[Invest&Law] Repaying Majority Shareholder Family Loans First with Investment Funds... Court Rules "Not 'Working Capital,' Breach of Contract"

Investment funds used to repay loans owed by the CEO's son and daughter-in-law, who are related to the largest shareholder
"The company and its CEO must pay about 500 million won to the investment firm"

The court has ruled that a venture company which repaid loans owed by the largest shareholder's family immediately after receiving investment funds violated the contractual restriction that the funds be used as "working capital."

According to the legal community on February 11, the Civil Division 17 of the Seoul Central District Court (Presiding Judge Lee Seungwon) recently ruled in a civil lawsuit filed by a domestic investment firm against IT (information technology) solutions venture company A and its representative, ordering that "the defendants shall be jointly and severally liable to pay 500 million won as share purchase price, 60 million won as a contractual penalty, and related interest and delay damages."

"Must be interpreted as everyday, recurring operating expenses... There was no urgent need to repay"

Previously, in June 2024, the investment firm entered into a redeemable convertible preferred shares (RCPS) subscription agreement with Company A and paid 500 million won as the subscription price. Under the contract, the use of the investment funds was restricted to "facility funds, new business development, and working capital."

However, starting from the day after the investment funds were deposited, Company A began transferring the money to its corporate account and paid 70 million won to the son of the largest shareholder (the representative) and 50 million won to his daughter-in-law, thereby repaying loans totaling 120 million won. The remainder was used for employee salaries and other purposes, reducing the balance of the dedicated account to 9,840 won. All of this took place in about one month after the funds were received.

After confirming this pattern of fund usage, the investment firm claimed a "breach of contract" and exercised its share purchase right and contractual penalty clause. In response, Company A argued that "around the time of the contract, due to a cash crunch, the company had raised large short-term loans from major shareholders and used them as a key source of the company's working capital," and that "repaying these loans also constituted an execution of working capital."

The court of first instance ruled entirely in favor of the investment firm. The court first noted that "working capital is interpreted as short-term funds necessary for a company to smoothly carry out its day-to-day business activities," and pointed out that "this includes funds needed to pay for everyday or recurring operating expenses such as raw material purchases, wages, and selling expenses, or to repay business debts that fall due within a short period."

"Leaving a small amount in the account to dodge reporting obligations was also a ploy"

The court stated, "Company A was suffering from a significant shortage of operating funds. As a way out, it promoted its proprietary technology, the promising outlook of its related business, and its expected future sales in order to attract investment," and emphasized that "rather than interpreting working capital broadly, it should be narrowly construed as 'funds for paying the expenses necessary to keep the company operating normally or to continue its business until the sales that are expected in the future actually materialize.'"

The court went on to rule, "Absent an urgent necessity to repay the debt immediately first, such as a situation where the company's creditworthiness or external business activities would be impaired, repaying loans ahead of other business expenses is difficult to regard as consistent with the purpose of restricting the use of the investment funds to 'working capital.'"

The court also pointed to other breaches, including false representations and warranties by Company A. Although the contract stated that "the company has no transactional relationships with stakeholders, shareholders, or executives and employees," the existence of the loans at issue meant that the representations and warranties were false.

The court further noted that Company A failed to comply with its obligation to report within seven business days after the investment funds were exhausted, as well as its obligation to submit quarterly and semiannual materials. Company A argued that the end of September, when the balance of the dedicated account reached zero, should be considered the point of exhaustion; however, the court recognized mid-July, when only 9,840 won remained, as the exhaustion point. The court criticized this by stating, "Leaving an extremely small amount of money in the dedicated investment account creates a permanent means of evading the reporting obligation, which runs counter to the purpose of the contract."

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