Republic of Korea: Selected Issues

This Selected Issues paper focuses on some of the key stylized facts of Korean business and export cycles over 1960–2001, and calculates a chronology for the classical cycle in these series by applying a variant of the Bry and Boschan (1971) cycle-doling algorithm. It highlights that the Korean classical business cycle and exports cycles are extremely asymmetric, as they exhibit long-lived expansions and much shorter-lived contractions. The results also indicate that the probability of ending a contraction or expansion phase in Korean industrial production and Korean real exports is independent of their duration.


This Selected Issues paper focuses on some of the key stylized facts of Korean business and export cycles over 1960–2001, and calculates a chronology for the classical cycle in these series by applying a variant of the Bry and Boschan (1971) cycle-doling algorithm. It highlights that the Korean classical business cycle and exports cycles are extremely asymmetric, as they exhibit long-lived expansions and much shorter-lived contractions. The results also indicate that the probability of ending a contraction or expansion phase in Korean industrial production and Korean real exports is independent of their duration.

VII. Reform of Korean Insolvency Laws: A Review of Critical Issues 1

The current insolvency regime in Korea does not provide appropriate tools to promote the orderly exit of nonviable companies and the rehabilitation of viable companies that are experiencing temporary problems. The laws are outmoded and inconsistent in policy direction. The government recognizes these problems and has initiated legislative reform to upgrade the insolvency regime so that it can better serve Korea’s current and prospective needs, especially the development of vigorous banking and corporate sectors. This paper outlines the desirable elements of a reform program, including the advantages of a unified insolvency system, ways to enhance timeliness and predictability, options for addressing inter-creditor issues, steps to encourage debtor and creditor participation, and enhancements to the law of secured transactions.

A. Introduction

1. There is an urgent need for reform of insolvency laws in Korea. At a basic level, the laws are outmoded and inconsistent in policy direction. The laws include the Bankruptcy Act (based on German law prior to the major 1994 amendments), the Corporate Reorganization Act (based on the corporate reorganization procedures in the pre-1978 U.S. Bankruptcy Code), the Corporate Restructuring Act (based on 1950s Austrian law), and the unprecedented Corporate Restructuring Promotion Act. These laws do not provide appropriate tools to develop vigorous corporate and banking sectors in Korea. Hence, the insolvency regime does not serve the current or prospective needs of Korea.

2. The crisis that erupted in 1997 provided the initial impetus to insolvency law reform, principally to expedite the exit of nonviable firms and facilitate corporate restructuring. The Korean government made some headway in reforming the insolvency regime, albeit in a somewhat piecemeal fashion. For example, the legal amendments in 1998 included the enabling of a Management Committee of private sector professionals to lend expertise to the courts and the establishment of Creditors’ Committees to take collective decisions with respect to the debtor enterprise. Furthermore, procedural and institutional reforms were introduced to improve the speed and efficiency of bankruptcy-related adjudication in the court system. These included issuance by the Supreme Court of a revised protocol on the corporate reorganization process, the imposition of some procedural time limits in court proceedings, and the establishment of specialized bankruptcy courts in the Seoul District and four provinces. More recently, in April 2001, legislation was introduced to sanction “prepackaged” bankruptcy plans, which in principle would allow for expedited court approval of a reorganization plan if agreed beforehand by creditors. Lastly, the introduction of the Corporate Restructuring Promotion Act in September 2001 is perhaps the most striking reform of the Korean insolvency regime. This Act formalizes corporate work-out procedures by, inter alia, providing legal mechanisms for “bailing-in” dissenting creditors.

3. However, these reforms, and others at the margin, have not gone far enough to address the fundamental weakness in the system. There is a significant overhang of insolvent companies for which the insolvency regime has failed to provide an effective exit mechanism. Without the credible threat of bankruptcy, debtor firms in concert with lenient creditors have evaded the responsible resolution of chronic financial problems. Further, dissenting creditors have been able to block agreement on restructuring plans until their narrow demands have been met. The recent case of Hyundai Engineering and Construction (HEC) highlights some of the basic problems in the operation of the current insolvency law regime. Dissenting creditors in the HEC case were able to delay agreement on a debt-equity swap. This delay led to HEC incurring additional losses. In the end, the government stepped in with bond guarantees to bring about an agreement, albeit on terms that are unsatisfactory to some creditors and that left the company’s viability suspect.

4. This paper provides a preliminary review of the issues that insolvency reform in Korea will need to address. Section B covers the principal elements of effective insolvency reform, including the advantages of a unified insolvency system, ways to enhance timeliness and predictability, options for addressing inter-creditor issues, steps to encourage debtor and creditor participation, and enhancements to the law of secured transactions. The goal is to provide a general outline of the key issues that will need to be addressed; precise recommendations on how these issues might be addressed in the Korean context would require further analysis. Section C offers some concluding remarks.

B. Principal Elements of Effective Insolvency Law Reform

5. The success of any reform effort to improve the insolvency legislative framework is, of course, interdependent on a number of factors. The first of these is discipline in the financial system. Financial sector reform should therefore be viewed in conjunction with insolvency reform, but is an area that is beyond the scope of this paper. Second, the creation and enforcement of security interests underpins the insolvency regime. Weaknesses in the law of security interests are reflected in the insolvency regime. Third, the successful operation of any insolvency regime relies on the enforcement mechanisms in the court system. Accordingly, this paper also notes aspects of the law of secured transactions and the court system in Korea that will need to be addressed with insolvency law reform.

Objectives of an Effective Corporate Insolvency System

6. An effective corporate insolvency regime strives to allocate risk among market participants in a predictable and transparent manner and to maintain economic value. These objectives are typically achieved through two complementary techniques: (i) direction of the orderly exit from the economy through liquidation of inefficient businesses; and (ii) rehabilitation of viable and productive business that are experiencing non-fundamental liquidity or operational difficulties. The main guide-posts for designing the law to achieve the objectives of an effective insolvency regime are outlined below.

Creation of a Unitary Insolvency Law System

7. Korean general insolvency laws is strikingly fragmented. In addition to the Bankruptcy Act, the Corporate Reorganization Act, the Corporate Restructuring Act, and the Corporate Restructuring Promotion Act, there are other provisions related to insolvency law, such as in the Corporate Restructuring Vehicle Act. At a minimum, harmonization of these laws is warranted in order to bring predictability and certainty to the insolvency regime.

8. Going beyond harmonization, the creating a “unitary” insolvency law would be even more advantageous. Consistent with the approach that has been recently adopted in a number of countries—most notably Germany—a unitary law would eliminate the complication of converting a rehabilitation proceeding into a liquidation proceeding (and vice versa). Under a unitary approach, the appropriate insolvency resolution technique can be determined within a prescribed period in the proceeding based on an assessment of viability of the debtor’s enterprise. Such a unified approach thus provides a framework for discipline and flexibility in the conduct of insolvency proceedings. A unitary approach also ensures that once a corporation is in the insolvency law regime, it cannot escape without a legal determination of its fate. Adoption of a unitary approach would yield substantial benefits in Korea given the extent of the current delays and uncertainty in the resolution of insolvency cases.

Timeliness and Predictability

9. Timeliness and predictability of an insolvency regime would provide considerable benefits to the restructuring process. To enhance timeliness and predictability in Korea, the following issues will need to be considered:

  • Time Limits—The absence of time limits (or at least the lack of their enforcement) have contributed to considerable delays in the current system. For instance, despite the 1998 streamlining of the Bankruptcy Act procedures, liquidations are projected to take five years, largely due to indeterminate procedures for the selling and distribution of debtor’s assets. The imposition of time limits at all stages of the proceedings, with penalties for noncompliance, would improve predictability in the insolvency regime.

  • Stay on Creditor Enforcement—Under the existing law, a stay on creditor enforcement only comes into force once the court decides that a bankruptcy action should “commence.” Prior to that decision, the imposition of the stay is subject to the discretion of the court. To enhance the predictability of the law, the stay could apply automatically once a creditor or debtor formally initiates proceedings.

  • Pre-packaged Bankruptcy—In circumstances where a debtor and the requisite majority of creditors have reached an out-of-court agreement on a restructuring, the law should provide for a “fast-track” mechanism that enables the plan to be approved shortly after filing, thereby avoiding the time and expense of full proceedings. The recent amendment to the Corporate Reorganization Act does not provide for such effective pre-packs.

Inter-Creditor Issues

10. Inter-creditor issues involve a number of competing considerations. On the one hand, the chances of a successful rehabilitation are increased when the leverage of dissenting creditors is reduced. This is particularly important where corporate insolvency is systemic and the option of wholesale liquidation of the corporate sector is not viable. On the other hand, the introduction of strong “cram down” rules against dissenting creditors weakens creditor rights. In the long term, strong cram down may reduce the availability of credit in the system. Furthermore, there may be concerns that cram-down rules will not be consistently applied by the courts in an equitable and predictable manner.

11. The benefits of cram down generally outweigh the disadvantages. However, a cram down mechanism will need to include principles on: (i) differentiating classes of creditors (based on both priority under liquidation and varying economic interests); and (ii) minimum protection for dissenting creditors. Cram down should be subject to rules providing that each dissenting creditor receive at least liquidation value (thereby safeguarding against forced rehabilitation where liquidation would be more efficient). And, a dissenting class should only be overridden where creditors in that class receive the full value of their claim or junior classes receive nothing (thereby safeguarding equitable treatment among creditor classes).

Debtor and Creditor Participation

12. The balance between debtor and creditor participation is a difficult but unavoidable issue in the design of insolvency law. Resolution of this issue needs to take account of institutional capacity of the courts and professional trustees to handle the potentially large volume of insolvency proceedings in Korea.

Debtor Involvement

13. Korean laws are inconsistent on removal of incumbent management of the debtor. Under the liquidation procedure of the Bankruptcy Act and the court-supervised rehabilitation procedure of the Corporate Reorganization Act, the incumbent management is removed by a court appointed administrator/receiver. By contrast, in a composition under the Corporate Restructuring Act, incumbent management remain in place. And, under the Corporate Restructuring Promotion Act, incumbent management can be removed by the creditors’ committee even before the plan is “agreed” among the creditors and the debtor company.

14. Skepticism about the involvement of incumbent management is justified given the record of corporate governance practices in Korea. These concerns, however, should be balanced by other considerations. First, where the law provides a blanket rule of ejection, incumbent management have a strong incentive to forestall or frustrate insolvency proceedings, which will often further undermine the chances of a successful rehabilitation. Second, the “trustee” model in Korea places inordinate reliance on the availability of suitable professionals to manage the debtor’s businesses during the insolvency proceedings.

15. The self-interest of management can be leveraged positively by providing management with a qualified right to operate the business. The law could provide for a specified exclusivity period in which the debtor can propose a rehabilitation plan, thereby encouraging the debtor to take early initiative. However, the conduct of management should be subject to oversight by a trustee and recourse to the courts where there is fraud or mismanagement. Further, the law could provide for mandatory grounds for debtor filing of insolvency proceedings and for liability for directors in “trading while insolvent.” Violation of the mandatory filing requirements would be a factor in removal of management during the insolvency proceedings.

Creditor Involvement

16. Two reforms would help optimize creditor involvement in the insolvency proceedings. First, the law could provide that the reasonable costs incurred in the operation of creditors’ committees (including the retention of professionals advisors) shall be borne by the debtor’s estate as an administrative expense. Such a rule would encourage more effective creditor participation. Second, upon the expiration of the period in which the debtor has the exclusive right to propose a plan, creditors could be allowed to propose their own rehabilitation plan.

Law of Secured Transactions

17. The Korean law of secured transactions apparently derives from German law. Under the German law model, the possessory pledge is the only recognized security interest in personal property (i.e., property other than land and fixtures on land). Because creation of a possessory pledge requires the transfer of the collateral to the creditor, the possessory pledge is of limited commercial utility when the collateral comprises assets used in the operation of the debtor’s business. A consequence of the legal limitation on creating security interests is that it prevents collateralization of valuable assets such as inventory and accounts receivables. Such a legal framework encourages an over-reliance on real estate collateral. This is the case in Korea, even though the value of real estate typically falls significantly short of covering the debt. These legal factors appear to have contributed to indiscriminate lending practices in Korea.

18. Modem German law, as demanded by a market-driven economy, has developed quasi-security interests in personal property (such as the fiduciary transfer of title) that have overcome the traditional limitations of that law. Korean law, however, has not moved in this direction. Reform of the law of secured transactions will therefore need to be a high priority.

19. The capacity to enforce the security interest is a critical element in the value of collateral. Specifically, swift and efficient foreclosure on collateral is vital. The effectiveness of such foreclosure proceedings depends on the operation of the court system. In Korea, the judicial procedure by which collateral is auctioned involves substantial delay. Such delay in effect deprives the creditor of the commercial value of the security interest. In particular, the practice of debtors (and their associates) in repeatedly filing appeals that automatically stay the auction procedure will need to be curtailed.

20. Improvements in the law of secured transactions and in the enforcement mechanisms would have a substantial cross-benefit to the Korean insolvency regime. It would support the ex ante differentiation of good and bad companies (in credit-risk terms) and provide an efficient alternative to insolvency proceedings for the recovery of credit claims.

The Court System

21. The effectiveness of the court system is fundamental to the operation of the insolvency regime. This point is valid whether the insolvency resolution either takes place directly in the courts or in an informal workout conducted in the shadow of the court system. As is the case with most jurisdictions across the world, it appears that the resources of the Korean court system are not sufficient to ensure the timely disposition of commercial cases. The initiative of the Korean government in establishing exclusive bankruptcy judges, six in Seoul and in three each in four other major cities, is welcome. This reform is appropriate in expediting the resolution of insolvency cases and in enhancing the quality of judicial determinations in those cases. Further streamlining of court procedures should be possible. For example, an extension of the three year service period in bankruptcy court of judges that have acquired expertise in insolvency matters would be beneficial.

C. Conclusion

22. The partial reforms of the insolvency system over the last four years did not go far enough, and getting the basis legal framework right will be indispensable to overcome the weakness in the corporate sector and support the development of a more market-driven economy. It is most encouraging that the Korean government recognize the need for further insolvency law reform, and that it has formed a task force to make proposals for such reforms. It is notable that the issues presented in the reform of insolvency laws are not unique to Korea. There is a wealth of comparative law experience out of which “best practices” in the design and implementation of insolvency law have evolved. Drawing on this experience, this paper has offered some preliminary guide posts on the critical issues that will need to be considered as this reform process moves forward. The recent reforms of German insolvency law may also provide some useful analogues for Korea.


This paper was prepared by Thomas Laryea (LEG).