Until recently, the Guideline for Investment with Options (“Guideline”) issued by the Financial Supervisory Service (“FSS”), dated July 19, 2005, applied to investments with put options and/or call options under which a private equity fund within the meaning of the Financial Investment Services and Capital Markets Act (“PEF”) would have put options exercisable against the invested company or their major shareholders, or the invested company or their major shareholders would have call options against the PEF.  In replacement of the Guideline, the Financial Services Commission and the FSS recently issued the Model Rules for PEF Investment with Options (“Model Rules”) on April 11, 2013, which took effect on April 15, 2013.

While the former Guideline was based on a negative system, which listed prohibited terms and conditions for put options and/or call options as they pertain to PEF investment, the new Model Rules adopt a positive system where “options with features of a loan” are in principle prohibited and such terms and conditions of options permissible for PEF investment are listed as an exception.  In addition, unlike in the past where the terms and conditions of options in a PEF investment had to be reported to the FSS, now a general partner of a PEF is to prepare and maintain documents on the reasonableness of the option triggering events and the exercise prices of options (thus, a big shift from safe-harboring pre-review of PEF investments with options to ex-post examination on the PEF operation).

It should be further noted that the Model Rules explicitly permit a PEF and an invested company’s major shareholder(s) to enter into an arrangement on the PEF’s exercise of its tag-along right and the major shareholder’s exercise of its drag-along right in relation to the shares of an invested company.

The Model Rules, in principle, prohibit certain options that would ensure generation of additional earnings for a PEF with no potential loss to the PEF’s investment (defined in the Model Rules as the “Option with Features of a Loan, Etc.”).  This, however, is exceptionally allowed when the following three requirements are met: (i) a breach of contractual obligation under an agreement aimed at preventing the major shareholder’s abuse of power or improving the business performance of an invested company occurs (option triggering event), (ii) the exercise price of an option is calculated at a reasonable level through an objective method based on the performance of the invested company (exercise price) and (iii) a general partner prepares and maintains documents on the reasonableness of the option triggering events and the exercise prices (obligation to prepare and maintain documents).

For a grey area exists as to whether certain methods of PEF investment with options that were not prohibited under the Guideline could also be viable under the Model Rules, general partners operating PEFs are likely be subject to an enhanced burden on assessing the legal risk of PEF investments with options, especially in that it has become difficult for general partners to obtain an ex-ante review from the FSS on whether certain investments with options are permitted.