On November 11, 2021, the Supreme Court of Korea overruled the lower court’s decision that held a representative director not liable for failing to monitor and supervise the acts of a company’s officers and directors in a shareholder derivative lawsuit initiated against the representative director for damages suffered resulting from the Korean Fair Trade Commission’s (the “KFTC”) imposing administrative fines against the company that engaged in market collusion practices. In addition, on September 3, 2021, in a separate shareholder derivative lawsuit, the Seoul High Court recognized that a representative director, directors and auditors of a company were liable because they failed to monitor a company for engaging in market bid rigging practices, reversing the lower court’s decision that only recognized the representative director liable for breach of his duty to monitor and supervise. This Seoul High Court decision is not yet final because both parties have appealed to the Supreme Court.
In each of the above decisions, the court noted that companies need to strengthen their internal corporate control systems in order to engage in compliant management operations. Even if a director did not actively instruct or engage in illegal acts, the courts held that an absence of reasonable internal control systems aimed at preventing illegal acts such as price-fixing by officers and employees, or a director’s failing to make efforts to build and implement such systems violate a director’s duty to monitor and supervise.
The court’s rulings above are consistent with the legal principles stated in Supreme Court Decision No. 2007Da31518 rendered on September 11, 2008 and Supreme Court Decision No. 2016Da260455 rendered on May 16, 2019. In the former case, the Supreme Court ruled that a director of a stock company “has a duty to establish a reasonable information and reporting system and an internal control system, and shall be careful to ensure that such systems work properly.” In the latter case, the Supreme Court recognized the liability of outside directors for illegal acts relating to the accounting recognition system applied to company donations. The decisions rendered this year have significant implications because the courts (i) recognized the liability of representative director and other directors who did not actively engage in the illegal act, (ii) recognized the KFTC’s administrative fine relating to the collusive act as damages, and (iii) ultimately concluded that a company’s internal controls systems are insufficient if they are only composed of the internal accounting control system established pursuant to the Act on External Audit of Stock Companies. The decisions rendered this year reflect the courts’ growing tendency to strengthen directors’ liability. Accordingly, companies and their directors and officers will need to establish or strengthen their corporate information reporting systems and internal control systems to prevent risks related to directors’ liability in advance.
The key points of the rulings rendered this year are summarized as follows:
1. Supreme Court Decision (November 11, 2021)
A shareholder of Company C, which merged into Company A, filed a shareholder derivative lawsuit against representative director B for damages equaling the KFTC's administrative fine imposed on Company C (currently Company A) for engaging in market collusion practices.
The lower court ruled against the plaintiff on the ground that "there is no evidence to prove that the defendant was involved in the collusive act or that the defendant neglected to monitor knowing that it was an illegal act." The appellate court also rejected the plaintiff's claim.
Even though the Supreme Court recognized that there was a lack of evidence to prove that representative director B actually instructed or engaged in the collusive acts, it noted that "if individual B, the representative director, was unaware of the continuous and systematic collusion, which is a serious illegal act committed by Company C, and could not have prevented it or taken corrective measures immediately after it occurred, this may be deemed to be a result of defendant's failure to make any efforts to establish an internal control system to control the risks potentially arising from the serious illegal and wrongful acts in the course of performing Company C's business, or despite having such system, intentional ignorance of the defendant's performance of his duty to monitor and supervise the overall business of Company C."
The Supreme Court also noted that "the internal accounting management system allegedly established by the defendant as an internal control system is generally limited to accounting as it is for the preparation and disclosure of accounting information under the Act on External Audit of Stock Companies, and the code of ethics enacted in 2003 is nothing more than an abstract and comprehensive guideline on the performance of duties by officers and employees" and thus it was difficult to deem that "the appointment and operation of outside directors and auditors, and decision-making through the board of directors, as alleged by the defendant, actually served as methods to prevent illegal acts such as price-fixing in advance, collect and report information on suspected or confirmed illegal acts, or further control illegal acts."
Accordingly, the court stated that "defendant B, the representative director, cannot be exempt from liability solely on the grounds that he was unaware of the schemes in detail and that he did not directly instruct the executives to engage in such illegal acts. If defendant B continued to neglect his duty to monitor as the representative director, and as a result, caused damage to the company, defendant B should be held liable for such damage."
Ultimately, the Supreme Court remanded the case to the Seoul High Court, noting that the lower court erred in finding defendant B not liable with respect to his duty to monitor and supervise the company as the representative director and thus not liable for damages without fully examining whether a reasonable internal control system was actually established and operated to prevent long-term systematic collusion.
In light of this decision, it has become more difficult for directors to argue that they have fulfilled their respective duty to monitor and supervise to prevent illegal acts of officers and employees solely based on the presence of an internal accounting management system and the fact that decisions are generally through the board of directors (which has authority centered around the outside directors). Companies will need to establish more specific and systematic information reporting systems and internal control systems to mitigate directors' liability risks.
2. Seoul High Court Decision (September 3, 2021)
The shareholders of Company D filed a shareholder derivative lawsuit against the then-representative director E, director F and other outside directors of Company D for damages in the amount of the KFTC's administrative fine imposed against Company D resulting from its practices of bid-rigging in the market.
The trial court held that only representative director E breached his duty to monitor Company D's officers and employees.
However, the Seoul High Court expanded the scope of liability to recognize that the other directors (including director F and other outside directors of Company D) also breached their duty to monitor and supervise. The Seoul High Court explained that "directors of a stock company, as members of the board of directors, are obligated not only to express their agreements or disapprovals on the agenda submitted to the board, but to also monitor the overall performance of their duties as well as those of other directors." It further added that "directors are liable for the damages imposed on the company because of either their failure to perform their duties in violation of their duty to monitor or their willful misconduct or negligence in spite of reasons to suspect that the performance of the representative director or other directors' duties are illegal." In addition, the court explained that "because the business of a stock company is divided and organized under the direction of the representative director and the director in charge of the business, a director's duty to monitor is not limited to the business directly under his scope, but also extends to the overall business of the company, and therefore, also includes the acts of his employees."
Furthermore, the Seoul High Court ruled that "even if the defendants were unaware of, could not have been aware of, or had no circumstance to suspect bid-rigging because they were not involved in or reported on the bidding for individual construction projects, the defendants breached their duty to monitor by failing to establish a reasonable information and reporting system and an internal control system that may have caught these illegal bid-rigging acts by the officers and employees and to fulfill their duty of care to ensure that such system works properly." Because both parties have appealed this decision, it is still possible that the Supreme Court could reverse the Seoul High Court's ruling.
Furthermore, there may be an increase in the risk of liability on the part of representative directors and directors' duty to monitor and supervise, especially in cases in which outside directors or non-executive directors are appointed to a joint venture or minority equity investment of target companies.
#Shareholder Derivative Lawsuit #Directors’ Duty #Legal Update