From the start of next year, for the first time in Korean history, shareholders of Korean corporations with total assets of more than W2 trillion ($1.72 billion) will be able to bring a securities-related class action against the company and its senior executives and board members for various violations, including false disclosures in the company's financial statements.
This unprecedented law is causing a stir in the boardrooms of large Korean companies. Corporate executives are concerned about its potential ramifications, not only for their organizations, but also for their officers and directors.
The arrival of the securities class action litigation will almost certainly result in increased corporate governance litigation, significantly increasing the risk to directors. And without the protection afforded by the right of indemnification, neither Koreans nor foreigners will want to serve on the boards of Korean Companies.
Crackdown
Executives are still stunned by the Seoul High Court's landmark ruling on November 20 2003. The Court required Samsung Electronics' chairman and nine other directors to pay W7 billion to compensate the company for damages caused by the directors breaching their fiduciary duties by making illegal political contributions and failing to exercise proper business judgment in the use of corporate funds. Although the amount of damages was substantially reduced from the trial court's judgment of W97.7 billion, the ruling held directors personally liable for damages caused to the company as a result of their actions. The decision reportedly forced some of the directors to cash in some of their stock options to satisfy the judgment.
Following this case, a few weeks ago on May 30 the Seoul Central District Court ruled that Daewoo Group founder Kim Woo-choong and two other former senior Daewoo executives were guilty of (among other things) false disclosures to their investors and the regulatory authorities. The Court also found the defendants personally liable for losses caused to an investor in Daewoo and ordered them to pay W97 million to the investor.
| The Securities-related Class Action Act Korea's Securities-related Class Action Act will be effective from January 1 2005, but will only apply to companies with total assets of W2 trillion or more. From January 1 2007, the Act will cover all companies whose securities are listed on the Korea Stock Exchange or registered with the Korea Securities Dealers Association. There are four causes of action under the Act: (i) damages for false information in a securities report or prospectus; (ii) damages for false information in business reports and semi-annual and quarterly reports; (iii) damages for insider trading or price manipulation; and (iv) claims against auditors. Damages are calculated in accordance with the Securities and Exchange Act (SEA) and other existing laws. If damages are complex to work out, however, courts may use sampling, averaging, statistical or other rational methods. Under the SEA, damages caused by false information are calculated by the acquisition price minus (i) the market price at the closing of the courtroom arguments, or (ii) if disposed of earlier, the disposition price. In certain cases, the burden of proof of the lack of causal connection between the falsity and damages will fall on the defendant. Damages will then be reduced by the portion that is proven as unrelated to the cause of action. Class certification requires: (i) at least 50 class members, with the total number of their shares constituting 0.01% of all issued and outstanding shares of the company; (ii) commonality of legal or factual issues; (iii) class action being an efficient and suitable means for protection of rights or interests of all members; and (iv) the complaint being properly drafted and not defective. The representative member should be one with the largest stake and capable of fair and proper representation. The Act also includes provisions on opt-out and preclusion effect on members who did not opt out, and parens patriae role of the court - the withdrawal or settlement of a lawsuit, waiver of a claim or right to appeal, and the distribution of damages, require the court's approval. Bribery by a member, class representative or class attorney is subject to punishment by as much as lifetime imprisonment and a fine not exceeding the amount of bribery. A falsity in the complaint or failure to comply with a court order to present documents will be subject to penalty of W30 million or less. Chulhyun Kim and Wonil Chung of Hwang Mok Park provided this section. |
Most analysts expect that the Seoul Central District Court's ruling in the Daewoo case will affect a host of alleged Daewoo irregularities. More rulings of this nature are expected.
Of particular concern is the Ministry of Justice's announcement in May of an interpretive ruling that false disclosures in a company's 2004 financial statements (released in early 2005) can become a basis for a securities class action. Even though the class action law officially becomes effective on January 1, large companies must keep accurate books and records starting this year to avoid exposure under the new law.
The executives of the affected Korean corporations greeted the Ministry's ruling with dissatisfaction. They had hoped for a grace period to clean up their books before next year. (The same law will apply to companies with less than W2 trillion in total assets from January 1 2007.)
Unlike in the US, for example, where companies routinely indemnify their directors and officers, Samsung Electronics' directors were forced to pay a substantial amount of money from their own pockets. Accordingly, any director should be nervous about serving on the board of a Korean company.
If the US did not have a well-established right of indemnification for directors, qualified American business people would not serve on public company boards. If the trend seemingly started in the Samsung and Daewoo cases continues, many qualified Koreans will be unwilling to serve on the boards of domestic companies.
Counter-productive
As the government pushes domestic companies to increase transparency in corporate governance, Korean companies are expected to increasingly bring prominent foreign business figures into their boardrooms. In fact, this has already begun. For example, Samsung Electronics has added three directors who are not Korean citizens. The presence of such outside directors gives the market an increased level of confidence that the companies are making a greater effort to increase transparency in the management of their affairs.
But without indemnification, only insiders loyal to the chairman or the controlling family will be willing to serve on company boards, thus undermining the government's effort to increase transparency and strengthen corporate governance.
There is a pervasive feeling in the Korean judiciary, media and public that indemnifying officers and directors is unethical and creates a moral hazard for corporate executives. The concern is that officers and directors, given the protection afforded by indemnification, would abuse this right and act in ways harmful to the company and its shareholders. This makes Korean commentators generally opposed to companies indemnifying their executives and directors.
In the US, however, indemnification is a widely accepted practice and has not created a moral hazard. In reality, it is a necessary and critical tool in recruiting experienced and independent outsiders to serve on boards.
State law governs indemnification in the US. There is no nationwide federal statute creating the right to indemnification or determining the circumstances in which it is available to officers and directors or the mechanisms for making payments. However, each of the 50 states has laws providing for indemnification consistent with a common set of principles.
Most US companies are incorporated in Delaware, where state law forbids indemnification for any improper acts found at trial to have been taken by corporate officers and directors. For example, illegal acts taken for a director's personal benefit, rather than in the interests of the company, cannot be indemnified.
The central principle of indemnification in Delaware (and throughout the US) is to protect officers and directors from personal financial exposure when they take actions they reasonably believed to be in the best interests of the companies they serve.
Under Delaware law, as in all 50 states, procedural safeguards ensure that decisions about indemnification are made independently and that indemnification rights are not otherwise abused. Directors implicated in events leading to a request for indemnification are not allowed to participate in corporate deliberations pertaining to the question of whether a request should be honoured.
Only independent directors, those not personally involved in the matters under investigation, can debate and vote on a fellow directors' request for indemnification. Where no independent directors exist because the entire board participated in the decisions under review, Delaware law provides for procedures intended to ensure that unbiased individuals make indemnification decisions. For example, in some instances, directors cannot be indemnified by the company without a favourable vote from a majority of its shareholders.
Indemnification is an important right for those directors wrongly accused of misconduct. Qualified independent directors must be confident that they will not be subjected to personal financial ruin if they take steps believed to be in the best interests of the company that are later deemed by a court to be illegal or otherwise harmful to the company they serve. Further, dissident shareholders cannot be induced to alter a board's make-up simply by bringing suit against directors whose views they oppose.
Delaware law, as does the law of nearly every US state, allows companies to advance legal defence costs on behalf of officers and directors who are under government investigation or named as defendants in shareholder litigation. Competent and truly independent directors cannot, as a general rule, afford to pay the vast costs sometimes associated with defending against government or shareholder allegations of wrongdoing. However, directors of Delaware companies requesting advancement of defence costs must promise in writing that if their conduct is later found to fall short of the statutory indemnification standards they will repay the company for the costs of defence.
Nearly all US companies buy a form of insurance known as directors' and officers' liability insurance (D&O insurance), allowing them to recover a substantial portion of the money advanced to officers and directors under investigation. Of even greater importance, D&O insurance policies provide that, if a company for some reason cannot indemnify directors and officers (for example, if it is so insolvent that it lacks the funds to do so), directors and officers can receive direct insurance payment covering defence costs, settlements or judgments.
If Korea is interested in fostering transparency in corporate governance, it must provide protection for the independent directors critical to that objective. Having adopted the securities litigation scheme in place for many years in the US, Korea should now adopt similar indemnification rights.
Jong Han Kim is head of the Korea practice group and a partner at Paul Hastings Janofsky & Walker LLP in Hong Kong. Neil Torpey is also a partner in the Hong Kong office. John A Reding is a partner in the San Francisco office and chairman of the firm's litigation department, and James Wareham is a partner in the Washington DC office.