Topics in Corporation:
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
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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,
Unentugs
Shagdar
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