- Use of Total Return Swaps (TRS) as a Credit Enhancement Tool to Fund Financially Troubled Affiliates
- Corrective Orders and a Fine of KRW 6.5 Billion (Provisional) Imposed
The Korea Fair Trade Commission (KFTC), chaired by Han Ki-jeong, has decided to issue corrective orders and impose a fine on CJ Corporation (hereinafter “CJ”) and CJ CGV Co., Ltd. (hereinafter “CGV”), both affiliates of the CJ Business Group designated as a large business group subject to restrictions on mutual investment. The sanctions relate to their use of total return swap (TRS) contracts as de facto credit enhancement and payment guarantee mechanisms to support affiliate companies CJ Construction Co., Ltd. (now CJ Logistics, hereinafter “CJ Construction”) and Simuline Co., Ltd. (now CJ 4DPLEX, hereinafter “Simuline”) in issuing perpetual convertible bonds at low interest rates.
A Total Return Swap (TRS) is a type of derivative contract where the counterparties agree to exchange the total return of a reference asset (e.g., stocks, bonds) for a predetermined cash flow over a specified period.
Perpetual convertible bonds refer to corporate bonds that include a conversion right into shares (convertible bonds) and have no maturity date (perpetual bonds), meaning they can be extended indefinitely.
From 2010 to 2014, CJ Construction posted net losses for five consecutive years (accumulating KRW 98 billion) and fell into a state of capital erosion in 2013 and 2014. Similarly, Simuline recorded net losses for three consecutive years from 2012 to 2014 (totaling KRW 7.8 billion), also leading to capital erosion by 2014. At the time of the support measures in 2015, both companies were facing severe financial distress, including credit rating downgrades and rising borrowing costs.
To raise capital, CJ Construction and Simuline sought to issue perpetual convertible bonds. However, due to their deteriorated financial conditions, they struggled to find investors (financial institutions) willing to underwrite the bonds, or anticipated significantly higher interest rates if any investors could be found.
In response, CJ and CGV (the "supporting parties") entered into TRS agreements on the same day as the issuance of the perpetual convertible bonds. These TRS contracts were part of a package deal with financial institutions, who agreed to purchase the bonds only under the condition that TRS agreements were executed.
Through the TRS agreements, financial institutions were able to transfer the credit risk associated with the perpetual bonds issued by the distressed affiliates (the "supported parties") to the supporting parties. Effectively, the TRS contracts served as a form of credit enhancement or payment guarantee.
On the surface, the TRS contracts could be interpreted as CJ and CGV taking on potential future gains from the bonds’ increased value. However, the bond terms restricted the exercise of conversion rights during the TRS period, and CJ and CGV had neither the intent nor the possibility to profit from value appreciation. In reality, they assumed only the credit risk of the affiliates' bonds.
At the time, CJ’s board of directors raised serious concerns, including whether the TRS contracts constituted "breach of fiduciary duty by guaranteeing poorly performing affiliates" and the potential for losses if the affiliates defaulted or failed to repay. The proposal was initially rejected due to these concerns.
As a result of the TRS-backed bond issuance, CJ Construction raised KRW 50 billion and Simuline KRW 15 billion in capital. Furthermore, the interest rates were set based on the credit ratings of CJ and CGV, enabling significant interest cost savings: approximately KRW 3.156 billion for CJ Construction and KRW 2.125 billion for Simuline.
These unfair support practices provided CJ Construction and Simuline with a substantial competitive advantage in their respective markets — general construction and 4D cinema equipment supply — thereby distorting fair market competition.
CJ Construction artificially improved its financial structure, avoided a credit downgrade, and expanded its external contract opportunities, leading to a continuous rise in its construction capacity evaluation rankings. This effectively limited business opportunities for independent SMEs.
Simuline also avoided market exit through artificial financial improvements, and maintained its position as the sole or dominant player in its market, effectively excluding potential competitors.
This case is significant as it identifies and sanctions practices where financially strong affiliates within a group support weaker affiliates, thereby undermining market competition and fair trade practices.
Moreover, this case highlights the regulatory stance that even if a financial instrument such as a derivative appears legitimate in form, it may be deemed a legal violation if used to covertly support an affiliate, serving as a disguised credit guarantee or support mechanism.
The KFTC will continue to monitor such cases regardless of the format or terminology used, and will impose strict sanctions when violations are confirmed, in order to ensure the establishment and maintenance of fair trade order in the market.