposal would allow shareholders to exercise minority shareholder rights without the six-month holding requirement, so long as they meet the shareholding ratio required for unlisted companies.

The Ministry of Justice and ruling party’s proposed amendments to the Commercial Act present themselves as measures to protect minority shareholder rights in the name of improving corporate transparency. In reality, however, they will apply mainly to listed companies, and in the case of large listed companies, the shareholders capable of meeting the ownership thresholds for exercising minority shareholder rights will mostly be foreign speculative capital moving vast sums on a global scale. In the end, they will merely be used for the “eat-and-run” practices of foreign speculative capital disguised as minority shareholders.

The Commercial Act is meant to support business activity, not regulate businesses. For healthy business activity, it must ensure corporate transparency while, beyond that, supporting efficient and proactive corporate management. In particular, managerial decisions, including investment decisions, have the special characteristic that companies cannot survive fierce domestic and international competition unless they forecast an inherently unpredictable future, accept risks, and make proactive decisions.

Nevertheless, when those risks materialize and a company suffers losses or goes bankrupt, managers become targets of derivative suits seeking damages or criminal complaints for breach of trust. Moreover, because such litigation occurs only after enormous damage has already been done to the company, judges unfamiliar with management may develop hindsight bias, assuming that the manager must have neglected his duties. Under such circumstances, managers will become reluctant to pursue proactive, risk-taking management, and companies will find it harder to attract talented executives.

The United States long ago established the business judgment rule to protect managers. In determining whether a director neglected duties in making a business decision, the primary review is limited to procedural and subjective issues such as whether the director gathered sufficient information necessary for the decision and whether the decision was made lawfully and in good faith, without personal interest. Only when problems are found in this primary review does the court go on to examine the substance of the business judgment itself. This business judgment rule may be regarded as a global standard; in Germany, for example, it has been expressly codified in the Stock Corporation Act.

Yet while Korea’s Commercial Act has been modeled on U.S. and German legislation, it turns away from legislation like the business judgment rule that supports active and efficient corporate activity, and instead focuses only on legislation that weakens business vitality.

In particular, unlike in the United States, Korean executives face criminal breach of trust charges, and when a company goes bankrupt after a failed business judgment, executives are often criminally booked for breach of trust. In the end, there are many cases in which they are acquitted in all three levels of court, or even if convicted in a lower court, are later acquitted on appeal or by the Supreme Court. But even when an executive is ultimately acquitted, years of search and seizure, investigation, and litigation leave the company damaged and the executive suffering irreparable mental and economic harm.

The way to prevent such situations and support proactive and efficient management is to introduce the business judgment rule as an explicit statutory provision, as Germany has done. Yet the business judgment rule appears only in the Revised Commercial Act proposed by the opposition party, while the Ministry of Justice shows no interest in it. Under these circumstances, not only is it unrealistic to expect Korean companies overseas to return, but even expecting job creation or income growth through the prosperity of Korean companies at home is a remote prospect.

Seokhoon Han

Professor, Sungkyunkwan University Law School

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Original title: 법무부가 외국 투기자본 '먹튀 조장 법안' 주도하다니

Author: Seok-hun Han

Date: 2020-08-05

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=20&idx=22983