[Invest&Law] Establishment of Affiliate Mortgage Right Before Rehabilitation... Court: "Invalid Due to Favoritism"

Attempt to Circumvent Repayment via Related Parties Blocked
Funds Borrowed Under M&A Pretext Immediately Transferred to Creditor's Affiliate
Court: "Unfair Act That Harms Other Creditors"

Regarding a case where a financially distressed company provided collateral exclusively to a specific creditor ahead of rehabilitation proceedings, the court has ruled that such collateral is "an act of favoritism that sacrifices other creditors," and therefore did not recognize the collateral right. Although the loan was ostensibly provided to support an M&A (mergers and acquisitions), in reality, it was primarily used to repay the claims of a specific creditor.

According to the legal community on November 26, the 14th Civil Division of the Suwon Bankruptcy Court (Presiding Judge Lee Jiyeong) recently ruled against finance company A in a lawsuit challenging the results of a claim investigation and confirmation trial, stating, "The rehabilitation collateral right of 1,914,220,000 won cannot be recognized."

"Used for Repayment of Existing Debt, Not New Funding...Subject to Avoidance"

Previously, company A had lent funds to LED (light-emitting diode) manufacturer and distributor company B on several occasions since 2022. Company B had repeatedly posted large losses since 2019, resulting in complete capital erosion and excessive liabilities. In particular, just before filing for rehabilitation in September 2023, company B borrowed an additional 2,036,000,000 won from company A under the pretext of "business funds."

However, as soon as company B received the funds from company A, it transferred the money to an affiliate of company A. This affiliate was tasked with repaying convertible bonds (CB) previously issued by company B, and in reality, the funds were prearranged to be used as repayment resources for company B's old CBs. In connection with the new loan from company A, company B also provided 9,079.5 square meters of factory land as collateral. The two parties entered into a contract to establish a maximum secured mortgage of 2,036,000,000 won, and the mortgage registration for the factory site was completed.

Less than two months later, company B applied for the commencement of rehabilitation proceedings. Once the court initiated the rehabilitation process, company A reported all of its claims, totaling approximately 2,900,000,000 won, as "rehabilitation collateral claims secured by the factory." However, the claim investigation and confirmation trial ruled that "the mortgage established immediately prior to rehabilitation constitutes an act of favoritism benefiting only a specific creditor and is therefore subject to avoidance under the Debtor Rehabilitation and Bankruptcy Act," and did not accept the claim.

Company A argued that "the mortgage is a valid collateral" and filed a lawsuit seeking to overturn the conclusion of the claim investigation and confirmation trial. In doing so, company A claimed that the new funds provided to company B were part of a capital-raising effort to normalize company B's management through a successful M&A," and asserted that it "was unaware that this would harm other creditors."

"Evidence of Special Relationships, Including Shared Addresses"

The court of first instance ruled against company A. The court stated, "At the time the mortgage was established, company B was already in a state of severe insolvency and capital erosion, and had been experiencing difficulties in repaying other debts even before the CBs matured," and pointed out, "In this situation, providing the factory real estate as collateral exclusively to a specific creditor constitutes an act of favoritism that undermines fairness among creditors."

The court also noted that company A, its affiliates, and the second-largest shareholder of company B shared the same address. The second-largest shareholder of company B could have been fully aware of the company's capital erosion and excessive liabilities through publicly disclosed financial statements and was found to have been deeply involved in the paid-in capital increase and M&A process.

The court concluded, "Considering the structure and circumstances involving the affiliates, it is difficult to believe that company A was unaware that the establishment of this mortgage would reduce the common collateral available to other creditors and primarily benefit creditors connected to itself." Accordingly, the court upheld the original decision of the claim investigation and confirmation trial regarding the rehabilitation collateral right.

This content was produced with the assistance of AI translation services.