KLRI : KOREA LEGISLATION RESEARCH INSTITUTE

Ⅰ. Backgrounds and Purposes

○ Recently, the capital markets in Korea have witnessed a range of investor damages arising from factors such as corporations’ possession and utilization of own shares, the split-offs of major divisions, and control transactions by controlling shareholders. Such incidents undermine confidence in the capital markets.

  - The inadequate dissemination of a company’s performance and outcomes to investors involved in the capital markets is giving rise to a significant societal concern.

○ The purpose of this study is to identify ways to improve legislation that ensures protection for investors in the capital markets and to establish a framework for the capital markets where companies and investors benefit from each other, thereby contributing to facilitating the capital market and fostering advancements in the financial industry.

 

Ⅱ. Major Content 

▶ Existing systems to address consumer damages on the capital market and protect investors and their concerns 

○ The characteristics of Korea’s capital markets are as follows:

  - The number of ordinary investors holding shares of domestically listed corporations in Korea had surmounted 14.4 million by the end of 2022, representing a quarter of the country’s total population. 

  - It is observed that retail investors hold a significant portion of the Korean capital markets, in contrast to overseas capital markets where institutional investors tend to dominate. Given its propensity for inducing severe fluctuations, stock values would move in unforeseen directions instead of reflecting the fundamental elements of the economy.

○ The characteristics of retail investors in the capital markets are as follows: 

  - Based on a survey conducted by the Korea Legal Research Institute (the KLRI) in 2023, which involved 1,000 retail investors, it was found that 52.9% of respondents reported an investment period of less than five years. The overall average investment period was 7.3 years, with an average investment amount of 30.83 million won.

  - A significant majority of the respondents, specifically 75.4% expressed their discomfort with engaging in long-term investing activities. This sentiment is attributed to the perception that Korean corporations tend to make decisions primarily influenced by controlling shareholders. The primary focus of their investment in stocks is the potential for stock price appreciation, accounting for 81.9% of their interest. Following closely behind is the consideration of dividends, which accounts for 17.1%. 

 - The preferred methods for achieving return on investment include an increase in dividends (48.2%); enhancement of dividend period (21.9%); and improvement in management performance through excellent management practices (15.6%).

  - However, a majority of respondents (65.5%) expressed dissatisfaction with the adequacy of domestic firms’ return on profit to investors.

  - There are several reasons for engaging in direct investment: a significant proportion of individuals find direct investing to be more convenient and intuitive compared to indirect investment, accounting for 31.7% of the respondents; 21.3% chose direct investment as a means to use their experience and knowledge in the investment process; and 18.8% anticipate a larger return from direct investment compared to indirect investment. 

  - There are several ways to access major disclosures: mobile applications and websites of brokerage firms; portal sites like Naver Stock (25.9%); and the Data Analysis, Retrieval and Transfer System offered by the Financial Supervisory Service.

  - When asked about the frequency of checking major disclosures, the survey found that 19.6% of respondents indicated rarely checking them; 19.6%, when evaluating their investment; 13.9%, when stock prices fluctuate; 11.5%, two or three times per week; 10.2%, on a daily basis.

  - In response to the inquiry regarding the duration respondents allocate to reviewing major disclosures, it was found that 46.6% reported spending 5-10 minutes; 34.0%, 10-20 minutes; and 16.1%, 30 to 60 minutes.

  - A significant proportion of the respondents, namely 81.0%, indicated a lack of prior experience in expressing their for/against opinions on matters related to mergers, spin-offs, and carveouts during general shareholder meetings.

  - However, 65.4% of the respondents are aware of  their ability to exercise their appraisal rights in situations where they disagree with the decisions made by the companies, such as mergers, spin-offs and carveouts.

○ Investor damages caused by companies’ possession and utilization of their own stocks.

  - Companies are currently possessing their own shares without engaging in their retirement or disposal, instead employing them to benefit controlling shareholders.

  - The failure of companies to properly dispose of their own shares results in a decline in company value. The utilization of own shares by controlling shareholders to convert into a holding company during spin-offs or secure friendly stakes or mutual stock to maintain managerial control undermines the principle of affluent capital and distorts voting rights, resulting in damage to investors.

○ Investor damages caused by split-offs of companies’ major projects.

  - The split-offs of major projects result in a decline in the value of parent companies, thereby leading to a reduction in the stock price of these parent companies.   

  - If a major business sector is split off to a subsidiary, the ownership of the equity of the subsidiary is no longer held directly by general shareholders, but rather indirectly. Consequently, they are unable to be involved in crucial decision-making process of the subsidiary.

  - Where a subsidiary lists its stocks on the market and issues new stocks, attracting new shareholders, the parent company does not exclusively possess 100% of the subsidiary’s economic benefits. These benefits should be distributed among the shareholders of the subsidiary.

○ Investor damages resulting from control transactions executed by controlling shareholders

  - In the event of a one to one transaction obtaining controlling shares from controlling shareholders, the risks arising from this transaction are allocated to the entire shareholders or the company itself. However, it is important to note that the allocation of economic benefits, such as the right to determine changes in control and control premiums, is exclusively reserved for the controlling shareholders.

  - In cases of control transactions, shareholders encounter difficulties in accessing basic information such as the acquirer’s identity, the purpose of the acquisition, the target equity ratio, the managerial plan subsequent to the acquisition, etc. Consequently, ordinary shareholders are compelled to make the decision to sell their shares under a disadvantageous condition. 

▶ Overseas Legislation on Investor Protection in Capital Markets

○ Overseas legislation governing the possession and utilization of own shares by companies

  - In the United States, the Corporation Act (specifically, the California Corporation Code, 1984 Revised Business Model Corporation Act) is a contemporary legislative framework that eliminates the notion of own stock. As a result, shares repurchased by a company are classified as authorized but unissued shares and do not possess any rights.

  - According to the provisions under the UK Companies Act, it is prohibited for a company to exercise any right in respect of the own shares, and any purported exercise of such a right is void.

  - Under the German Stock Corporation Act, shares purchased by a company as own shares shall be valid for a maximum of five years. They should be acquired based on a resolution adopted by the general meeting and should not exceed ten percent of its share capital. The company does not have any rights with respect to the own shares. 

  - According to Japan’s Companies Act, companies may possess their own shares as own shares without any specified time limit, but the same regulations governing the issuing of new stocks also apply to the disposal of the own shares.

○ Overseas legislation on split-offs

  - With the exception of the Pennsylvania Business Corporation Law and the Texas Business Corporation Act, the US lacks an independent 

    system for addressing split-offs. The split-offs are executed by the distribution of dividends, which may take the form of in-kind investments or the transfer of business. However, it is a prevalent occurrence for a subsidiary to remain unlisted despite its parent company being listed, owing to the widespread notion of interest conflict. 

  - The 2017 European Union Corporate Directives categorize spin-offs as ‘merger’ and ‘consolidation,’ but do not provide for split-offs.

  - The Japanese Companies Act does not include provisions for the categorization of split-offs and spin-offs, which were previously regulated under the Commercial Act. According to the provisions, spin-offs are defined as the aggregate of split-offs and surplus dividends.

○ Overseas Legislation on Tender Offer when Change of Control of Controlling Shareholders

  - The US Securities Exchange Act, a federal law, establishes tender offer rules that can be categorized into two axes: disclosure regulations and discriminatory tender offer regulations, on the securities market. The regulations regarding mergers in each state prescribe the protection of minority shareholders during a change of control and measures to protect the management of the changed company. These laws are further reinforced by legal concepts derived from court decisions within each state.

  - To protect minority shareholders, the UK has implemented regulations pertaining to the change of control through the utilization of a ‘mandatory tender offer system’ where an acquiring company must acquire all the securities, etc. that have been offered and subscribed to in principle when it obtains controlling shares. 

  - Japan’s tender offer system compromises those in the US and the UK. Where more than ten persons intend to purchase and, after purchasing stock certificates, its ownership ratio of the stock certificates, etc. exceeds 5% or its holding ratio of the stock certificates, etc. exceeds 1/3, such purchases should be made by means of a tender offer. In addition, where the ownership ratio of the stock certificates, etc. exceeds 2/3 after the tender offer, all the stock certificates, etc. offered to sell should be purchased.

▶ Analysis of a Focus Group Interview of Experts to Design Systems to Protect Investors in the Capital Markets

○ Overview of Focus Group Interview (FGI)

  - Conducting a focus group interview to obtain recommendations for enhancing the existing systems by focusing on experts on the capital markets to collect their opinions to take measures to protect investors.

  - Composed of members of interested parties and experts engaging in various fields, including private equity funds, economic research institutes affiliated with securities firms, the Korea Listed Companies Association, the National Pension Fund Operation Committee, universities, professional policy research institutes, etc.

▶ A Survey Conducted to Assess the Effectiveness of the Current Systems to Protect Investors in Capital Markets

○ An in-depth interview with investors regarding the capital markets, conducted by the Korea Legislation Research Institute (KLRI)

  - Conducting in-depth interviews with investors who have made investments exceeding five million won for a duration of at least one year among ordinary investors in the securities market (May 1 to May 14, 2023)

  - Based on the in-depth interview with ordinary investors to collect their opinions on various policies implemented by Korean companies, including the return of profit, possession of own shares, split-offs, and tender offers in cases of corporate management changes, and analyzing investors’ perceptions on disclosure systems introduced to protect ordinary investors, appraisal rights, and measures implemented to protect minority shareholders.

○ A survey pertaining to investors on the capital markets, conducted by the KLRI

  - The implementation of a mobile panel survey, utilizing structured questions to gather data from a sample of 1,000 ordinary investors aged 20 and above who are invested in the domestic stock market. (From August 2, 2023 to August 9, 2023)

  - When asked about the occurrence wherein companies retain their own shares without retiring or disposing of them, 39.9% of the respondents conveyed a negative sentiment, which somewhat surpassed the proportion of individuals expressing a positive view (38.1%). A significant proportion of the participants, specifically 70.1%, indicated that the compulsory retirement and disposal of own shares following stock repurchases is necessary in order to protect investors. 

  - 78.7% of the respondents expressed their support for the measures to disclose the objective behind the acquisition of own shares.

  - When asked about the distinctions between spin-offs and split-offs, 37.7% of respondents indicated a lack of knowledge, while 34.4% said that they were vaguely aware of them.

  - Among those responding that they are somewhat aware of the distinctions between spin-offs and split-offs, 53.4% expressed a preference for spin-offs over split-offs.

  - When asked about the efficacy of countermeasures implemented by the Financial Supervisory Commission in addressing the decrease in stock prices resulting from split-offs, the majority of respondents (50.1%) expressed uncertainty over their effectiveness. The percentage of respondents who indicated that such measures were effective, including 30.3% (0.6% for highly effective and 29.7% for moderately effective), exceeded the proportion of individuals who reported them as ineffective.

  - With 63.3% saying that a change in controlling shareholders is important (10.3% for very important and 53.0% for important), ordinary investors are perceiving a change in controlling shareholders to possess significant importance. 

  - The most common reason given for why a change in controlling shareholders is important is the reliance on controlling shareholders and management for  business performance and future vision, as indicated by 51.2% of respondents. This is closely followed by concerns over ownership risk issues, which accounted for 23.3%.

  - When considering the decision to vote in favor or against a change of controlling shareholders and the implementation of ‘appraisal rights’ or ‘mandatory tender offer system,’ 64.6% (8.1% for absolutely necessary + 56.5% for necessary) responded that those measures are necessary.

▶ Measures to Improve Measures for Protecting Investors in Capital Markets

○ Measures to improve legislation for protecting investors when companies possess or utilize own shares

  - It is necessary to seek measures to secure fairness in the purchase of own shares and their possession and disposal with respect to the following issues: 1) when a company undergoes a spin-off, the partial allocation of new stocks to the own shares in order to maintain the control of controlling shareholders; and 2) the disposal of the own shares for the purpose of holding shares in a mutual relationship to safeguard the management of controlling shareholders. In this regard, the enhancement of the disclosure system is an easier way to secure fairness in the acquisition of own shares and the disposal thereof, as well as to promote the transparency of corporate information and the fairness of corporate decision-making while upholding market autonomy.

  - Specifically, it is imperative to implement ‘measures aimed at ensuring fairness in the utilization of own shares’ to resolve investor damage caused by the allocation of split shares to own shares for the benefit of controlling shareholders during spin-offs. In this regard, it is necessary to prohibit the allocation of new shares to own shares in the event of a split or merger based on the principles governing unissued shares of own shares.

  - Investor damage occurs in cases where own shares are disposed of for the purpose of safeguarding management control, as opposed to the original purpose of purchasing own shares, to enhance preferred shares or to retain mutual shares. Consequently, there is ongoing deliberation regarding the implementation of measures aimed at ensuring fairness in the disposal of own shares. In this regard, it is necessary to introduce an explicit provision in the Commercial Act that recognizes own shares as unissued shares and to clarify that provisions regarding preemptive rights are applicable to the disposal of the own shares.

  - However, where the own shares are frequently disposed of, it becomes onerous to consistently adhere to the procedures for extending offers to shareholders on every occasion. Therefore, in the case of modest amounts, it is necessary to allow the sales on the market or transfer them to a third party and to establish exemptions that serve different purposes, such as the disposal of own shares for employee benefits, etc.

  - Furthermore, it is necessary to implement measures aimed at safeguarding management control that are advantageous to companies, such as the utilization of preemptive rights in the form of a poison pill.

○ Measures to improve legislation to protect investors in the event of split-offs

  - In order to safeguard the interests of investors in the event of split-offs, the Financial Supervisory Commission implemented measures aimed at enhancing disclosure systems. These systems are perceived as desirable due to the potential for investors to value market autonomy and make informed decisions based on transparent information disclosure. Nevertheless, the current disclosure systems only apply to listed companies and a limited number of unlisted companies. Other unlisted companies’ ordinary shareholders are not likely to be protected.

  - The appraisal rights under the Enforcement Decree of the Capital Markets Act were introduced by the Financial Supervisory Commission in 2022. However, these rights are also applicable to listed corporations and may have certain limits when protecting the interests of ordinary shareholders of unlisted companies.

  - As an alternative, it is proposed that an amendment be made to the Commercial Act in order to protect shareholders of unlisted companies, allowing appraisal rights to them. However, in situations where split- offs are commonly conducted as a means to secure funds to expand investment in the split-off division, the excessive exercise of appraisal rights may actually impede the company’s ability to obtain financing. Therefore, it is advisable to consider amending the Commercial Act to restrict the exercise of appraisal rights solely to instances where a significant split-off occurs.

  - The practice of distinguishing between spin-offs and split-offs inside Korea’s legislative system is not often observed in other countries. Therefore, it is important to consider implementing different measures concerning split-offs, such as the adoption of hybrid division (a combination of split-offs and spin-offs) that enables the distribution of split shares to shareholders of a parent company. This measure aims to protect ordinary investors in cases of split-offs, as opposed to maintaining the current divided system outlined in the Commercial Act.

○ Measures to protect investors in the event of control transactions by controlling shareholders

  - When asked about the measure to allow investors to exercise their appraisal rights through a general meeting in cases of a change in controlling shareholders, a significant proportion of retail investors responded favorably based on survey data. However, expert focus group interviews revealed a greater prevalence of dissenting viewpoints. 

  - Control transactions are considered to be private transactions, and should be distinguished from other corporate conduct such as transfers of business, mergers, etc. Furthermore, it is imperative to extend the application of the principle of freedom of stock transfer to encompass controlling shareholders. Thus, it is deemed unfavorable to include provisions within the Commercial Act, which contains the regulations pertaining to collective law, granting controlling shareholders the right to convene a general meeting and exercise their appraisal rights in relation to the transfer of shares. 

  - It is advisable to establish regulations pertaining to the protection of investors in cases involving changes in controlling shareholders under the Capital Markets Act. This legislation is designed to foster the sound development of capital markets and ensure the protection of investors, as opposed to relying on the provisions outlined in the Commercial Act. In light of this context, there are ongoing discussions regarding the implementation of mandatory tender offer provisions under the Capital Markets Act, as well as efforts to enhance the existing tender offer system. 

  - However, there are concerns regarding the disruption of M&A when considering the implementation of an EU-style mandatory tender offer system. A potentially more feasible option would involve maintaining the existing tender offer system as outlined in the Capital Markets Act while enhancing safeguards for investors and promoting investor protection and M&A through lowering certain requirements.

○ Policy recommendations for investor protection in capital markets

  - Professionals and policy authorities often regard the enhancement of the disclosure system as a favored policy alternative to uphold market autonomy. However, it appears that investors in Korea’s capital markets are not effectively utilizing DART, the most authoritative system available. Furthermore, their level of interest in disclosure and the amount of time they dedicate to it are notably low. 

  - Currently, investors in Korea lack the capacity to independently safeguard their interests. Merely relying on market autonomy is insufficient; it is imperative to establish policies that empower retail investors to identify themselves as shareholders and strengthen their rights and interests in this capacity. 

  - Furthermore, it is imperative for the Commercial Act to acknowledge the director’s duty of good faith towards shareholders, in addition to their existing duty towards the company. This recognition should be based on the principle of shareholder equality. Moreover, the Commercial Act should also acknowledge the major shareholder’s duty of good faith towards minor shareholders. This would enable minor shareholders to initiate a shareholder representation lawsuit in case of any violation. Consequentially, this would ensure that the principle of equality between controlling shareholders and minor shareholders is upheld during tender offers for stock repurchases, split-offs, and changes in control. 

 

Ⅲ. Expected Effects

○ This study can be employed to make necessary revisions to pertinent statutes, such as the Capital Markets Act and the Commercial Act, with the aim of protecting investors in the capital markets.