November 17 2003
The Seoul High Court's recent decision in Eun Sub Jung v Pyong Sub Jung 2002 NA 13746 (August 22 2003) represents a significant landmark with respect to the issue of standing in shareholder derivative actions. The court held that the shareholders of a corporation have standing to file a double derivative action on behalf of one of the corporation's subsidiaries against the subsidiary's directors, even where they possess no shares therein. The first derivative action was thought to have been filed in Korea only in 1997, and so the court's decision may be viewed as setting a precedent and indicating a move by the domestic courts towards increased shareholder rights and directors’ liability.
The plaintiff, an individual owning around 30% of the shares of Hwasungsa Co Ltd, a Korean joint stock company, filed a derivative suit seeking monetary damages against the defendants in their capacity as directors of Hwasungsa. The plaintiff alleged misconduct in connection with the initial public offering of shares of Sungdam Co Ltd, an 80% owned and controlled subsidiary of Hwasungsa, and the subsequent transaction for the sale of Sungdam shares to certain third parties for the purpose of settling Hwasungsa's inter-company debts. The plaintiff also filed a double derivative suit against one of the defendants in her capacity as representative director of Sungdam, alleging misappropriation of funds in connection with the sale of certain real estate assets owned by Sungdam.
Issue of standing with respect to double derivative action
The most significant aspect of the court's decision is the standing issue in connection with the double derivative suit against one of the defendants in her capacity as representative director of Sungdam. The court held that the plaintiff had proper standing to file the double derivative claim and ordered the defendant to pay damages to Sungdam. In its decision, the court considered two commonly raised arguments against allowing double derivate actions as follows.
Contemporaneous ownership requirements
A frequently raised argument against double derivative suits is that shareholders in such actions lack contemporaneous ownership requirements - usually legislative requirements that a shareholder own shares at certain times in order to bring the suit. Article 403 of the Commercial Code effectively provides that derivative suits may be brought only by shareholders owning at least 1% of the outstanding shares of a company against the company's director at the time of filing the action, while Article 191-13 of the Securities Exchange Act changes this shareholding requirement to at least 0.01% of the outstanding shares to be continuously owned for the past six months at the time of filing with respect to listed or KOSDAQ (Korean Securities Dealers Automated Quotations) registered companies. These provisions do not require the shares to be held at the time of the cause of action. However, according to a strict reading of these provisions, a company shareholder who does not hold shares of a subsidiary company would be barred from filing a double derivative suit on behalf of such subsidiary against its directors, since he or she would not meet the share ownership requirement.
Another commonly raised argument against double derivative suits is that shareholders in a double derivative action already have a remedy available in the form of a derivative action on behalf of the parent company against its directors. According to this reasoning, a shareholder must demand a remedy from both the subsidiary's and the parent's board of directors before filing a double derivative suit. Once the parent's directors have refused to take action regarding the subsidiary at issue, a double derivative action is unnecessary because the shareholder has a remedy in the form of a single derivative action against the parent's directors on behalf of the parent corporation for failing to take action to protect the parent's investment in the subsidiary, under the principle that any harm to the subsidiary constitutes a direct harm to the parent.
The court ultimately rejected the foregoing arguments as inequitable and artificial. In its opinion, it is necessary to permit double derivative actions in certain cases such as Eun Sub Jung where both the parent company and the subsidiary are under the common control of the defendants; the defendants could shield themselves from liability by conducting business and any potential improprieties through the subsidiary. In addition, the alternate remedy of single derivative suits was not feasible in some cases since it may be very difficult to appraise the indirect harm to the parent company caused by direct harm to the subsidiary. Moreover, relying on single derivative actions may result in multiple derivative suits filed by the respective shareholders in cases where multiple shareholders own shares in a single subsidiary corporation. By contrast, only one double derivative suit would be necessary to provide a remedy for all the shareholders holding stock in the subsidiary.
The court also cited general policy decisions for its decision, stating that to allow double derivative suits would have a deterrent effect with respect to misconduct or generally any breach of fiduciary duty by a director of a subsidiary, and that double derivative suits should be permitted since damages or losses by a subsidiary ultimately have a negative impact on the parent company. Finally, the court held that the 'shareholders' permitted by the Commercial Code to file derivative actions may be interpreted to include shareholders of shareholders which are corporations.
Initial public offering of Sungdam shares
The plaintiff claimed in its derivative suit against the directors of Hwasungsa that the decision of the Sungdam board to make a public offering of Sungdam shares was unnecessary and detrimental to the firm. This claim appears to have been incorrectly filed since it is clear that the decision to make a public offering was made by Sungdam and not Hwasungsa. The court dismissed the claim as the plaintiff did not have proper standing.
Sale of Sungdam shares by Hwasungsa to third parties
The plaintiff filed a derivative suit against the defendants as directors of Hwasungsa, alleging that the company sold stocks to certain third parties below market price, thereby causing harm to Hwasungsa. The court rejected the plaintiff's argument that the shares were undervalued, as the sales prices were close to the market price. As a dictum, the court ruled that the sale of shares of a subsidiary will not be subject to special approval at a shareholders meeting unless the shares to be sold are substantial and the selling entity is a merely a holding company.
Sale of Sungdam shares to pay inter-company debt
The court also rejected the plaintiff's argument that Hwasungsa should have paid the inter-company debt to Sungdam by issuing new shares, merging with Sungdam or receiving dividends from Sungdam. In addition to the practical difficulties of a capital increase and merger and dividend distribution due to a dispute between two largest shareholders of Hwasungsa, the court accepted the decision of Hwasungsa's board.
Although Eun Sub Jung represents the first double derivative action to appear before the Korean courts, the court's opinion regarding the standing of the plaintiff appears to be based on general principles and arguments in connection with the issue of double derivative actions, and does not set any clear thresholds or delineate any clear boundaries for future double derivatives cases. For example, although the court states in its decision that one of the factors in finding that plaintiff had proper standing for the double derivative suit was that Hwasungsa controlled Sungdam, it failed to explain what level of ownership is deemed to merit 'control'. However, it is possible to infer some general guidelines that the courts may follow to find standing in future double derivative cases. For example, it is likely that courts reviewing future double derivative actions will require substantial connection between the parent company and subsidiary in the manner that existed between Hwasungsa and Sungdam (eg, a large shareholding interest and common directors).
In addition, the theories applied by the court in Eun Sub Jung can be extended to apply to derivative suits brought under other derivative action clauses provided under the Commercial Code such as Article 324 (concerning promoters’ liability and shareholders’ derivative suits), Articles 424-2 (concerning the liability of subscribers of shares at unfair prices) and Articles 467-2 (concerning prohibitions against granting pecuniary benefit)¸ as well as under the Securities and Exchange Act.
The case is not yet final and is being appealed to the Supreme Court.
For further information on this topic please contact Hee-Chul Kang or Mi Gu Jang at Woo Yun Kang Jeong & Han by telephone (+822 528 5200) or by fax (+822 528 5300) or by email (email@example.com or firstname.lastname@example.org).
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