[Lee Soo-man Raises Hand in Court] (Part 1) The 'New Share Issuance Restriction' in Commercial Law Decided the Outcome

Editor's NoteThe court accepted Lee Soo-man's injunction request on the 3rd to prohibit SM from issuing new shares and convertible bonds, giving HYBE an advantageous position in the 'SM acquisition battle.' We reveal in two parts the background of Lee Soo-man's injunction request, the claims of both Lee Soo-man and SM, and why the court found issues with SM's issuance of new shares and convertible bonds and sided with Lee Soo-man, as detailed in the injunction ruling.

From the left, Bang Si-hyuk, Chairman of HYBE; Lee Soo-man, former SM Chief Producer; Kim Beom-su, Founder of Kakao (Head of Future Initiative Center)

Former SM Entertainment (SM) Chief Producer Lee Soo-man's injunction request to prohibit SM from issuing new shares and convertible bonds to Kakao was accepted by the court, giving HYBE an advantageous position in the 'SM acquisition battle' between HYBE and Kakao.

The court rejected SM's claim that "a strategic alliance with Kakao was essential to realize the SM 3.0 business strategy, which requires at least 600 billion KRW in business costs", while accepting Lee Soo-man's claim that "there is a risk of irreparable damage to existing shareholders due to illegal or unfair issuance of new shares and convertible bonds that do not meet the requirements set by the Commercial Act and SM's Articles of Incorporation."

Court Fully Accepts Lee Soo-man's Request... SM Suffers Complete Defeat

According to legal circles on the 4th, the Seoul Eastern District Court Civil Division 21 (Presiding Judge Kim Yoo-sung) fully accepted Lee Soo-man's injunction request against SM to prohibit the issuance of new shares and convertible bonds.

In its order, the court stated "The debtor (SM) is prohibited from issuing the new shares listed in Article 1 and the convertible bonds listed in Article 2 of Appendix 1, which are currently being prepared for issuance based on the board resolution dated February 7, 2023." It also added "The litigation costs shall be borne by the debtor."

The order recognized by the court matches exactly the purpose of Lee Soo-man's injunction request. The court accepted all of Lee Soo-man's claims and ordered SM to bear all litigation costs.

However, since the court accepted Lee Soo-man's primary cause of action as is, it stated that it would not separately rule on the selective cause of action regarding the injunction based on the right to preserve the claim for invalidation of issuance under Article 429 of the Commercial Act.

Criticism of Lee Soo-man → Joint Agreement between Align and SM → Announcement of 'SM 3.0' Business Strategy

In the injunction ruling, the court acknowledged the following facts based on the records submitted by both parties and their arguments during the hearing.

SM signed a 'Producer Service Outsourcing Contract' with Like Planning, operated by Lee Soo-man, on January 7, 2004, paying producer royalties. This contract was renewed several times or re-concluded with similar terms until the final 'Producing License Contract' was signed on March 11, 2021, setting the contract period from January 1, 2021, to December 31, 2023.

Since around 2012, criticism arose in the media and elsewhere, and one of SM's major shareholders, KB Asset Management, criticized in a public shareholder letter dated June 5, 2019, that royalties paid to Like Planning accounted for 46% of SM's operating profit over the past three years, requesting a merger between Like Planning and SM.

Align Partners Asset Management Co., Ltd. (Align) acquired some shares of SM around 2021 and pointed out issues with the contract and royalty payments between SM and Like Planning. Align proposed candidates for SM's auditor on February 11, 2022, and at SM's regular shareholders' meeting on March 1, 2022, Align's candidates received 3,166,104 more votes than SM's candidates and were appointed as SM auditors.

Align continuously requested SM to terminate the producing license contract with Like Planning, and SM agreed on October 14, 2022, to terminate the contract early as of December 31, 2022. Align also pointed out issues regarding transactions between SM and companies A and B, in which Lee Soo-man and his relatives hold significant shares, and filed a shareholder derivative lawsuit on January 15 this year, claiming damages against former directors of SM, and on January 18, filed a request to maintain illegal acts against current directors of SM.

Under the Commercial Act, the right to maintain (留止請求權) allows shareholders to request the company to prohibit illegal acts by the company or its directors in advance.

Article 402 of the Commercial Act (Right to Maintain) states that "if a director violates laws or the articles of incorporation and there is a risk of irreparable damage to the company, an auditor or a shareholder holding at least 1% of the total issued shares may request the director to maintain the act on behalf of the company."

Subsequently, SM and Align announced 12 joint agreements on January 20, stating that SM accepted Align's proposals. The announcement included: ▲SM will compose the board of directors at the 28th regular shareholders' meeting scheduled for March 2023 with 3 inside directors, 3 outside directors, and 1 other non-executive director, and the 3 newly appointed outside directors will be recommended through a temporary outside director candidate recommendation committee composed of 1 inside director, 1 external person, and 1 Align-recommended member (Item 1); ▲SM will recommend Align's CEO C as the newly appointed other non-executive director at the regular shareholders' meeting (Item 2); ▲After the regular shareholders' meeting, SM will establish an internal transaction committee composed of all directors and auditors except inside directors to closely review all transactions between SM and major shareholders, related parties, affiliates, and subsidiaries and take necessary measures (Item 5); ▲SM will officially announce and implement the transition to a multi-producing system (Item 7); ▲Align will withdraw the lawsuit (Item 11); ▲Align will end the public shareholder campaign for one year and cooperate with SM's board as a friendly shareholder to improve SM governance and enhance shareholder value (Item 12).

SM held a board meeting on January 22 and approved agenda items related to the temporary outside director candidate recommendation committee among the joint agreements. On February 3, SM announced the future business strategy called 'SM 3.0,' which includes transitioning from Lee Soo-man's sole producing system via Like Planning to a multi-producing system. Subsequently, on February 21 and 23, SM announced the 2nd and 3rd phases of the 'SM 3.0' strategy.

If SM Issues New Shares and Convertible Bonds, Kakao Becomes 2nd Largest SM Shareholder... Lee Soo-man's Shareholding Diluted by 1.67%p

SM management held an emergency board meeting on the 7th of last month and resolved to issue 1.23 million new shares and convertible bonds worth a total of 105.222 billion KRW to Kakao via a 'third-party allotment' method, and on the same day, signed separate subscription agreements for the new shares and convertible bonds with Kakao.

The par value per new share was 500 KRW, the issue price was 91,000 KRW, raising 111.93 billion KRW, with payment due on March 6. The convertible bonds were unregistered, non-interest-bearing, unsecured private convertible bonds, subscription date February 7, payment date March 6, maturity March 6, 2028, conversion ratio 100%, conversion price 92,300 KRW per share, conversion request period from March 6 to March 8, 2024, with 1.14 million shares to be issued upon conversion.

At the time Lee Soo-man filed the injunction on February 8, SM's largest shareholder was Lee Soo-man, holding 4,392,368 shares (18.45%), followed by the National Pension Service (8.96%) and KB Asset Management Co., Ltd. (5.12%).

If the 1.23 million new shares are issued as resolved by SM's board, Kakao's shareholding would reach 4.9% [1.23 million ÷ (23,807,301 existing shares + 1.23 million shares)], and after conversion of the convertible bonds resulting in 1.14 million shares issued, Kakao's shareholding would rise to 9.05% [(1.23 million + 1.14 million) ÷ (23,807,301 + 1.23 million + 1.14 million)], making it the 2nd largest shareholder. Conversely, Lee Soo-man's shareholding would be diluted from 18.45% to 16.78% [4,392,368 ÷ (23,807,301 + 1.23 million + 1.14 million)], a decrease of 1.67 percentage points.

Accordingly, Lee Soo-man filed an injunction on February 8 to prohibit SM from issuing new shares and convertible bonds, and on the next day, sold 3,523,420 shares (14.8%) of the 4,392,368 shares he held to HYBE at 120,000 KRW per share, and for the remaining 868,948 shares (3.65%), signed a contract granting a put option to sell at the same price within one month from the earlier of the corporate merger approval date or the transaction closing date. HYBE completed the transaction for 3,523,420 shares after payment and other procedures on February 22.

According to data disclosed by Kyobo Securities, after the court's injunction acceptance decision, SM's shareholding structure is HYBE (14.8%), National Pension Service (9.0%), Com2uS (4.2%), KB Asset Management (3.8%), Lee Soo-man (3.7%), Align (1.1%), and minority shareholders (63.4%).

SM's total issued shares slightly increased to 23,810,401 as of February 8. However, the court stated that since the dispute was based on the total issued shares before the increase (23,807,301 shares) and the increase of 3,100 shares did not affect the court's judgment, it did not consider the increase in this injunction case.

Lee Soo-man: "Third-Party Issuance Violates Commercial Act and Articles of Incorporation"... No 'Business Necessity'

Lee Soo-man claimed in his injunction request that "SM's resolution to issue new shares and convertible bonds to Kakao, who is not an SM shareholder, without the business necessity such as 'urgent fundraising, business expansion, or strategic alliance' as stipulated by the Commercial Act and SM's Articles of Incorporation, infringes on the preemptive rights of existing shareholders including myself and constitutes an illegal act."

He further stated that he sought the injunction based on the right to maintain under Articles 424 and 516 of the Commercial Act or the right to preserve the claim for invalidation of issuance under Article 429 of the Commercial Act.

Article 424 of the Commercial Act (Right to Maintain) stipulates that "if a company issues shares in violation of laws or articles of incorporation or by a manifestly unfair method causing shareholders to suffer disadvantages, shareholders may request the company to maintain the issuance."

Article 516 (Application Provisions) Paragraph 1 applies Article 424's right to maintain to the issuance of convertible bonds.

The provisions Lee Soo-man cited as grounds for illegality of SM's issuance are Article 418 Paragraph 2 proviso and Article 513 Paragraph 3 of the Commercial Act.

Article 418 (Contents of Preemptive Rights and Designation and Public Notice of Allotment Date) Paragraph 1 states that "shareholders have the right to receive allotment of new shares in proportion to the number of shares they hold," regulating shareholders' rights to subscribe for new shares.

Paragraph 2 allows the company to allot new shares to third parties contrary to Paragraph 1 according to the articles of incorporation, but the proviso restricts this to cases where it is necessary to achieve business purposes such as introduction of new technology or improvement of financial structure.

Article 513 (Issuance of Convertible Bonds) Paragraph 1 authorizes the company to issue convertible bonds. Paragraph 2 states that matters not stipulated in the articles of incorporation regarding convertible bonds shall be decided by the board of directors unless otherwise decided by the shareholders' meeting.

Paragraph 3 of Article 513 regulates issuance of convertible bonds to third parties, stating that if the articles of incorporation do not specify the amount, conversion conditions, content of shares to be issued upon conversion, or conversion request period, these must be decided by a resolution under Article 434. This applies mutatis mutandis the proviso of Article 418 Paragraph 2.

Article 434 (Special Resolution for Amendment of Articles of Incorporation) requires a resolution at a shareholders' meeting with at least two-thirds of the voting rights of attending shareholders and at least one-third of the total issued shares. Applying this means that unspecified major details of convertible bond issuance to third parties must be decided through the same procedure as amending the articles of incorporation.

Applying the proviso of Article 418 Paragraph 2 means that issuance of convertible bonds to third parties must also meet the requirement of being necessary for business purposes such as introduction of new technology or improvement of financial structure, just like issuance of new shares.

Meanwhile, Article 10 (Preemptive Rights) of SM's Articles of Incorporation Paragraph 1 states that "shareholders have the right to receive allotment of new shares in proportion to the number of shares they own," regulating shareholders' rights to subscribe for new shares.

Paragraph 2 allows the board of directors to allot new shares to third parties in certain cases, enumerating exceptions for third-party allotment.

The relevant clause in this dispute is Item 6, which stipulates that the company may issue new shares to domestic and foreign financial institutions, investment associations formed under law, other corporations, and individuals for business necessity including urgent fundraising, business expansion, strategic alliances, and financial structure improvement.

Article 10-2 (Public Offering, etc.) Paragraph 4 stipulates that the company may issue new shares by board resolution to third parties within 30% of the total issued shares for business necessity including urgent fundraising, business expansion, strategic alliances, and financial structure improvement.

Article 14 (Issuance of Convertible Bonds) Paragraph 1 allows the company to issue convertible bonds to third parties by board resolution within a total face value of 150 billion KRW, enumerating cases where issuance is possible. Item 3 includes issuance to domestic and foreign financial institutions, investment associations formed under law, other corporations, and individuals for business necessity including urgent fundraising, business expansion, and strategic alliances.

SM: "Inevitable Choice Due to Business Necessity"... Lee Soo-man No Longer Has Stake

On the other hand, SM argued that at the time of issuing the new shares and convertible bonds, SM had business necessity such as 'strategic alliance and business expansion with Kakao' and 'urgent fundraising', and the issuance was an inevitable choice to achieve management objectives, so it does not infringe on existing shareholders' preemptive rights.

SM claimed that a strategic alliance with Kakao was essential to realize the new SM 3.0 business strategy, and at least 600 billion KRW in business costs were required.

SM cited the following as the basis for the necessary business costs: ▲3.5 billion KRW for producing strategy including 30 billion KRW for domestic and foreign label acquisitions and 5 billion KRW for internalizing publishing business ▲7 billion KRW for IP monetization strategy including 3 billion KRW for internalizing and building fan platforms and 4 billion KRW for investing in Seoul Arena shares ▲5 billion KRW for building global management and IP production centers ▲5 billion KRW for new investment strategy including 3 billion KRW for metaverse business and 2 billion KRW for other business costs.

SM also pointed out that Lee Soo-man sold a significant portion of his SM shares to HYBE and holds a put option for the remaining shares, so he no longer has a stake as the largest shareholder of SM, and therefore, the issuance of new shares and convertible bonds would not cause Lee Soo-man significant damage or imminent risk.