Commercial Act Amendment Imminent... U.S. Precedents on "Duty of Loyalty to Shareholders" [Invest&Law]

UOP Precedent: Both Procedural and Price Fairness Must Be Upheld
MFW Precedent: Business Judgment Rule Applies Only with Strict Procedural Safeguards

On June 23, at the National Assembly, Oh Ki-hyung, the chairperson of the Democratic Party of Korea's "KOSPI 5000 Special Committee," emphasized the urgency of amending the Commercial Act, directly referencing the Lotte Rental case. Earlier, in February, the board of directors of Lotte Rental resolved to sell the major shareholder's stake at 77,115 won per share and simultaneously conduct a paid-in capital increase through a third-party allotment at 29,180 won per share. The decision for the existing major shareholder to sell shares at a high price while the new major shareholder receives more shares at a lower price is seen as disadvantageous to minority shareholders. This has led to concerns that such actions may violate the "duty of loyalty to shareholders" stipulated in the soon-to-be-amended Commercial Act, which is expected to pass the National Assembly soon.

Article 382-3 of the current Commercial Act stipulates that "directors shall perform their duties faithfully for the company in accordance with laws and the articles of incorporation." The amended Commercial Act centers on extending the duty of loyalty to include shareholders as well. As a result, there is growing interest in U.S. precedents, where the duty of loyalty to shareholders has been firmly established.

The fundamental principle: No discrimination between controlling and minority shareholders

The "Weinberger v. UOP" case (hereafter, the UOP precedent) and the "Kahn v. M&F Worldwide" case (hereafter, the MFW precedent) are landmark U.S. corporate law cases that set the standards for minority shareholder protection. The core of these cases is that, while the UOP precedent imposed very strict procedural and substantive fairness requirements on management, the MFW precedent somewhat relaxed these requirements by respecting the business judgment of directors under strict conditions. However, the fundamental principle that there must be no discrimination between controlling and minority shareholders remains unchanged.

The UOP precedent is a milestone in the protection of minority shareholders in the United States. In 1975, Signal Companies acquired a 50.5% stake in the petrochemical company UOP. While considering a squeeze-out of the remaining shares, Signal obtained an external fairness opinion from Lehman Brothers, which concluded that $21 to $24 per share was appropriate. In 1978, Signal executed a squeeze-out at $21 per share for the remaining UOP shares. Minority shareholders, including Weinberger, challenged the fairness of the merger and filed a lawsuit. In 1983, the Delaware Supreme Court ruled in favor of the minority shareholders, remanding the case. Before the final decision on remand, Signal agreed to compensate the minority shareholders for the difference from the fair value, thus settling the case.

The UOP precedent established the "entire fairness" doctrine, which requires strict scrutiny of both "procedural fairness"?the disclosure of all material information to minority shareholders and negotiation by an independent board or committee?and "substantive fairness"?that the price offered must be economically fair to minority shareholders. The court also ruled that determining a fair price requires a comprehensive consideration of various valuation methods, including asset value, market value, and earnings value.

Subsequently, the entire fairness standard from the UOP precedent has been reaffirmed in various cases, including the Emerald Partners precedent ("Emerald Partners v. Berlin"). In the Emerald Partners case, the Delaware Supreme Court confirmed that if directors push through a transaction at the behest of a controlling shareholder, mere board approval does not absolve them of liability for breaching their duty of loyalty. Furthermore, if both procedural and substantive fairness are not satisfied, directors may be held liable for damages even if the transaction reflects market value.

The MFW precedent: Setting the standard for deference to directors' business judgment

The MFW precedent is seen as having somewhat relaxed the entire fairness standard, striking a balance between the business judgment rule for directors and the protection of minority shareholders. In 2011, M&F Holdings made a public proposal to acquire the minority-held shares of its subsidiary, MFW, through a squeeze-out. The proposal stipulated two conditions for the squeeze-out: approval by a special committee composed of independent directors and approval by a majority of the minority shareholders. The special committee, which was granted the authority to reject the transaction, approved the proposal, and at the end of 2011, the squeeze-out was carried out with the consent of a majority of minority shareholders. In 2012, minority shareholders, including Kahn, filed a lawsuit challenging the independence of the special committee members, but in 2014, the Delaware Supreme Court ruled against the minority shareholders.

At first glance, this may appear to favor management by respecting the "business judgment rule" for directors. However, the precedent established a dual safeguard: the formation of an independent committee and the prohibition of discrimination against minority shareholders. This ruling can be interpreted as compelling management to secure strict procedural legitimacy.

Specifically, the MFW precedent set out six requirements: (1) a conditional proposal requiring both special committee approval and majority-of-the-minority shareholder consent; (2) special committee members must be completely independent of the controlling shareholder's interests; (3) the special committee must have autonomous authority, including the selection of advisors and the right to reject the transaction; (4) the special committee must fulfill its duty of care by utilizing financial advisors and considering multiple alternatives to negotiate a fair price; (5) minority shareholders must be provided with sufficient information about the transaction terms, committee evaluations, and financial analyses before voting; and (6) there must be no coercion or inducement of minority shareholders.

Kang Namkyu, managing partner at Gaon Law Firm, stated, "At a minimum, minority shareholders must be guaranteed procedural participation for any differential pricing based on control premiums to be justified. In cases like Lotte Rental, where only the two parties agree to differentiate the prices of the controlling shareholder's shares and the newly issued shares, there is a possibility of liability for damages for breaching the duty of loyalty to shareholders under the amended Commercial Act, even by U.S. standards."