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Everland's Convertible Bonds Case
The recent ruling on the Everland's convertible bonds is attributed to the misconception that cash inflows through capital transactions are corporate profits. First, let's take a closer look at the background of the case. Everland issued convertible bonds at a price of 7,700 won, and transferred them to certain people through consultation by the board of directors since existing shareholders would not purchase them. The court reported although the stock value after conversion could not be exactly calculated, 7,700 won was an obvious underpricing, thus ruling that "The defendants incurred an loss to the company through underpricing." In that if Everland gained income less than expected due to underpricing of convertible bonds, the company was clearly damaged, the court found Everland's CEO guilty of breach of duty.
According to Article 355 of the Criminal Law, when a person managing other person's business acts against his duty to gain personal profits or allows a third person relevant profits, inflicting losses on the original owner, he commits breach of duty. The issue of the recent ruling is to determine whether the CEO caused any damage to the corporation by issuing convertible bonds at well below-market prices. Here, damage to the corporation includes current property losses or future potential profits. Precedents proved since a shareholder and a corporation should be regarded individually, once the corporation lost its assets because of the shareholder's act, the shareholder should take responsibility for the already-committed breach of duty even though he suffered a loss as well (Dec. 13. 1983 Fundamental principles 83, 889). In line with this principle, even though the existing shareholder sustained damage, it does not constitute breach of duty if the corporation was not damaged. Even if the CEO allowed a third person to gain wrong profits against his duty, it is not regarded as breach of duty as long as it does not affect corporation's interest.
Yet, only issuing convertible bonds at a lower price does not cause any loss to the company. If a company sells an item, which should be traded at 80,000 won, at 7,700 won, it obviously inflicts losses on the company, but the important thing is that issuance of convertible bonds is not a sales activity but a capital transaction. When it comes to capital transactions, an increase in cash income does not always mean higher corporate profits. It is because, when a company borrows 10 billion won from a bank, increasing its cash income by 10 billion won, its debt increases as well. It can lead to more profits, of course, if its sales are promoted based on the increased cash income, but the profits are not attributed to increased cash income because the sales activity can bring about a loss as well. In the sense, the increase in cash income attributable to capital transactions should be separated from corporate profits.
This is the case in convertible bond issue as well. For instance, a company issued 10 billion won of convertible bonds, which were all purchased by shareholders but not convertible to stocks. Then, the company's cash assets increase by 10 billion won and its debts also increase by 10 billion won. Those capital transactions correspond to bank loans, which are not corporate profits. If the shareholders convert all of the convertible bonds to stocks, it does not change company's cash assets but decreases its debts by 10 billion and increases capital by 10 billion won. These results are not affected by the conversion price at all. In other words, the conversion price does not have anything to do with the company's assets, debts or capital. The conversion price only affects the total stock issue after conversion. Accordingly, a lower conversion price would lead to more stocks, diluting value of existing stocks, without inflicting any loss on shareholders as long as the shareholders bought the bonds. It is because the loss caused by decreased value of existing stocks equals the profits from newly converted stocks.
As seen above, when a company issued convertible bonds to secure 10 billion won of fund and shareholders acquired them, the company's financial structure or shareholders' interests are not related to the conversion price. The company's financial structure is not affected by the conversion price and does not lead to losses of existing shareholders. If all convertible bonds, in the recent Everland case, had been acquired and converted to stocks by the existing shareholders, it would not have caused any problem even though the conversion price was 5,000 won.
Nevertheless, the conversion price could have affected sales of the convertible bonds. For instance, when the conversion price is 7,700 won, the market price of the convertible bonds is 10 billion, and when the conversion price is 5,000 won, the market price is 11 billion won. If the capital market is on the right track, the market price would reflect real value after conversion. At this time, the price increase of 1 billion won equals possible profits from conversion and possible losses of the existing shareholders in dilution of stock value. Therefore, if the shareholders purchase all convertible bonds, they would not suffer any loss or profits. Now let's assume that a company sold shareholders convertible bonds, which should have been traded at 10 billion won, at 11 billion won precisely reflecting the value after conversion. If the company issued 10 billion won of convertible bonds and sold them at 11 billion won, its cash assets and debts would increase by 11 billion won and 10 billion won respectively. And excessive earnings of 1 billion won would be generated through the bond issue, but it does not mean the company got 1 billion won of profits. This became more convincing if the bonds were all converted to stocks. If the convertible bonds are all converted to stocks, the company's cash assets of 11 billion won would not change, but the capital would be 11 billion won coupled with 1 billion won of excessive earnings attributable to the bond issue as the debts of 10 billion won changed to capital. It is a capital increase by 11 billion won as the company issued 10 billion won of convertible bonds. Now, let's say that the company got the shareholders to acquire the convertible bonds, which were worth 11 billion won in the capital market, at a price of 10 billion won. If the shareholders converted all of the bonds to stocks, the company's cash assets and capital would increase by 10 billion won respectively, which translates the company's capital increase of 10 billion won. This result is like that the company lost an opportunity to increase its capital by 1 billion won by issuing bonds at a well below-market price. However, it does mean the company lost 1 billion won. In short, 1 billion won of capital increase which could have been additionally achieved cannot be regarded as the company's profits. Otherwise, the company could gain limitless profits through capital increases.
The effect of bond conversion corresponds to a paid-in capital increase at a conversion price. Raising 11 billion won through a paid-in capital increase at a price of 5,000 won per share does not mean the company's earnings increased by 1 billion won, compared to fund raising of 10 billion won at a price of 7,700 won per share. Also, even though it issued stocks, which could have been issued at 7,700 won, at 5,000 won, it did not cause any loss to the company. Free issue is the typical case in point.
Many companies carry out free issue, but they do not sustain losses through it. Free issue, as a form of capital transaction, changes neither company's cash income nor financial structure. It only changes excessive earnings of capital into capital stock. Only the total stock issue would change, thus existing shareholders do not gain any profits because value of existing stocks is diluted. If the company issued bonds at a price of 5,000 won per share, instead of free issue, then it could have gotten cash assets to some extent, which, however, does not mean the company lost the amount that could have been gained through free issue. Article 17, Provision 1 of the Corporation Tax Law says any premium in stock issue cannot be taken as corporate profits even though it brings actual income to the company. Likewise, any loss caused by stock issue at a below-market price cannot be regarded as corporate loss.
If company's profits do not have anything to do with the conversion price or paid-in capital increase price, what makes it problematic? It is because of redistribution of wealth between existing and new shareholders. For instance, existing shareholders would not acquire low-priced convertible bonds, thus the board of directors determined to transfer them to a third party to convert all of them to stocks. In this case, the company's financial structure does not change compared to when existing shareholders convert them to stocks. The company does not sustain any loss whether the stocks are acquired by existing shareholders or by a third party. However, the existing shareholders would get losses from decreased value of existing stocks. The profits that the third party gained equal the losses the existing shareholders sustained. Those who lack fund to acquire low-priced convertible bonds or hesitate about new contribution may inevitably suffer losses by giving up the purchase, but they also can evade the losses by selling their stocks or rights to acquire convertible bonds.
In short, the recent ruling on the Everland case is attributed to misbelief that the company had gotten losses, by mistaking cash inflows through capital transactions for corporate profits. If, as in the recent ruling, inflow of cash assets through capital transactions is regarded as corporate profits, the company can gain limitless profits through capital increases, thus making all CEOs, who are not engaged in capital increases, an obstacle to corporate interests disregarding potential corporate profits. Of course, if a company issued convertible bonds at a below-market price purposely and allowed existing shareholders to transfer the profits to a third party, it could bring about a legal problem over donation. Nevertheless, it is not breach of duty with corporate loss as one of requirements. Also, if the existing shareholders gave up purchase of convertible bonds when given the opportunity in advance, the CEO may not accept responsibility for subsequent losses. It is nonsense to hold the CEO responsible for corporate loss which was not actually generated..
If the conversion price or paid-in capital increase price is not related to corporate profits, what if the CEO illegally issued convertible bonds to a third party or perform a paid-in capital increase targeting a third party? Since it does not compromise corporate profits, it cannot constitute breach of duty with corporate loss. However, it unlawfully infringed on existing shareholders' profits, accordingly the shareholders are entitled to claim damages against CEO' s illegal act.
II. Convertible Bonds Regulations in Korea
Commercial law on Korea
Article 40. (Issuance of bonds with warrants)
1. The company may issue bonds with warrants for the others but shareholders up to an amount in which the total par value shall not exceed KRW800,000,000,000...
2. The amount of new shares for which can be demanded by holders of bond with warrants shall be determined by the board of directors provided that maximum amount of new shares to be subscribed by holders of bonds with warrants shall not exceed the total par value of bonds with warrants.
3. The shares to be issued due to the exercise of preemptive rights shall be of the total amount of the par value of common shares (KRW600,000,000,000) and non-voting preferred shares (KRW200,000,000,000) and the issue price of the shares shall be par or above par as determined by the board of directors at the time of issuing bonds with warrants.
4. The period in which a bondholder may exercise his preemptive rights to new shares shall be from the day succeeding the day of issuance of bonds with warrants to the day immediately before the date of maturity. Provided that the period can be determined by the board of directors during the period aforesaid in accordance with relevant laws and regulations in Korea.
5. As for the interest or dividend for bond holders who has exercised his preemptive rights to new shares, the issuance of new shares shall be regarded as having been made immediately before of fiscal year in which total amount of new shares issued is to be paid. However, when the Company has issued new share according to the conversion after the record date of interim dividend of the Article 37-5, the new shares shall be deemed to have been issued immediately after the record date of interim period.
Very truly yours,