In a derivative action filed by the second largest shareholder of Company A, where the Plaintiff argued that Defendant one, who was a director or the representative director of Company A, as well as the chairman of the business group, and Defendant two, who was the representative director of Company A (collectively “Defendants”), caused damages to Company A by executing multiple derivative contracts related to the shares of affiliates, in violation of their fiduciary duty or their duty to monitor, the Supreme Court held on March 30, 2023, that the Defendants are liable for damages caused to the Company A by entering into the above contracts, on the grounds that at the time that the Defendants signed some of these contracts, they failed to either sufficiently review the necessity of the contracts and the risk of loss associated with the contracts, or take necessary measures despite being aware of insufficient review. On the same grounds, the Supreme Court dismissed the Defendants’ appeal against the lower court’s decision, which partially accepted the Plaintiff’s claim. (Supreme Court Decision No. 2019Da280481 rendered on March 30, 2023, “Decision.”)
While upholding case precedents on the principles of management decisions that apply when directors’ breach of duty is at issue (Supreme Court Decision No. 2006Da33333 rendered on October 11, 2007, etc.), the Supreme Court ruled on the following issues of first impression in this case: (i) what benefits may justify directors’ management decisions; (ii) what duties the directors of a company belonging to a business group have towards the company while performing their roles related to an affiliate; (iii) what directors should review, when a company belonging to a business group with a circular shareholding structure intends to acquire shares of an affiliate in order to defend its control over the affiliate; (iv) what directors should review when the company signs a derivatives contract to allow a third party to hold shares in its affiliate for a specified period. In addition, the Supreme Court reaffirmed its previous position that the directors of a company have the duty to monitor or supervise whether the company is in compliance with the laws and the company’s articles of incorporation. In particular, the Supreme Court ruled that even if a certain director is likely to benefit from the duties performed by another director, the subject director still has these duties to the company.
The Decision will impact your company’s decision-making process going forward, as the Supreme Court specified the legal standards for the duty of due diligence and duty of loyalty for subject directors of a company who belong to a business group when making decisions regarding investments in shares of the company’s affiliate, and outlined detailed legal principles and standards for imposing such duties on the other directors of the company who were not leading this investment decision. The details of the Decision are as follows.
1. Overview of the Case
Company A, Company B, and Securities Company C, are affiliates belonging to the same business group which has a circular shareholding structure, with Company A having control over Company B as its largest shareholder. In order to maintain Company A’s control over Company B in a potential hostile M&A takeover, Company A entered into derivatives contracts with a number of other parties, wherein the other parties will hold shares issued by Company B, and exercise their voting rights in favor of Company A during the term of the contract in return for payment of fees by Company A, and Company A will make settlement payments to these other parties for the difference between Company B’s stock prices at the time of maturity versus at the time of signing these contracts. Company A also entered into derivatives contracts with other parties, under which (i) these other parties will participate in Securities Company C’s capital increase in return for payment of fees by Company A, and Company A will make settlement payments to these other parties for the difference in stock prices of Company C at the time of maturity versus at the time of signing these contracts. Pursuant to these contracts, Company A paid fees to these other parties, as well as huge settlement amounts resulting from significant declines in stock prices of both Company B and Securities Company C. The Plaintiff filed a derivative action against the Defendants, arguing that the Defendants entered into the above contracts in violation of their duty of due diligence or duty to monitor, thereby causing damages to Company A equivalent to the above fees and losses from the significant declines in these stock prices of both Company B and Securities Company C.
2. Court’s Decision
The Supreme Court made its decisions outlined below based on the following findings: (i) in principle, the benefits that can justify management decisions by the directors of a company must be something specific that the company can actually obtain, and such benefits must not be merely general or vague expectations that are not commensurate with the costs or risks borne by the company, and (ii) as affiliates in a business group are individual companies with independent legal personality, and the directors of such individual companies have the duty of due diligence and the duty of royalty to the respective company to which they belong even when they perform roles related to the business group or other affiliates.
① If a company intends to participate in an affiliate’s capital increase with consideration and acquire new shares issued by that affiliate, the company’s directors shall specifically review the following based on objective information: (i) the extent to which the affiliate has contributed to the business of the company; (ii) the degree of the potential financial burden on the company if it participates in the capital increase with consideration; (iii) the affiliate’s financial status and business conditions; (iv) the advantages and disadvantages that the company may encounter when it participates in the capital increase with consideration; (v) the effect on the affiliate when the company participates or does not participate in the capital increase with consideration; (vi) the expected advantages and disadvantages that the company may encounter in the above two scenarios.
② When a company belonging to a business group with a circular shareholding structure intends to acquire additional shares of an affiliate which is under its control in order to prevent attempted or potential hostile M&A of an affiliate, the company’s directors shall specifically review the following based on objective information: (i) whether the company and the affiliate are commercially and financially related to each other and, if so, to what extent; (ii) the degree of advantages and disadvantages that the company may encounter if it maintains or loses its control over the affiliate; (iii) the sustainability of the company’s business in the event of a change in the business group or the controlling shareholder’s loss of control; (iv) whether the cost required to acquire such additional shares is appropriate considering the company’s financial status and business plans.
③ For the objectives stated in (1) and (2) above, if the company intends to sign a derivatives contract with a third party with the affiliate’s shares as the underlying asset and allow the third party to hold the affiliate’s shares during the term of the contract, the company’s directors shall (i) objectively and reasonably review the possibility and scale of loss due to fluctuations in the underlying asset, i.e., the stock price of the affiliate, which is a unique risk associated with the above contract and the company’s ability to bear such risk, and (ii) appropriately adjust the scale and revise the terms and conditions of the above contract based on the above review to minimize the cost or risk borne by the company.
With respect to the directors’ duty to monitor, the Decision further states that, “Even if a specific director is likely to benefit from the representative director or another director’s performance of their roles, the former still has the duty to monitor and the duty to supervise.”
In addition, the Supreme Court declined to rule that this derivative lawsuit was an abuse of shareholders rights, given that the lawsuit was filed based on the requirements procedures for a derivative lawsuit under the Commercial Act, and there was no requisite “special circumstances” to indicate that the Plaintiff filed this derivative action solely for the purpose of achieving a private purpose by pressuring these Defendants; although the Plaintiff acknowledged its attempt to M&A with Company A, the Supreme Court found this insufficient to constitute the requisite “special circumstances” required to find an abuse of shareholder rights in a derivative lawsuit where any benefits from the lawsuit must go to the company.
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