Leveraged buyout

Leveraged buyout (LBO, 차입매수/借入買收) means a M&A financing in which a large part of the purchase price is financed through leverage borrowing and the assets of the acquired company are used as collateral for such borrowing. Companies of all sizes and industries have been the target of LBO transactions on condition that the target company is able to make regular loan payments after the completion of a leveraged buyout.

Typically, leveraged buyout uses a combination of bridge financing from banks, junk bonds below investment grade, etc. If the company subsequently defaults on its debts, the LBO transaction will frequently be challenged by creditors or a bankruptcy trustee as a kind of fraudulent transfer.

In Korea, LBO transactions occur occasionally in the mergers and acquisitions (M&A) market, but its legality has been debated in two Supreme Court cases as explained below.

Key words
M&A financing, leveraged buyout (LBO), fraudulent transfer, legality, breach of trust or malfeasance in office

Supreme Court cases
With respect to the legality of LBO financing, there seems to be few concrete criteria in case law.

In terms of breach of trust of the directors in charge of such LBO transactions, court rulings are divided into guilty (Shinhan case) and not guilty (Hanil Synthetic Fiber case). Daesun Soju, Co. and Himart cases have not yet decided. So the following two Supreme Court cases should be noted.

Shinhan case
This Supreme Court Decision 2004Do7027 was delivered on November 9, 2006. It was the criminal case on the violation of the Act on the Aggravated Punishment, etc. of Specific Economic Crimes (Malfeasance in office).


 * Where a person takes out a loan from a financial institution and later provides the asset of the company as collateral (so-called LBO method) to raise fund to take over a company, if the primary debt is not repaid, the company that is taken over bears the risk of losing the asset that is provided as collateral. So the collateral provision shall not be permitted with no limit, and it shall be permitted only when a compensation for the risk caused by the above collateral provision is provided. If the asset of the company that is taken over is made to be provided as collateral without any compensation, it is fair to deem that the person that takes over the company or a third party gained property profit that is equivalent of the value of the collateral and that the company that is taken over bears damages to its property. In the case of a stock company that is under a company reorganization procedure due to bankruptcy as well, the potential benefit of the company's stockholders and creditors shall still be protected, so the above conclusion does not affect corporations that are under company reorganization procedures.


 * Where the representative director of a company provides the asset of the company as a collateral for a third party and replaces the already established collateral, if the value of the newly provided collateral is higher than the value of the existing collateral, it shall be deemed that a property damage has occurred to the company, unless there is a special situation. But in the case where the representative director of a company provides the asset of the company as a collateral for a third party and replaces the already established collateral, if the value of the newly provided collateral is lower than or equal to the value of the existing collateral, it shall not be deemed that a property damage has been caused to the company.

Hanil Synthetic Fiber case
This Supreme Court Decision 2009Do6634 was delivered on April 15, 2010. It was the criminal case on the violation of the Act on the Aggravated Punishment, etc. of Specific Economic Crimes (Malfeasance in office, Embezzlement and subsequent Bribery).


 * [S]o-called take-over by means of borrowing or leveraged buyout (LBO) is not a single concept of legal terms. It is generally used as management terms referring to comprehensive M&A financing in which a significant part of purchase price of a acquired company is financed by borrowing with the assets of the target company granted as collateral, or such part of consideration will be paid by cashflow from the assets of the target company. In reality, LBO transactions occur in various ways.


 * As no single law regulates this kind of M&A financing, it is hard to say conclusively whether the players of LBO transactions committed malfeasance in office, or breach of trust, or not. In other words, it depends on whether any action in the course of LBO transactions falls within the scope of such malfeasance in office, and accordingly the decision shall be made in a separate manner.

MOJ LBO Guideline
In view of the increasing M&As including LBO, the Ministry of Justice has made a guideline to decide whether the LBO deal is in breach of trust or not based on the study conducted by Seoul National University Law School.

It is a safe harbor principle to regard the LBO deal as a legally conducted one insofar as the deal falls under the following criteria:
 * Where all the shareholders and creditors of Target company agree to the deal
 * Executive Director has notified the shareholders and creditors of Target company in writing of the proposed LBO deal.


 * Where the relevant procedure for the protection of shareholders and creditors of Target company has been implemented, and in no case that the executive directors have unfairly received any personal benefit.
 * The relevant protection procedure shall be one of the followings.:
 * Acquiring company has acquired all the shares of the target company, or more than 95 percent of total shares and ask for the purchase of the remaining shares.
 * Acquiring company has acquired all the shares via a tender offer bid (TOB).
 * Acquiring company has provided opposition shareholders of Target company with an option to sell their shares.
 * An independent specialist selected by 2/3 of shareholders of Target company excluding the acquiring company.


 * Where there is significantly low risk to infringe upon the interests of the shareholders and creditors of Target company by satisfying all of the following standards
 * The equity to capital ratio of Acquring company exceeds 50 percent.
 * In case of an SPC, its major shareholder other than private equity funds (PEFs) with 50 percent or more shares has granted appropriate guanrantee or other collateral for necessary financing.
 * A credit rating agency (CRA) has rated the credit standing of Target company as 'investment grade'.

Implications for future M&A transactions
In view of the current M&A market, the chances and needs for LBO are increasing more than ever. As LBO financing is backed by the corporate assets which could be acquired by the said LBO funds. However, it should not be underestimated that LBO financing is one of the important methods of coporate takeover around the world. If it could enhance the corporate restructuring more competitively, paradigm shift is in need because such financing is probably subject to punishment on account of breach of trust.

Also it should be noted that LBO financing would cause the excessive debt to the improperly-run company as well as the excessive unrest of the capital market. The current judicial review of LBO transactions has made foreign investors as well as local entrepreneurs to avoid restructuring opportunities. In order to allow LBO financing for the effective corporate restructuring, a comprehensive system with lawful procedures such as disclosure and internal control system, and best practices or guidelines need to be established.

In this regard, the management of the acquiring company must observe the principle of good faith for the purpose of business rationalization and improvement. Otherwise it could be liable for the violation of eithe the Criminal Act or the Civil Act. The private equity fund (PEF) would be utilized as an alternative to the controversial LBO technique.