[Lee Soo-man Raises Hand in Court] (Part 2) "Judgment on New Share Issuance to Increase Kakao's Influence over SM"

Sufficient Assets Including Cash... No Borrowings from Financial Institutions
Issuance of New Shares or Convertible Bonds Not an Inevitable Decision
SM's Objection Unlikely to Reverse the Conclusion

Editor's NoteThe court granted Lee Soo-man's injunction request on the 3rd to prohibit SM from issuing new shares and convertible bonds, putting HYBE in a favorable 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, based on 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).

The court examined the requirements of the right to be preserved and the necessity of preservation, which are prerequisites for injunctions, in the provisional injunction case filed by former SM Entertainment (SM) chief producer Lee Soo-man, who requested to prohibit SM from issuing new shares and convertible bonds to Kakao.

As revealed in the previous (Part 1), the court reviewed these requirements for Lee Soo-man's primary claim based on the right to request suspension under Articles 424 and 516 of the Commercial Act and granted the injunction. Therefore, the court did not separately rule on the alternative claim based on Article 429 of the Commercial Act, which concerns the invalidity of issuance as the right to be preserved.

The right to request suspension is a shareholder's right to preemptively request the prohibition of illegal acts by a corporation or its directors. Article 424 of the Commercial Act stipulates shareholders' right to request suspension concerning new share issuance, and Article 516 applies this to convertible bond issuance.

Supreme Court Precedent Applied... "Strict Judgment Required for Issuance of New Shares and Convertible Bonds to Third Parties"

The court first cited Supreme Court precedents regarding the amendment of the Commercial Act, which restricts third-party allotment of new shares to certain conditions.

Previously, the Supreme Court ruled in 2009 that "Article 418 of the Commercial Act previously allowed broad restrictions on shareholders' preemptive rights by articles of incorporation, but after the July 24, 2001 amendment, Paragraph 1 states 'shareholders have the right to receive allotment of new shares according to the number of shares they hold,' and Paragraph 2 states 'notwithstanding Paragraph 1, the company may allot new shares to persons other than shareholders as prescribed in the articles of incorporation. However, this is only allowed when necessary to achieve business purposes such as introducing new technology or improving financial structure.' This reflects the intent to protect existing shareholders' preemptive rights by generally allotting new shares to them and limiting third-party allotment to exceptional cases necessary for business management, considering the risk of dilution of existing shareholders' stock value or loss of control when new shares are allotted to third parties."

The court stated, "Therefore, in light of the legislative intent of Article 418 Paragraphs 1 and 2 of the Commercial Act, which aims to protect existing shareholders' control and prevent dilution of economic value by allowing shareholders to preferentially subscribe to new shares according to their holdings, whether the company's allotment of new shares to third parties other than existing shareholders is necessary for achieving business purposes must be strictly judged considering the impact on existing shareholders' preemptive rights.

Furthermore, this principle applies to the issuance of convertible bonds to non-shareholders under Article 513 Paragraph 3 of the Commercial Act, which refers to the proviso of Article 418 Paragraph 2," the court added.

The court pointed out, "It is difficult to conclude that SM needed to exclude existing shareholders' preemptive rights and allot and issue the new shares and convertible bonds in question to Kakao to achieve urgent fundraising, business expansion, or strategic alliances. There is a high possibility that the issuance of these new shares and convertible bonds, which violate Article 418 Paragraph 2 proviso, Article 513 Paragraph 3, or SM's articles of incorporation, or are issued in a manifestly unfair manner, would harm existing shareholders' proportional interests or weaken their control over the company."

"SM Holds Sufficient Cash... No Need for Urgent Fundraising"

The court first found that SM had sufficient cash reserves when it resolved to issue new shares to Kakao, so there was no urgent need to raise over 200 billion KRW. Also, there was no evidence that SM carefully considered alternatives to third-party allotment, which could cause significant disadvantages to existing shareholders, nor did it consult with existing shareholders, including Lee Soo-man, during the resolution process, making it hard to view the decision as unavoidable.

The court judged, "Around the time of the resolution to allot and issue the new shares and convertible bonds in this case, SM held sufficient cash and cash equivalents and had no urgent debts to repay, so it is difficult to see an urgent need for fundraising at that time."

Based on records and hearings submitted by both parties, the court stated, "As of September 30, 2022, SM held approximately 69 billion KRW in cash and cash equivalents and about 120.8 billion KRW in bank deposits, had no bank borrowings, and recorded cumulative operating profit of about 75.7 billion KRW up to the third quarter of 2022."

Regarding SM's claim that "a strategic alliance with Kakao was essential to realize the newly promoted 'SM 3.0' business strategy, requiring at least 600 billion KRW for the project," the court noted, "Kakao is one of the two major domestic platform companies along with Naver, operating in story, media, and music sectors, and has Kakao Entertainment Co., Ltd. as its subsidiary, which manages seven management companies and four music labels." It added, "Since Naver already cooperated with SM's competitors HYBE and YG Entertainment Co., Ltd., SM's decision to form a strategic alliance with another platform company, Kakao, has some reasonable grounds."

However, the court observed, "These business strategies appear to be planned for phased implementation over a considerable period, and even according to SM's disclosed 'SM 3.0' second and third phase strategies, some investments are scheduled for 2025 or within the next three years." It concluded, "Thus, it is difficult to see the immediate necessity of such a large amount at the business strategy planning stage, and considering SM's sufficient cash and cash equivalents, it is hard to conclude that SM urgently needed to exclude existing shareholders' preemptive rights and issue the new shares and convertible bonds to Kakao to raise approximately 217.2 billion KRW at that time."

Additionally, the court found that ▲ there was insufficient concrete and thorough review of funding needs and benefits at the time of the resolution to allot and issue the new shares and convertible bonds, ▲ detailed cost breakdowns and calculation bases were not submitted, making it unclear whether the project costs reached the claimed amount, ▲ there was no objective evidence that SM carefully considered other strategic alliances or funding methods that would not cause or would minimize disadvantages such as dilution of existing shareholders' stock value or weakening of control by directly allotting a significant amount of new shares and convertible bonds to Kakao, a non-shareholder, and ▲ existing shareholders, including Lee Soo-man, were not informed or consulted during the resolution process. Based on these, the court stated, "Ultimately, there is insufficient evidence to regard SM's decision to allot and issue the new shares and convertible bonds to Kakao via third-party allotment for urgent fundraising to promote the new 'SM 3.0' business strategy as an unavoidable decision at that time."

"Seems Intended to Weaken Lee Soo-man's Control and Strengthen Kakao's Influence"… Right to Be Preserved Established

Furthermore, the court judged that considering the circumstances surrounding SM and the scale of new shares to be allotted and issued to Kakao at the time of the resolution, there is a strong possibility that the purpose was to weaken Lee Soo-man's control over SM and strengthen Kakao's influence.

The court pointed out, "The resolution to allot and issue the new shares and convertible bonds in this case was made amid an imminent dispute over SM's management rights, and it can be seen as an act to realize this by increasing Kakao's stake in SM to weaken the control of Lee Soo-man, the largest shareholder."

The court noted, "Although Lee Soo-man, as SM's founder and largest shareholder, had significant influence over SM's management and control, his shareholding was only about 18.45%, so changes in SM's management or control could occur depending on alliances among major shareholders such as the National Pension Service and KB Asset Management or support from minority shareholders." It added, "In fact, at the March 1, 2022 SM regular shareholders' meeting, an auditor candidate recommended by Align was appointed as SM auditor with the support of Align's friendly shares, and lawsuits for damages were filed against former and current SM directors, indicating influence on SM's management and business direction."

In this context, the court stated, "SM's decision to allot and issue a significant amount of new shares and convertible bonds to Kakao via third-party allotment without notifying existing shareholders, including Lee Soo-man, constitutes an act that realizes the dispute over SM's management rights."

The court analyzed, "If the new shares are issued, Kakao's stake will reach 4.9%, and after conversion of the convertible bonds, 1.14 million shares will be issued, increasing the stake to 9.05%, while Lee Soo-man's stake will be diluted from 18.45% to 16.78% after conversion." It concluded, "Ultimately, Kakao will become the second-largest shareholder of SM regardless of the intentions of Lee Soo-man and other existing shareholders, potentially exerting significant influence over SM's management and control depending on alliances with other major shareholders and minority shareholder support."

Moreover, the court added, "The size of the new shares in this case is 1.23 million shares, close to the maximum number of new shares (1,251,214 shares) that can be additionally issued via third-party allotment without amending SM's articles of incorporation. Kakao also secured the right of first refusal for future third-party allotments of new shares or equity-linked securities by SM. These circumstances suggest that the resolution to allot and issue the new shares and convertible bonds was intended to weaken Lee Soo-man's control over SM and strengthen Kakao's influence over SM's management and control."

The court stated, "Even if Lee Soo-man, as SM's founder and largest shareholder, caused damage to SM by using his influence to make SM engage in unfavorable transactions with companies related to him, civil and criminal liability against Lee Soo-man under relevant laws is a separate matter, and such circumstances alone do not justify the third-party allotment and issuance of the new shares and convertible bonds in this case." It concluded, "Therefore, the right to be preserved for this claim is established."

"Necessity of Preservation to Prohibit Issuance of New Shares and Convertible Bonds Also Fully Recognized"

The court judged that since Lee Soo-man still holds 868,948 shares (3.65%) of SM after selling 3,523,420 shares (14.8%) out of his 4,392,368 shares to HYBE, he can exercise the exclusive shareholder right of request suspension. If SM proceeds with the issuance of new shares and convertible bonds as resolved, Lee Soo-man, as an SM shareholder, is likely to suffer irreparable harm, so the necessity of preservation is fully recognized.

The court stated, "The right to request suspension under Articles 424 and 516 of the Commercial Act is an exclusive shareholder right recognized to protect shareholders' interests against illegal or unfair issuance of new shares and convertible bonds. Shareholders fearing disadvantages from such issuance can individually apply for injunctions prohibiting issuance regardless of the number of shares or voting rights held."

It further noted, "Lee Soo-man remains an SM shareholder holding 3.65% of SM shares, and if the new shares and convertible bonds in this case are issued, there is a risk that Lee Soo-man's influence over SM's management and control and his proportional interests as an SM shareholder will be weakened, causing irreparable harm."

Presenting Supreme Court rulings, the court concluded, "Considering that after issuance of the new shares and convertible bonds, the grounds for invalidity are strictly interpreted to ensure transaction safety and protect stakeholders' interests, and that a judgment invalidating new share issuance only affects future transactions, the necessity of preservation to prohibit issuance before it occurs is also fully recognized."

This injunction case is a so-called final or satisfaction injunction, which establishes a right relationship substantially identical to that sought in the main trial through a provisional injunction to set a temporary status. SM can appeal the injunction decision through an objection, but in court practice, objection cases fall under the exclusive jurisdiction of the court that issued the injunction order, so the likelihood of reversal is low.