A Primer on Korean Bankruptcy Law

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Jun 1999

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The International Scene

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While a great deal of interest in bankruptcy laws of Asian countries exists in the United States today, there is a

dearth of literature explaining these laws to American practitioners. In this article, we seek to bridge that gap by

describing in basic terms how the South Korean bankruptcy laws work.

<h3>Bankruptcy Procedure Background</h3>

There are basically three bankruptcy procedures in Korea: composition<a href="#1" name="1a">1</a> (under the Composition Act), liquidation<a href="#2" name="2a">2</a>

(under the Bankruptcy Act) and corporate reorganization<a href="#3" name="3a">3</a> (under the Corporate Reorganization Act). The Corporate

Reorganization Act, established in 1962, was basically adopted from Japanese corporate reorganization law, which

in turn is based on chapter X of the U.S. Bankruptcy Act before it was revised in 1978.

The Corporate Reorganization Act was amended in 1981 and 1984, though with little change to its structure.

The Korean composition law had not been revised since its enactment in 1962 until recently. Under pressure from

the recent surge in bankruptcies and requests by international lending institutions to modernize Korean bankruptcy

procedures, all bankruptcy-related laws were amended in February 1998.

Out-of-court voluntary liquidation was the ordinary solution for small firms in distress until recent years.

Utilization of bankruptcy court procedures was rare until the 1980s due to the lack of large incorporated firms at the

time. The utilization of court procedures in cases of default increased rapidly after 1990, when the Constitutional

Court ruled that auctioning off secured debt owed to financial institutions of a firm under corporate reorganization

was unconstitutional.<a href="#4" name="4a">4</a> Meanwhile, composition, originally designed for small firms, was rarely used until very

recently due to the little understanding on the part of potential users.

Until the mid-1980s, the government's heavy intervention in the industrial sector prevented more effective

utilization of bankruptcy court procedures. The entry and exit of large firms were an intrinsic part of government

industrial policy, and the government controlled these processes mainly through the Industrial Development Act,<a href="#5" name="5a">5</a>

the Tax Exemption Act<a href="#6" name="6a">6</a> and through its heavy influence over the financial sector. This policy relegated bankruptcy

court procedures to a role supporting government decisions. The government's control loosened in the 1990s as the

Industrial Development Act gradually faded from the economic landscape. Yet, when large Korean firms failed, the

government tended to take matters into its own hands on an ad hoc basis. In doing so, the government showed

little regard for consistency of policy, thorough economic analysis or adherence to legal procedures.

The shortcomings of the Korean legal bankruptcy laws have only become evident with their more frequent use

during the 1990s. The movement toward a more legalistic approach to resolving corporate defaults, as opposed to

heavy reliance on the government, underscores the importance of recent reformed bankruptcy related laws and the

ongoing debate. What follows are brief descriptions of the procedures for composition and corporate reorganization

under Korean law.

<h3>Composition</h3>

Composition under the Composition Act was originally established for small- and medium-sized firms with

simple capital structures. It was originally designed to be shorter, and therefore less costly, than corporate

reorganization. However, there has been no explicit upper limit to firm size, attracting many large corporations to

apply for composition in 1997.

The greatest merit of composition from the viewpoint of management is that the original shareholders and

managers remain in control. The shareholders and managers of large firms, which would have had to relinquish

control, have taken advantage of this provision. This has led legislators to make requirements for application and

withdrawal for composition stricter under the 1998 amendment. For example, (1) an application for composition

cannot be withdrawn once an order of stay is declared; (2) the court guidelines to judges recommend that

composition not be allowed for firms with total bank loans of more than 250 billion won;<a href="#7" name="7a">7</a> and (3) composition

will not be allowed if insolvency/bankruptcy resulted from the misappropriation of corporate funds by managers.

Composition must be filed along with a new plan for debt restructuring. An unofficial pre-agreement with the

creditors is important because under composition, not all classes of debt are covered. Secured loans, trade credit,

government claims and taxes are free to be collected. Nevertheless, new loans can be acquired, which can be paid

back before pre-petition credits with the approval of the court.

Whether composition procedure will be granted is not automatic with filing. The court will make the decision

to approve the application after an investigation of the state of the firm and existence of fraud. The procedure

commences with the approval.

At the time of application, related parties can also apply for a stay (a temporary injunction on any claims to the

firm's assets, effective only until the commencement of composition) to protect the firm's assets and prevent

selective debt payments during the hiatus between the filing and approval of composition. If a stay is granted, a

temporary receiver is appointed by the court to manage and oversee the firm's assets.

A committee of trustees has been established to assist the court in all bankruptcy cases. The trustees report their

opinion to the court on the appointment of the temporary receiver, investigation officers and the receiver.

Sometimes, members of the trustee committee can themselves be appointed as investigation officers or receivers in

order to speed up the process.

After the composition begins, the creditors' meeting is held, and votes either for or against the new plan are

taken there. If the creditors reject the plan, the composition is either dismissed or turned into a liquidation case. If

the new plan is approved, it is implemented. If the new terms and conditions are not carried out, composition can

be cancelled or turned into a liquidation case. However, the court's involvement is minimal after the approval of the

plan, only receiving quarterly reports on the implementation process.

In many cases, composition has failed to revive distressed firms. Terms of new agreements are usually

unfavorable to debtor firms, exerting a difficult burden on their ability to pay back. For example, the interest rates

are often higher than in corporate reorganization. Such an arrangement may be inevitable, given that those creditors

usually need inducements to agree to composition rather than to press for liquidation or corporate reorganization.

But the unfavorable terms for a small debtor firm also result from its weak bargaining position vis-a-vis its

creditors, which are often large banks. Therefore, though designed for small firms, composition on the whole has

been quite an ineffective procedure for reorganizing small firms.

<h3>Corporate Reorganization</h3>

Corporate reorganization is designed for large incorporated firms whose bankruptcy may have significant

repercussions throughout the economy. Small firms, with assets worth less than 20 billion won and capitalization

under two billion won, were prevented from applying for reorganization on the premise that the procedure is too

expensive and lengthy. However, recognizing the little chance of reorganization for small firms, the 1998

amendment has included a special provision under which small firms can opt for the corporate reorganization

procedure in certain cases.

Managers, shareholders or creditors can file for reorganization. An application for a stay is filed at the same

time. There is no automatic stay; it is decided on a case-by-case basis. Usually, when a stay is denied, it means that

the reorganization procedure will not be approved, and many firms do not survive the hiatus between the filing and

the beginning of the court procedure if a stay is not granted. The 1998 amendment has made granting a stay more

lenient, while making a decision on corporate procedure stricter. For example, a corporate reorganization will not be

allowed when the firm value is greater under liquidation than in operation under reorganization.

After an investigation, a temporary receiver is appointed if the stay is approved. Then a committee of creditors

is formed and the first meeting of related parties is called. Details of the case are disclosed, and creditors are invited

to report their claims. The creditors' committee coordinates conflicting interests among the creditors and advises the

court of its views concerning the reorganization process. Creditors are entitled to any important information

regarding the process from the court and the trustee. The committee can make recommendations to the court,

including dismissing the case, even though the court ultimately decides. After investigation of the claims, the firm

(i.e., the receiver) submits a reorganization plan.<a href="#8" name="8a">8</a>

Creditors consider the plan in the second meeting of related parties and can request changes to be made in the

plan. The plan is voted on in the third meeting by the creditor class. The plan needs an approval of two-thirds of the

unsecured creditors and three-fourths (when concerning extension period) or four-fifths (when concerning

reduction/exemption) of the secured creditors. The plan is then implemented, and depending on whether it is

successful or not, the procedure is brought to an end by the court or is dismissed. If the creditors do not approve the new plan, the procedure is dismissed or turned into a

liquidation case.

Formerly, management was forced to resign and shareholders were required to relinquish all their shares without

compensation. A court-appointed receiver managed the firm until it emerged from the court procedure. The

harshness with which shareholders and managers were treated forced distressed firms to seek protection under

composition, even in cases where the debt structure was complex and the level of debt high, making them

inappropriate for such a short and simple process as the composition. Therefore, to increase the incentives for large

firms to apply for corporate reorganization rather than composition, and have them do so early rather than when

recovery becomes impossible, some changes were made by the 1998 amendment. Under the new rules, existing

management (if judged by the court to be suitable) is allowed to remain in joint control with a court-appointed

trustee. Further, major shareholders are not required to relinquish their shares except when:

<ol>

<li>They are involved in seriously mismanaging the firm or found guilty of illegal activities. In this case, they will

be required to give up more than two-thirds of their holdings, and in addition, will not be allowed to acquire newly

floated shares in the reorganized company.

</li><li>The amount of debt is greater than the asset value. In this case, shareholders must give up more than 50 percent of

their shares (it can be 100 percent) without compensation.

</li></ol>

The 1998 amendment also attempted to make bankruptcy procedures more efficient and speedy. The court is now to

decide whether to provide a stay on a firm's assets within two weeks of the application for corporate reorganization.

Once all debts of the firm are registered and clarified, the trustee must submit plans for reorganization within the

ensuing four months. The court can end the reorganization process if the process is not resolved within one year of

initiating the reorganization process. (Under extraordinary circumstances the deadline for resolution is extended to

one and a half years.) Further, the recommended maximum payback period has been reduced from 20 to 10 years.

To handle information flows more efficiently, all three bankruptcy procedures are now to be administered by the

regional courts, whereas before the 1998 amendment, liquidation and composition had been handled by local courts

and corporate reorganization by regional courts.

<h3>Relationship Between Corporate Reorganization, Composition and Liquidation</h3>

Korean bankruptcy law favors reorganization over liquidation. Between corporate reorganization and

composition, the former is favored to the latter. This is apparent from the priority the court gives to corporate

reorganization. Once a corporate reorganization is approved, application for composition or bankruptcy cannot be

filed. Further, application for corporate reorganization overrides composition, even if the latter has already been

applied for or is in process. Kia is a good example of this; the management had applied for composition, but

creditors forced it into corporate reorganization. At the same time, only when corporate reorganization is denied or

the process is stopped can an application for composition be filed. When liquidation and composition are filed

together, composition takes priority, and once composition is approved, application for liquidation cannot be filed.

However, once the firm is denied composition, it has to file for liquidation and cannot go into corporate

reorganization.

<h3>Proposed New Amendment</h3>

While the 1998 amendment solved some of the problems, it is still viewed as inadequate to be able to cope

with delayed corporate restructuring of distressed firms emerging from the recent financial crisis. The Ministry of

Justice prepared another amendment of the three bankruptcy procedures in February. After a public hearing, the

proposed amendment will have been voted on in the National Assembly (as this Journal goes to press). The thrust

of many of the proposed amendments is to improve the efficiency of the process.

<h3>Comparison to Chapter 11</h3>

There are important differences between chapter 11 and the Korean bankruptcy laws. The most significant ones

are defined below:

<ol>

<li>No Automatic Stay. Under chapter 11, a debtor is immediately protected from creditor actions upon filing by

the automatic stay under §362 of the Bankruptcy Code. Under Korean bankruptcy laws, the court decides on a

case-by-case basis whether to grant the corporate debtor protection similar to the automatic stay.

</li><li>Divestiture of Equity Interest. Until a plan is confirmed, shareholders cannot be divested of their equity

interest in the firm under chapter 11. In Korea, depending on whether the court perceives that shareholders have

mismanaged the business or the debt level of a firm is too high, shareholders must relinquish their equity interest at

an earlier stage of the process.

</li><li>Voting on Plan. To obtain a consensual approval of a plan under chapter 11, an impaired creditor class has to

approve the plan by two-thirds in amount and one-half in number. Korean bankruptcy law presently requires a

higher amount of secured creditors to approve a plan.

</li><li>No Absolute Priority Rule. Unless all creditors in the priorities established under the Bankruptcy Code are paid

in full, junior creditors and equity interest holders cannot receive, on account of their claim or equity interest, any

distributions under chapter 11. Korean bankruptcy law does not strictly require the application of the absolute

priority rule.

</li><li>Role of Management. Under chapter 11, management of the debtor plays an important role in operating the

company and proposing a plan to repay the creditors, subject to supervision by the bankruptcy court, the U.S.

Trustee and the creditors' committee. Under Korean law, a whole host of other players, including the receiver, the

court-appointed trustee and the creditors' committee, have a more significant role in formulating the plan to repay

creditors and directing the future of the firm.

</li><li>Role of Professionals. Chapter 11 has well-established rules and guidelines for the retention and payment of

professionals to assist the debtor in either reorganizing or liquidating the entity. While Korean bankruptcy law has

well established rules and guidelines for the payment of officials to assist the court, it is just beginning to adopt

rules and guidelines for the payment and retention of professionals to assist the debtor, especially when the

reorganization plan involves a merger or acquisition by another firm.

</li></ol>

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Act No. 997, January 20, 1962; amended by Act No. 5518, February 24,1998 (latest amendment). <a href="#1a">Return to article</a>

<a name="2">2</a> Act No. 998, January 20, 1962; amended by Act No. 5519, February 24, 1998 (latest amendment). <a href="#2a">Return to article</a>

<a name="3">3</a> Act No. 1214, December 12, 1962; amended by Act No. 5517, February 24, 1998 (latest amendment). <a href="#3a">Return to article</a>

<a name="4">4</a> Constitutional Court Ruling 1990, 6, 25. 89 Hunnga 98, 101 (Collection of Constitutional Court Cases, V. 2, pp. 132-164); Heung Myung Industrial Ltd. went into Corporate Organization in 1985. In 1989, certain financial institutions acquired permission from Deagu Province Court to auction the companies' assets owed to them under the Special

Law on Arrears owed to Financial Institutions by Firms under Corporate Organization (Act 2570, Article 7.3, March 3, 1973). This law provided that financial institutions can

collect debts through auctioning off assets owed to them (or as security), even though a restructuring plan is being carried out under the Corporate Reorganization Act. The

trustee of the company took the cases to the Constitutional Court, which ruled the auction under the Special Law unconstitutional. <a href="#4a">Return to article</a>

<a name="5">5</a> Industrial Development Act, Act No. 5214, July. <a href="#5a">Return to article</a>

<a name="6">6</a> Regulation of Tax Reduction and Exemption Act, Act No. 1723, December 20, 1965. <a href="#6a">Return to article</a>

<a name="7">7</a> Using the exchange rate of April 1, 1999, U.S.$1 is equivalent to 1225 Korean won. Therefore, the 250 billion won is equivalent to U.S.$204.8 million. <a href="#7a">Return to article</a>

<a name="8">8</a> The 1998 amendment allows existing managers or plant managers to act as co-receivers, but shareholders and existing management hold no independent control. <a href="#8a">Return to article</a>

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Journal Authors

Kyung S. Lee

Mikyung Yun

Journal Date

Tuesday, June 1, 1999 - 12:00