M&A in insolvency proceedings

M&A in insolvency proceedings (도산절차/倒産節次에 있어서의 인수합병/引受合倂) is sought by the bankruptcy court in case the going concern value of the insolvent company is much bigger than the liquidation value and the company is worth to be reorganized.

In supervising insolvency proceedings, the courts have played a major role to facilitate mergers and acquisitions (M&As). Under active court supervision, companies in rehabilitation proceedings have been ushered in M&A arrangements in orderly fashion, and the number of such deals has increased dramatically.

Key words
insolvency proceedings, bankruptcy, rehabilitation plan, creditors' committee, rehabilitation claims

Statutory ground
After the IMF Crisis, the Korean insolvency regime underwent fundamental overhaul. In consequence, the previous three types of insolvency proceedings under the Corporate Reorganization Act (회사정리법), the Composition Act (화의법) and the Bankruptcy Act (파산법) have been consolidated into a single act, i.e., the Act on Debtor's Rehabilitation and Bankruptcy (hereinafter the "Act" 채무자 회생 및 파산에 관한 법률 or 통합도산법),. The new Act, effective on April 1, 2006, purports to streamline existing laws and regulations governing corporate and individual bankruptcies in Korea.

Meanwhile, in 2000, the Seoul Central District Court, which in charge of most of bankruptcy cases in Korea, established the Internal Code for M&A of Companies under Reorganization. The internal code turned out to be successful in promoting M&A among debtor oompanies. As the leadingbankruptcy court, other courts immediately began following the Seoul Central District Court’s internal code.

Rehabilitation proceedings
In the rehabilitation proceedings, creditors are classified into three basic categories — those with unsecured rehabilitation claims; those with secured rehabilitation claims; and those with claims for the common benefit. Common beneﬁt claims are not subject to the restrictions of the rehabilitation proceedings.

Once rehabilitation has begun, the court will announce a period during which claims may be filed. After this, a rehabilitation plan is prepared and submitted for approval by interested parties: secured creditors, unsecured creditors and shareholders of the debtor company, but shareholders' approval is not required if the debtor company’s total debts exceed its total assets at the start of the rehabilitation.

Rehabilitation plan
The plan is then submitted to the court for approval. The court may override - the veto of a certain class and approve the plan by taking appropriate measures to protect the interests of the vetoing class. Once approved by the court, the plan comes into force and the rehabilitation claims not duly filed with the court are discharged, in principle, the trustee operates the debtor company under court supervision until all rehabilitation claims are paid in full as provided in the plan.

The important provisions of the internal code are summarized as follows: 1. The trustee of the debtor company is generally required to pursuethe sale of the debtor company once the court has approved theplan, and it is desirable that a sale is sought before the rehabilitation plan has been approved. 2. Once a rehabilitation proceeding has been successfully closedthrough M&A, the court may award special compensation to thetrustee. 3. A model M&A process is as follows:
 * Any person wishing to acquire the debtor company may file a letter of intent with the trustee or the court.
 * To secure fairness and expertise, the trustee will hire a financial adviser or other experts at the start of the M&A process.
 * The purchaser will subscribe to new shares in the debt or company in order to secure stable control. The funds from the new shares are used to repay the debtor company's rehabilitation claims.
 * Once an acquisition agreement has been executed for the debtor company, the purchaser must deposit 10 percent of the purchase price.
 * In line with the acquisition agreement, the plan may be modified to reduce the distribution ratio of rehabilitation claims and/or to reduce the debtor company's issued and outstanding shares. The purchase price should be paid in advance, or otherwise secured, prior to the meeting of interested parties to modify the plan.
 * At least 50 percent of the new shares (or lock-up shares) should not be resold within a year. The shares are deposited with the Korea Securities Depository (KSD) during this period.
 * The debtor company's rehabilitation proceedings are closed as soon as all the requirements are satisﬁed, including full payment of rehabilitation claims.
 * During the process, the trustee must make updated reports to the court.

M&A process
In practice, purchasers are selected through open bidding. The process is similar to an auction, as the terms and conditions of the acquisition agreements are almost identical, with little room for negotiation.

In addition, not all of the purchase price is used to subscribe to new shares - up to 50 percent may be used to subscribe to bonds issued by the debtor company. No representations or warranties are provided to the purchaser in subscribing for new shares and bonds because the rehabilitation claims are either listed on the plan or discharged, and most of the common beneﬁt claims are traceable via records and documents maintained by the court supervised trustee. The court’s supervision is an important factor to make such "as is" conditions acceptable to the purchaser.

Operation of the Internal Code
Above all, it is necessary to settle all the rehabilitation claims withthe purchase price since, without such a pay-off, the rehabilitation proceedings will not be closed and the purchaser cannot obtain controlof the debtor company free of court supervision. If the purchase price is less than the outstanding rehabilitation claims under the plan, it is necessary to negotiate with the creditor to reduce the repayment ratio of the claims.

Ordinarily, it takes about a year to start an M&A process once the rehabilitation proceeding has been filed. Although the internal code encourages M&A efforts before the rehabilitation plan has been conﬁrmed, and the Act allows a pre-packaged plan, it is quite difficult to arrange for the sale of a company at this early stage. This is, to a large degree, due to the failure of creditors to agree amongst themselves on the terms and conditions of the rehabilitation, including how to operate the debtor company in future.

Considering that creditors do not play an active role in reorganizingthe debtor company, it is not surprising that their M&A initiatives arenot included in the internal code. The rationale for such silence is that creditors’ interests are properly protected since all the rehabilitation claims will be paid off with the purchase price obtained through open bidding.

Recently, however, there has been an increase in cases where potential buyers hold the rehabilitation claims of the target company. So far, M&A in Korean insolvency proceedings, however, having a large portion of claims has not proved to be a decisive factor in acquiring the target company under the internal code. The courts appear to think that the purchaser must win the auction regardless of the claims it, or the competition, has.

M&A under the new Act
Though the new Act has significantly reformed Korea’s insolvency regime, only a few provisions directly address M&A of debtor companies. They are:
 * a new provision states that any person wishing to acquire a debtor company may request certain information from it;
 * a debtor company's business may be sold before the rehabilitation plan is conﬁrmed (previously, business transfer was possible only once the plan was in place), and
 * a rehabilitation pian for liquidating a debtor company may be approved by creditor(s) with four fifths of all secured rehabilitation claims (previously, unanimous consent was required) and may include a business transfer (previously, a business transfer was not listed as a method of liquidation).

The above provisions are not likely to seriously affect the M&A model under the internal code. The Act does, however, have some provisions relating to control of the debtor company. First, the company‘s representative may be appointed as its trustee. This is different from the debtor-in-possession (DIP) system in Chapter 11 of the US Bankruptcy Code. Though it is not clear exactly what role is expected of the incumbent management under the Act, at least it is a sign that management continuity will be respected.

In addition, the status and powers of the creditors’ committee have been reinforced. It is now mandatory to establish such a committee, except for individuals or small companies. The committee may ask the court and the trustee for certain information and to investigate the debtor company, and may present its opinion on certain important issues. The court may also decide that the debtor company must bear the costs and expenses of the creditors’ committee.

One major assumption of the Court internal code is that no entity exercises control over the debtor company, and new control is created for thepurchaser through the M&A auction process. This assumption may be changed with incumbent management and the enhanced role ofthe creditors’ committee. However, it is too early to predict whether the code should be changed until these two features are fully reviewed with the development of practices. In fact, legal issues surrounding these two features may not be settled anytime soon, triggering a series of discussions on the corporate governance of financially troubled companies in Korea.