The Impact of the Amendment to the Commercial Act on Corporate Management

Kwon, Jae Yeol

Professor of Law, Kyung Hee University Law School

1. Introduction

2. Impact of the Amendment to the Commercial Act on Corporate Management

3. Conclusion

1. Introduction

The Commercial Act is one of the so-called “Six Basic Codes” and falls under the jurisdiction of the Ministry of Justice. As the principal statute governing the establishment, organization, operation, and dissolution of companies, the Commercial Act regulates all aspects of corporate activity. Any amendment to it changes the legal environment for enterprises, thereby exerting a significant influence on corporate decision-making processes, governance structures, and investor relations. For this reason, major amendments to the Commercial Act have generally been carried out only after the Ministry of Justice convenes the Special Committee on the Commercial Act?comprising legal scholars (professors), practitioners (judges, attorneys), and industry representatives?to conduct systematic and long-term studies.

However, in recent years, under the banner of resolving the so-called “Korea Discount,” amendments to the Commercial Act have been enacted in succession under the leadership of the majority party in the National Assembly, without sufficient consideration of systematic coherence or the far-reaching effects of such changes. Specifically, on July 3, the National Assembly passed an amendment expanding the fiduciary duty of shareholders, introducing electronic general meetings of shareholders, adopting and expanding the system of independent directors, and applying the cumulative 3% rule for the election of audit committee members. This amendment was promulgated on July 22.

Less than two weeks after the promulgation of the amendment expanding directors’ fiduciary duties, on August 1, the ruling party unilaterally pushed another amendment through the plenary session of the Legislation and Judiciary Committee of the National Assembly. This new amendment mandates that, in large listed companies with assets of 2 trillion KRW or more, directors must be elected through the mandatory cumulative voting system, and the number of separately elected audit committee members must be increased to at least two. As a result, the so-called “second-phase” amendment to the Commercial Act, which further tightens regulations on companies, is now on the verge of being passed by the National Assembly. In addition, several other amendment bills?proposing the mandatory retirement of treasury shares?have been introduced by ruling party lawmakers and are expected to pass in the near future.

In the following sections, the paper will outline the systems related to stock corporations under the upcoming amendments to the Commercial Act and examine the potential impacts of these legislative changes on the management of Korean companies.

2. Impact of the Amendment to the Commercial Act on Corporate Management

1) Mandatory Cumulative Voting System

Under the cumulative voting system, a shareholder is granted voting rights equal to the number of directors to be elected multiplied by the number of shares the shareholder holds. The candidates receiving the highest number of votes are sequentially elected as directors. For example, if three directors are to be elected, a shareholder holding one share will have a total of three votes. The stated rationale behind mandating cumulative voting is to allow general shareholders to elect candidates who will protect and represent their interests, thereby limiting the appointment of directors solely by majority shareholders and enabling minority shareholders to exert influence on corporate decision-making.

However, in practice, even under cumulative voting, it is virtually impossible for general shareholders of a listed company to elect a director to represent them unless they hold a substantial percentage of the shares. For this reason, if cumulative voting becomes mandatory, it will ultimately serve as a “feast” only for the second- and third-largest shareholders. Consequently, the system will remain a tool primarily for large shareholders, such as institutional investors and activist funds.

Moreover, under cumulative voting, there is a risk of representation issues arising, as it is possible for a candidate to be elected with an extremely small number of votes. To illustrate, suppose a company has issued 100 shares. Shareholder A, the largest shareholder, holds 40%, while Shareholders B and C hold 39% and 21% respectively. If two directors are to be elected from among five candidates via cumulative voting, A, B, and C will hold 80, 78, and 42 votes respectively. If all three shareholders vote strategically?say, A casts 79 votes for Candidate A and 1 vote for Candidate B to ensure the election of at least one preferred candidate, and coincidentally, both B and C also cast all their votes for Candidate A?then Candidate A will be elected with 199 votes and Candidate B with only 1 vote. While both A and B are formally directors, the staggering 198-vote gap between them is an issue that cannot be simply ignored.

The reason cumulative voting has never been, and will never become, a global standard likely lies in its inherent limitations in utility and its vulnerability to electing directors who fail to represent the interests of the shareholder body as a whole. Considering that Korea’s political system adopts representative democracy, and that the corporate structure under the Commercial Act is fundamentally modeled on such representative democracy, skepticism toward the cumulative voting system is perhaps only natural.

2) Expansion of the Scope of Separately Elected Audit Committee Members

Discussions on the separate election of audit committee members began in earnest after the Ministry of Justice issued a legislative notice in June 2013. These discussions continued for years until, in December 2020, the Commercial Act was amended to require that at least one audit committee member be elected separately. Thus, the system of separately electing audit committee members had been at the center of controversy for more than seven years before finally being enacted into law. Expanding this requirement to mandate the separate election of at least two audit committee members can be interpreted as rekindling a debate that had only recently been settled.

In the United States, Japan, and Korea alike, an audit committee member holds the position of a director. Under the amended Commercial Act, when at least two audit committee members?who are also board members?are elected separately, any voting rights exceeding 3% of the total issued shares are excluded from the calculation, regardless of whether the shareholder in question is the largest shareholder or not. This restriction is effectively no different from limiting the right to elect directors, and thus can be seen as infringing upon a shareholder’s ability to protect their own interests. It is therefore unsurprising that neither U.S. law nor Japanese law contains identical or similar restrictions on voting rights. In particular, allowing controlling shareholders and their affiliates, who hold sufficient equity to elect directors, to exercise only up to 3% of voting rights in such elections is tantamount to restricting their control rights.

Given that the control or managerial rights attached to the shares held by the largest shareholder have proprietary value, forcibly depriving them of such rights by law raises questions as to whether this is compatible with the Constitution. Indeed, during the 20th National Assembly, even the Legislation and Judiciary Committee’s own senior legal advisor stated that “the exercise of voting rights in the election of directors is the most fundamental means by which shareholders participate in corporate management and realize their control rights; to restrict this is to limit the most essential right of shareholders to participate in corporate management, and thus may infringe upon the essential content of shareholder rights, which are a form of property rights” (Kang Byung-hoon, Senior Advisor, Review Report on the Partial Amendment to the Commercial Act proposed by Rep. Kim Jong-in, Nov. 2016, p. 31: “[U]nlike a pure auditor or audit committee that solely supervises the execution of directors’ duties, the board of directors is a decision-making body of the company. Thus, restricting the voting rights of controlling shareholders in electing outside directors who also serve as audit committee members risks excessively infringing upon the principles of majority rule in capital and private autonomy.”).

As the number of audit committee members required to be separately elected increases, the risk of management instability is expected to grow. For instance, suppose a company has issued 100 shares, with the largest shareholder and its affiliates holding 65%, two domestic institutional investors holding 10% each, and five foreign activist funds each holding 3%. Under the current Commercial Act, the election of directors requires a majority of voting rights present at the meeting and at least 25% of the total issued shares. If all shareholders attend the general meeting, a candidate would need at least 25 votes to be elected as a director. However, when electing audit committee members separately, shares exceeding the 3% threshold are excluded from the total issued shares for voting purposes. In this example, the company would be deemed to have issued only 24 shares for the election. A candidate would then need only 6 votes (25% of 24) to be elected as an audit committee member.

The problem arises if the foreign activist funds collude, enabling them to exercise as many as 15 out of the 24 available votes?effectively allowing them to act as the de facto largest shareholder and elect both separately elected audit committee members. Considering that an audit committee is generally composed of three members, this would mean that a majority of the audit committee could be elected by foreign activist funds. Given their inherent focus on short-term gains, if such funds participate in board decisions, there is a significant risk that the company’s ability to manage with a long-term vision would be seriously undermined.

3) Mandatory Retirement of Treasury Shares

In Korea, the most commonly used defensive measure against hostile M&A attempts is the acquisition of treasury shares. When the target company acquires its own shares, the volume of shares circulating in the market is reduced, making it more difficult for the acquirer to obtain the number of shares necessary to gain control. Furthermore, if the target company sells the acquired treasury shares to a friendly third party, this can significantly aid in maintaining control over the company. While treasury shares themselves do not carry voting rights, disposing of them in a way that increases the voting power of friendly shareholders remains a viable option. In addition, the acquisition of treasury shares reduces the number of shares in circulation, which can lead to an increase in share price in the securities market. As a result, if the acquirer attempts a market purchase or a tender offer, they will require a greater amount of capital than initially planned in order to complete a hostile takeover, thereby discouraging such attempts. Moreover, if the target company uses surplus funds to acquire treasury shares, its cash reserves will be reduced, making it a less attractive target for M&A in the first place.

Recently, YoungPoong and MBK Partners twice filed for injunctions to prevent Korea Zinc from acquiring treasury shares to defend against their tender offer, but the court rejected both requests. It can be reasonably inferred that the court took into account the difficult reality that, if even treasury share acquisition were prohibited, domestic companies would be forced to passively stand by in the face of hostile M&A. Given that treasury share acquisition is virtually the only legally recognized defensive measure available in Korea, the rationale for institutionalizing mandatory retirement of treasury shares is questionable. Such a measure would effectively signal to domestic companies that they must unconditionally surrender to predatory activist funds. This line of reasoning assumes that the acquirer is inherently “good” and the target company inherently “bad,” thereby denying the legitimacy of directors defensive actions.

Furthermore, the Commercial Act currently provides for various ways in which treasury shares can be used for legitimate corporate financial purposes and restructuring needs. For example, treasury shares can be granted when employees exercise stock options, when exchange bonds are converted, or when redeemable bonds are redeemed. They can also be used as consideration in cases of mergers, spin-off mergers, or share exchanges. If mandatory retirement of treasury shares prevents companies from effectively conducting financial operations or restructuring, this could itself become another cause of the so-called “Korea Discount.”

3. Conclusion

The new administration’s regulatory policies on the capital market can be evaluated as stemming from a commitment to address the chronic structural issues of Korea’s capital market and to advance it toward a more sophisticated system. The stated vision is that strengthening the rights of minority shareholders, improving corporate governance, and enhancing market transparency will, in the long term, increase the appeal of the Korean capital market and eliminate the so-called “Korea Discount.” However, it must not be overlooked that recent attempts to radically reform corporate governance through amendments to the Commercial Act could undermine the autonomy of corporate management. Mandatory cumulative voting, the expansion of separately elected audit committee members, and the compulsory retirement of treasury shares each carry the potential to exacerbate, rather than resolve, the “Korea Discount.” For example, by weakening corporate defenses against hostile takeovers, such measures could jeopardize managerial stability and incentivize a focus on short-term gains.

Therefore, before introducing the systems proposed in the amendments to the Commercial Act, it is essential to thoroughly consider the realities of Korean corporations and the characteristics of the domestic market, and to seek an appropriate balance. A careful review of the regulatory framework from the ground up is needed, one that incorporates a wide range of opinions from the companies subject to regulation in order to minimize foreseeable side effects. Given that Korean enterprises have long supported the nation’s economy, it is imperative to avoid a situation where the amendments to the Commercial Act inadvertently result in “making porridge only for the dog to eat,” to borrow the old Korean proverb?expending effort only to hand the benefit to others.

Note: The views expressed herein may differ from those of the Hansun Foundation

(※ It's a translation based on machine translation)