Leveraged Buyouts (LBO) and Embezzlement: Complete Analysis of Legal Risks and Practical Response Strategies
Table of Contents
1. Concept and Basic Structure of Leveraged Buyouts (LBO)
A Leveraged Buyout (LBO) refers to a technique in merger and acquisition (M&A) transactions where the assets of the target company are used directly or indirectly as collateral to raise acquisition financing for purchasing that company. In other words, it is a method of acquiring a company by borrowing funds with the target company’s assets as collateral or with the expectation that the target company’s assets will be used for repayment.
The general procedure for LBOs is as follows:
(1) Establishment of Special Purpose Vehicle
The acquirer establishes a Special Purpose Company (SPC)
(2) Acquisition Financing
The SPC borrows acquisition funds from financial institutions
(3) Share Acquisition
The SPC acquires shares of the target company using the borrowed funds
(4) Debt Repayment
After acquisition, the target company’s assets or cash flows are utilized to repay the borrowed funds
LBOs are primarily utilized in the following situations:
(1) Limited Financial Resources
When acquirers with insufficient financial capacity attempt large-scale acquisitions
(2) Private Equity Investment
When private equity funds use leverage to enhance investment returns
(3) Strategic Acquisitions
For strategic acquisitions related to corporate restructuring or business diversification
However, such structures can impose excessive debt burdens on target companies, increase operational risks, and potentially harm the interests of existing shareholders and creditors, leading to legal controversies.
2. Legal Issues and Embezzlement Disputes in LBOs
The core legal issue in LBOs arises when target companies provide their assets as collateral or assume debt repayment obligations not for their own benefit but for the acquirer’s benefit. The potential for such actions to cause harm to the company and stakeholders (shareholders, creditors, etc.) makes the establishment of criminal embezzlement a key legal issue.
Relationship between LBOs and Embezzlement
Situations where embezzlement becomes an issue in LBO transactions primarily include:
(1) Collateral Provision
Directors or management of the target company providing company assets as collateral for the acquirer’s benefit
(2) Asset Usage
Acquirers who gain management control after acquisition using the target company’s assets to repay their own borrowed funds
(3) Mergers and Asset Extraction
Actions that harm the target company through mergers or asset extraction
Embezzlement is established under Article 355, Paragraph 2 of the Criminal Code when “a person handling another’s affairs commits acts contrary to their duties, thereby obtaining property benefits for themselves or causing a third party to obtain such benefits and causing harm to the principal.” Occupational embezzlement (Article 356) provides for enhanced punishment.
Relationship with Commercial Code Regulations
The current Commercial Code does not directly regulate LBOs. However, for listed companies, regulations restricting transactions with major shareholders and other interested parties (Commercial Code Article 542-9) prohibit companies from providing loans, guarantees, or collateral for the repayment or security of acquisition funds raised by major shareholders, with violations subject to punishment (Commercial Code Article 624-2).
Additionally, the prohibition on directors’ self-dealing (Commercial Code Article 398) can serve as a regulatory provision for LBO activities. Under this provision, self-dealing without board approval can be void, and LBOs can be viewed as indirect forms of self-dealing where companies provide collateral for the benefit of acquiring major shareholders.
3. Various Types of LBOs
LBOs can be broadly categorized into four types based on their implementation methods, with judicial attitudes toward embezzlement establishment varying by type.
Collateral-Providing LBO
(1) Definition
A type where the acquiring company maintains separate legal personalities for the Special Purpose Company (SPC) as the acquisition entity and the target company, while providing the target company’s assets (deposit assets, real estate assets, etc.) as collateral for the SPC’s acquisition loans to raise corporate acquisition funds.
(2) Characteristics
– Receives cooperation from major shareholders and CEOs of the target company to gain management control
– After acquisition, provides the target company’s assets as collateral in the CEO position to secure acquisition funds
– The acquirers’ corporate acquisition intentions are often clearly aimed at misappropriating only the target company’s assets rather than normal business operations
Precedent: Shinhan Case (Supreme Court Decision 2004Do7027, November 9, 2006)
This case involved the defendant establishing an SPC to acquire Shinhan Co., which was undergoing corporate restructuring proceedings, borrowing 35 billion won from Dongyang Hyundai General Finance, with the SPC participating in Shinhan’s paid-in capital increase and establishing pledge rights on new shares to be acquired, and separately providing approximately 62 billion won worth of restructuring claims and secured restructuring rights against Shinhan as collateral to Hanmi Bank.
Court’s Position: The Supreme Court recognized embezzlement. The key points of the decision were:
1. Unlimited collateral provision solely for the acquirer’s benefit cannot be permitted, and should only be allowed when the target company receives appropriate consideration or other counter-benefits corresponding to the risk burden from collateral provision
2. If the acquirer causes the target company to arbitrarily provide its property as collateral without providing any counter-benefits to the target company, it can be seen as enabling the acquirer or third party to obtain property benefits equivalent to the collateral value and causing corresponding property damage to the target company
3. Even for companies under restructuring proceedings, the potential interests of shareholders and creditors should be protected, so this does not affect the determination of embezzlement establishment
This decision is significant for clearly establishing that embezzlement can be established for collateral provision acts in collateral-providing LBOs without appropriate counter-benefits to the target company.
Merger-Type LBO
(1) Definition
A type where the acquirer establishes an SPC that borrows funds to acquire the target company through share acquisition, after which the target company and SPC merge, and the surviving company repays the existing loan obligations.
(2) Characteristics
– Transfers the burden of acquisition financing borrowed by the SPC to the target company through merger
– Legal risks may be lower compared to collateral-providing types as it operates through legal merger procedures
– Shareholder and creditor protection mechanisms under Commercial Code merger procedures are activated
Precedent: Hanil Synthetic Fiber Case (Supreme Court Decision 2009Do6634, April 15, 2010)
In this case, to acquire Hanil Synthetic Fiber, which was under restructuring proceedings, the acquirer established an SPC with affiliates by contributing approximately 100 billion won, the SPC borrowed 466.7 billion won from financial institutions to raise acquisition funds and acquired Hanil Synthetic Fiber for 500 billion won. Subsequently, the SPC was absorbed and merged into the acquirer, and later the acquirer absorbed and merged Hanil Synthetic Fiber.
Court’s Position: The Supreme Court denied embezzlement establishment in this case. The key points of the decision were:
1. Embezzlement cannot be uniformly established or denied for those who led corporate acquisitions through leveraged buyout methods, and must be judged individually
2. Unlike methods that directly provide target company assets as collateral, when there are no defects in the substance or procedures of the merger, it is difficult to see that the company suffered harm
3. Through merger, the acquiring company and target company become personally unified and integrated, and their assets become indistinguishably unified through this effect, making it difficult to evaluate that harm was caused to the target company
This decision suggests that in merger-type LBOs, embezzlement establishment is difficult to recognize when conducted through legitimate merger procedures.
Asset Extraction-Type LBO
(1) Definition
A type where the SPC acquires the target company but does not merge, maintaining the SPC’s position as the largest shareholder while recovering investment capital according to methods stipulated in the Commercial Code (mainly paid-in capital reduction).
(2) Characteristics
– Method of recovering funds through legitimate capital reduction procedures
– Complies with procedures stipulated in the Commercial Code (special resolutions of shareholder meetings, creditor protection procedures, etc.)
– Capital reduction for fund recovery may deteriorate the company’s financial structure
Precedent: Daesun Brewery Case (Supreme Court Decision 2011Do524, June 13, 2013)
This case questioned whether acquirers’ recovery of funds through paid-in capital reduction and profit distribution after acquiring Daesun Brewery through an SPC constituted embezzlement.
Court’s Position: The Supreme Court denied embezzlement establishment. The key points of the decision were:
1. Paid-in capital reduction and profit distribution are results of exercising shareholder rights guaranteed by law and have no procedural defects
2. Considering the capital reduction refund and distributable profits, it cannot be seen that shareholders were enabled to obtain unfair benefits thereby causing harm to the company
3. Company paid-in capital reduction or profit distribution that complies with legal procedures cannot be seen as acts that harm company creditors per se
These decisions show that embezzlement is difficult to establish for fund recovery acts in asset extraction-type LBOs when conducted in compliance with procedures stipulated in the Commercial Code.
Hybrid LBO
(1) Definition
A type where there are collateral provision acts by the target company, followed by merger between the SPC and target company (including asset extraction after merger).
(2) Characteristics
– Combined form of collateral-providing and merger-type characteristics
– Complex structure that raises and repays acquisition funds through collateral provision and merger
– Various legal issues appear mixed together
Precedent: Onse Communications Case (Supreme Court Decision 2012Do9148, March 12, 2015)
This case involved paid cancellation of all old shares of Onse Communications, which was under restructuring proceedings, followed by acquisition of 100% of new shares from paid-in capital increase and convertible bonds (BW). Subsequently, Onse Communications provided its assets as collateral for the acquirer’s existing loan obligations for raising acquisition funds.
Court’s Position: The Supreme Court denied embezzlement establishment in this case. The key points of the decision were:
1. Strict interpretation standards should be maintained when determining whether corporate managers had embezzlement intent regarding business judgments
2. Corporate management inherently involves risks, so damage can occur to companies even when managers make careful decisions in good faith without any intention of personal gain
3. Embezzlement intent should only be recognized when, considering all circumstances including the background and motives leading to the business judgment in question, the nature of the business being judged, the company’s economic situation, the probability of loss and profit generation, etc., it is recognized as an intentional act with awareness of obtaining property benefits for oneself or third parties and causing harm to the principal
This decision is significant for applying business judgment principles in hybrid LBOs and presenting strict criteria for determining embezzlement intent.
4. Requirements and Criteria for Embezzlement
To determine whether embezzlement is established in LBO-related cases, the constituent elements of embezzlement must be carefully examined.
Person Handling Another’s Affairs
The subject of embezzlement is a ‘person handling another’s affairs.’ In the LBO context, the following issues arise:
(1) Acquirer’s Position
When an acquirer is in a position to manage the target company’s property or has actually seized management control even without holding executive positions, they can be recognized as a ‘person handling another’s affairs.’
(2) Director’s Duty Object
Company directors bear fiduciary duties and loyalty obligations to the company, thus corresponding to ‘persons handling another’s (company’s) affairs.’ The interests of shareholders and the corporation may not always align, and precedents take the position of viewing the company as ‘another.’
(3) Special Cases
In collateral-providing LBO cases, acquirers have been recognized as subjects of embezzlement, but recognition may vary in other types of LBOs.
Breach of Duty
Embezzlement refers to a person handling another’s affairs committing acts contrary to their duties. ‘Acts contrary to duties’ means failing to perform expected actions or performing prohibited actions under laws, contracts, or principles of good faith.
Regarding LBOs, acquirers bear the following duties:
(1) Prohibition of Self-Dealing
Commercial Code prohibition on directors’ self-dealing
(2) Duty of Care
Duty of care as a prudent manager
(3) Duty of Loyalty
Fiduciary duty
Violations of these duties may constitute breach of duty under criminal law. However, determination of breach of duty may vary by LBO type:
(1) Collateral-Providing LBO
Providing target company assets as collateral for acquirer’s loans is generally likely to be viewed as breach of duty, but different judgments are possible if appropriate counter-benefits were provided to the target company.
(2) Merger-Type LBO
When conducted through legitimate merger procedures, it may be difficult to view as breach of duty.
(3) Asset Extraction-Type LBO
When complying with methods and procedures stipulated in the Commercial Code (paid-in capital reduction, dividends, etc.), it may be difficult to view as breach of duty.
Property Damage
For embezzlement to be established, the actor or third party must obtain property benefits and property damage must occur to the principal. The key issue in LBOs is whether property damage occurred to the target company.
Precedents view the concept of damage as including not only actualized damage but also the occurrence of concrete risks of actual damage, with ‘risk of property damage’ meaning concrete risks equivalent to damage occurring to the principal from an economic perspective.
Damage assessment criteria by LBO type are as follows:
(1) Collateral-Providing LBO
When providing real estate as collateral, risks of asset loss occur, so property damage can be recognized. The loss of possibility to utilize collateral value itself due to collateral provision can be evaluated as actual damage.
(2) Merger-Type LBO
There is difficulty in evaluating damage as companies become personally unified through merger and assets become indistinguishably integrated. When mergers follow legitimate procedures and merger ratios are reasonably determined, recognizing damage is difficult.
(3) Asset Extraction-Type LBO
When distributing profits earned from business activities or taking legitimate paid-in capital reduction forms, if procedures and methods stipulated in the Commercial Code were followed, it cannot be viewed as breach of duty. However, even without procedural defects, if there are significant differences in light of capital maintenance and adequacy principles, there may be room to view as damage.
Embezzlement Intent
For embezzlement to be established, there must be awareness of ‘committing acts contrary to duties’ and awareness of ‘causing property damage to the principal.’ Awareness of ‘oneself or third parties obtaining property benefits’ is also necessary.
When determining embezzlement intent regarding LBOs, ‘business judgment’ becomes an important consideration:
(1) Precedent Criteria for Manager Intent Determination
The Supreme Court comprehensively considers judgment background and motives, business content, company’s economic situation, probability of loss and profit generation, etc., when determining manager intent. Particularly in judgment background and motives, whether there were improper solicitations or personal intentions and other interested relationships are important factors.
(2) Intent Determination by Type
– Collateral-Providing LBO: Providing collateral for acquirer’s debts unrelated to the target company is likely to have recognition and intent regarding acquirer benefit acquisition and causing harm to the target company, making embezzlement intent easy to recognize.
– Asset Extraction/Merger-Type LBO: Determining damage or risk occurrence from paid-in capital reduction or merger is difficult, making it hard to recognize awareness or intent regarding damage based solely on objective facts (debt increase, capital reduction, etc.). In these types, business judgment plays an important role in determining embezzlement intent.
5. Business Judgment Rule and Embezzlement
One important issue in determining embezzlement related to LBOs is whether the ‘Business Judgment Rule’ originating from U.S. corporate law applies.
Significance of the Business Judgment Rule
The Business Judgment Rule is a principle that if managers make decisions faithfully and carefully for the company’s best interests based on reasonably available information, they should not be held liable even if the company suffers damage as a result of that decision. This theory developed from the consideration that corporate management inherently involves risk-taking, and judging solely based on results after the fact could discourage entrepreneurial spirit.
Business Judgment Rule in Korean Precedents
While Korean precedents do not directly cite the U.S. legal term “Business Judgment Rule,” they importantly considered the concept of ‘business judgment’ when determining embezzlement intent in the Onse Communications case (Supreme Court Decision 2012Do9148, March 12, 2015).
The Supreme Court stated that “corporate management inherently involves risks, so damage can occur to companies even when managers make careful decisions in good faith without any intention of personal gain, and imposing criminal liability for occupational embezzlement by relaxing interpretation standards for intent even in such cases violates the principle of legality and risks dampening corporate economic activities.”
Therefore, “embezzlement intent should only be recognized when, considering all circumstances including the background and motives leading to the business judgment in question, the nature of the business being judged, the company’s economic situation, the probability of loss and profit generation, etc., it is recognized as an intentional act with awareness (including possible awareness) of obtaining property benefits for oneself or third parties and causing harm to the principal.”
6. Conclusion: Legal Risk Management Strategies for LBOs
Strategies for minimizing embezzlement risks in LBO transactions are as follows:
1. Providing Reasonable Counter-Benefits for Target Companies
Particularly important in collateral-providing LBOs is ensuring target companies receive appropriate counter-benefits corresponding to risk burdens from collateral provision. The Supreme Court recognized embezzlement for collateral provision acts without counter-benefits to target companies in the Shinhan case. Therefore, the following strategies can be considered:
– Utilizing part of acquisition funds for target company capital enhancement or debt repayment
– Paying appropriate consideration (fees) for collateral provision
– Preparing management improvement measures such as enhancing target company creditworthiness
2. Compliance with Legal Procedures
Thorough compliance with procedures stipulated in the Commercial Code is important in LBO transactions:
– In merger-type LBOs, ensuring appropriateness of merger ratios and compliance with shareholder and creditor protection procedures
– In asset extraction-type LBOs, meeting legal requirements for paid-in capital reduction or profit distribution
– Compliance with necessary decision-making procedures such as board approval and shareholder meeting resolutions
– Compliance with director self-dealing regulations (Commercial Code Article 398)
3. Establishing Transparent Decision-Making Processes
Transparency and prudence in decision-making processes are important for the Business Judgment Rule to apply:
– Seeking opinions from independent external experts (accountants, lawyers, financial advisors, etc.)
– Review and approval by disinterested outside directors
– Maintaining detailed records of decision-making processes and rationales
– Reviewing and documenting economic rationality of transactions
4. Excluding Personal Interest Pursuit
It is important to clarify that LBO transaction purposes are for enhancing corporate value rather than misappropriating target company assets, and to prepare evidence demonstrating no intent to pursue personal interests:
– Establishing and implementing post-acquisition management improvement plans
– Specifying post-merger integration (PMI) plans
– Preparing mechanisms to prevent conflicts of interest between acquirers and management
– Ensuring rationality of investment recovery plans
Conclusion
LBOs are important M&A techniques that enable acquirers with insufficient financial capacity to conduct large-scale corporate acquisitions, but they risk imposing excessive debt burdens on target companies. Therefore, legal review to minimize embezzlement risks is essential when structuring LBO transactions.
Precedents judge embezzlement establishment differently according to LBO types, applying particularly strict standards to collateral-providing LBOs. Conversely, they tend to deny embezzlement establishment for merger-type and asset extraction-type LBOs when Commercial Code procedures are followed.
Additionally, recent precedents apply strict criteria to embezzlement intent determination considering the special nature of business judgments, so ensuring economic rationality of transactions and transparency of decision-making processes is important when planning LBO transactions.
About the Author