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Jipyong News|KOREA LEGAL INSIGHT

Implications to PEFs of Supreme Court Ruling on “Good Faith” Cooperation in Shareholder Exit Processes

2021.07.19

“An exit process based on good faith is essential.” 
 
Private equity funds (PEFs) should take note of a Korean Supreme Court ruling observing that “an exit process based on good faith is essential ” and holding that a shareholder exercising ‘drag-along’ rights to compel another shareholder to sell its shares may be subject to ‘good faith’ cooperation obligations. 
 
On January 14, 2021, the Supreme Court of Korea issued its ruling in a lawsuit filed against Doosan Infracore (“DIC”) by top local private equity funds regarding a proposed sale of DIC’s Chinese subsidiary, Doosan Infracore China (“DICC”) (the “DICC Lawsuit”).1  Claiming damages of 700 Billion Korean Won (approx. USD 610 million) for breach of their shareholders’ agreement (the “DICC Shareholders’ Agreement”), Korea’s top private equity funds as DICC’s second largest shareholders (the “PEF Shareholders”) alleged that DIC had failed to perform its obligation to cooperate with the PEF Shareholders’ proposed sale of DICC shares (the “Sale Transaction”).  Understandably, the DICC Lawsuit attracted a great deal of legal and political attention given the size of the claim amount and the impact the outcome would have on the fate of Doosan Group’s corporate restructuring plan. 
 
In reaching a rather explicit ruling on certain legal issues that may arise in proposed exit processes involving PEFs, the Supreme Court’s ruling in the DICC Lawsuit (the “DICC Ruling”) provides PEFs with several points for consideration in their investment and management strategies. 
 
 
A Shareholder’s Exercise of Drag-Along Rights is Subject to Cooperation Obligations 
 
The DICC Ruling proposed an express guideline with respect to cooperation obligations that may arise in the exercise of a shareholder’s drag-along rights during an exit process.  Given that drag-along rights were involved, the Supreme Court held that DIC had a ‘good faith’ obligation under the DICC Shareholders’ Agreement to cooperate with the PEF Shareholders as selling shareholders (the “Selling Shareholders”) upon receiving notice from the Selling Shareholders of their intention to sell their shares of DICC and exercise their drag-along rights; this cooperation obligation included the prompt provision of relevant information concerning DICC and an opportunity to conduct due diligence investigations to facilitate a smooth completion of the Sale Transaction.  However, the Supreme Court also held that the Selling Shareholders also had an obligation to cooperate with DIC, such as by promptly providing upon DIC’s request all such information required for DIC to determine whether the proposed buyer had a genuine desire to purchase the DICC shares and there were any issues with the purpose or intent of the Sale Transaction.  In contrast to the rulings of the lower courts, the Supreme Court recognized an obligation on a selling shareholder exercising its drag-along rights to cooperate with the other shareholder(s) against whom the drag-along rights are being exercised, by providing the information needed by such other shareholder(s) to confirm the essential terms of the proposed sale transaction. 
 
The DICC Ruling is meaningful as it expressly holds that a general partner of a PEF (i) cannot be permitted during the exit phase to rely on a strict and formalistic interpretation of investment agreements (such as shareholders’ agreements) to impose unilateral demands for performance or other sacrifice by the counterparty and (ii) must comply with the general civil law principle of ‘good faith’ to provide sufficient information on the target company that reasonably takes into account the particulars of its then existing circumstances. 
 
 
Clear Drafting of Exit Provisions Ensures a Successful Exit 
 
The DICC Ruling also illustrates how taking sufficient time during the investment phase to ensure that exit procedures are drafted into investment agreements (such as shareholders’ agreements) with sufficient care and detail will form a solid basis for a successful exit. 
 
The problematic provisions of the Shareholders’ Agreement that came under scrutiny in the DICC Lawsuit provided for (i) drag-along rights of the Selling Shareholders that were subject to certain elective/alternative rights (in Korean, seon taek chae gwon) exercisable by the other shareholder, and (ii) an obligation on Doosan Group to maintain its then current shareholdings in Doosan (China) Financial Leasing Corp. (“DCFL”). 
 
The drag-along provisions of the Shareholders’ Agreement stated that the Selling Shareholder may elect to sell its shares in DICC (the “Selling Shareholder’s Shares”) in the event DICC failed to consummate an initial public offering within three (3) years (a “Drag-along Sale”); and, in doing so, the Selling Shareholder may also elect to require the other shareholder (the “Non-Selling Shareholder”) to sell all of the shares held by such shareholder (the “Drag-along Right”).  However, the Non-Selling Shareholder also had the option to (i) agree to the Selling Shareholder’s exercise of the Drag-along Right, (ii) purchase the Selling Shareholder’s Shares at either (determined in its sole discretion) (x) the price set forth in the Selling Shareholder’s notice of exercise of the Drag-along Right or (y) a pre-agreed purchase price, or (iii) request the proposed Drag-along Sale to be made with a different third-party purchaser on more favorable terms and conditions.  The lower courts ruled that the drag-along provisions provided for bilateral terms on equal footing; however, the Supreme Court found that the elective/alternative rights of the Non-Selling Shareholder under sub-paragraphs (ii) and (iii) effectively granted the Non-Selling Shareholder the right to revise (i.e., over-ride) the principal agreement relating to the Drag-along Right under sub-paragraph (i).  The lesson here is that the drag-along provisions were drafted in a way that allowed for a different interpretation from that intended by the PEF Shareholders, which effectively barred the PEF Shareholders from utilizing the Drag-along Right as the exit mechanism they intended. 
 
A similar interpretation issue arose with the covenant to maintain the then current shareholdings of DCFL, which provided that “the Doosan Shareholder shall use its efforts to procure that Doosan Capital maintains its shareholding status in DCFL.” It was unclear whether the clause imposed any specific obligation on Doosan Group.  The Supreme Court observed that where contract provisions contain phrases such as ‘…shall cooperate to the fullest extent possible ’ and ‘…use its efforts ’, a comprehensive consideration should be made of all factors (such as the entirety of the agreement and the parties’ true commercial intent) to determine whether any particular circumstances existed to indicate that the provision was meant to stipulate an intention to bear a legal obligation; the Supreme Court held that if such circumstances are found to exist, such provision shall be deemed a binding and enforceable obligation.  The Supreme Court further held that Doosan Group was indeed obligated to maintain Doosan Capital’s then shareholdings in DCFL and had breached such obligation.  The DICC Ruling expressly holds that a provision declaring the underlying principle of good faith of contracting parties through use of phrases such as ‘…shall cooperate to the fullest extent possible ’ can be deemed to constitute a legally binding and enforceable obligation if the circumstances call for it.  However, the real lesson from the DICC Ruling is that Doosan Group would have been better deterred from disposing of its shares in DCFL if the Shareholders’ Agreement had more clearly and unambiguously stipulated Doosan Group’s obligations relating to its shareholdings of DCFL. 
 
 
The Five-Year Road to the DICC Ruling 
 
Finally, the DICC Ruling shows that (i) an exit process based on good faith (on the part of both investors and the target company) is essential and (ii) implementation of an exit process through litigation may not be a reasonably viable option.  The DICC Ruling was finally made on January 14, 2021, some five years from November 19, 2015, when the PEF Shareholders filed suit in the Korean courts.  It is fair to say that dragging out a lawsuit involving billions of Korean Won in an ever rapidly changing global economy is beneficial to neither investors nor the target company.  As was expressly stated in the DICC Ruling, the participants of the DICC Lawsuit would have achieved greater economic benefit and been able to progress management and operation of the funds and target company more efficiently if they had interpreted the relevant agreement provisions in good faith and sought to resort to a reasonable exit process. 
 
The DICC Ruling unequivocally suggests the direction that PEFs (marking 16 years since their introduction into the Korean market) need to take in their investment and management strategies.  Even if not expressly set forth in applicable agreements, investors (PEFs) and target companies need to apply the fundamental principles of Korean civil law by (i) cooperating with each other to ensure a reasonable and efficient investment phase and (ii) performing the obligations set forth in their applicable agreements in good faith – the DICC Ruling effectively reflects this philosophy.

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