[Why&Next] Buying Shares in Acquired Company Turns Costly... Legal Risks for Second-Generation Cosmecca Owners

Alleged Advance Knowledge of Englewood Lab's Positive Earnings
Borrowed 5 Billion Won Using Cosmecca Shares as Collateral
Purchased 875,000 Affiliate Shares
Stock Price Surged 14% the Day After Earnings Release

The second-generation owner siblings of Cosmecca Korea, a domestic original design manufacturing (ODM) cosmetics company, have both become embroiled in legal risks. As the global popularity of K-Beauty has boosted the valuations of domestic beauty companies, past stock transactions by the owner family appear to be coming back as a boomerang.

According to the industry on September 7, the Criminal Division 3 of the Seongnam Branch of the Suwon District Prosecutors’ Office indicted Cho Hyunseok, President of Cosmecca Korea and eldest son of company founder Cho Imrae, and his younger brother Cho Hyuncheol, CEO of Englewood Lab, without detention last month. They faced charges of violating the Act on Capital Markets and Financial Investment Business.

According to the prosecution, the two brothers purchased shares in Englewood Lab after Cosmecca Korea acquired the U.S. cosmetics company in 2018. The prosecution suspects that they traded shares with prior knowledge that Englewood Lab’s third-quarter sales in the same year—despite the company’s unprofitability—had increased by more than 30% compared to the previous year.

Brothers Cho Hyunseok and Hyuncheol Pledged Cosmecca Shares ... Purchased 875,000 Englewood Lab Shares

According to the Financial Supervisory Service’s electronic disclosure system, Cosmecca Korea decided to acquire Englewood Lab, a U.S.-based ODM company specializing in basic cosmetics, in April 2018, and purchased a 34.71% stake in June of the same year, becoming the largest shareholder.

On October 23 of that year, the two brothers bought shares in Englewood Lab in the open market. CEO Cho bought 430,000 shares at KRW 4,960 per share, while President Cho purchased 445,000 shares at KRW 5,550 per share. The 875,000 shares they acquired in a single day represented a 2.16% and 2.24% stake in Englewood Lab, respectively.

The funds used were KRW 2,132,800,000 from CEO Cho and KRW 2,469,750,000 from President Cho, totaling KRW 4,602,500,000. At the time, their large shareholding disclosure reported that the entire amount was financed by loans. The brothers borrowed a total of KRW 5 billion from NH Investment & Securities and posted 274,662 shares of Cosmecca Korea as collateral.

The collateral was set up around the time of the share purchases. Eight days before the purchase, on October 15, President Cho entered a pledge contract with NH Investment & Securities, using 135,677 Cosmecca Korea shares as collateral. On October 23—the day he bought Englewood Lab shares—CEO Cho provided 138,985 Cosmecca Korea shares as collateral.

On October 30, Cosmecca Korea submitted an "Initial Large Shareholder Disclosure Report" for Englewood Lab. As a result of the brothers' acquisitions, the total stake held by Cosmecca Korea and its related parties in Englewood Lab rose from 34.7% to 39.1%.

'Unprofitable' Englewood Lab Turns Profitable After Cosmecca Acquisition

The issue is that just over two weeks after the brothers bought Englewood Lab shares, the company released unexpectedly strong results. On November 15, 2018, Englewood Lab announced its third-quarter results: sales were USD 35.51 million (about KRW 49 billion), an increase of 98.2% from USD 17.92 million (about KRW 24.7 billion) in the previous year. Over the same period, operating results shifted from a loss of USD 2.35 million (about KRW 3.2 billion) to a profit of USD 4.38 million (about KRW 6.1 billion).

At that time, CEO Cho was a registered director of Englewood Lab. President Cho was an executive director at Cosmecca Korea as well as a director at Englewood Lab. Both were listed as special related parties of Cosmecca Korea regarding Englewood Lab.

The prosecution considers that the brothers, in their management positions at Englewood Lab, learned before public disclosure that the company’s third-quarter 2018 sales would be more than 30% higher than the previous year. They are accused of using this information to purchase Englewood Lab shares.

Share Price Rose to KRW 8,000 After Earnings Release

After the earnings announcement, Englewood Lab’s share price soared. According to the Korea Exchange, the stock closed at KRW 5,290 on October 30, then rose to KRW 5,660 on November 2, and KRW 6,370 on November 14—just before the results were announced—reaching as high as KRW 8,000 within a week. This represented a 61.3% increase over CEO Cho’s purchase price of KRW 4,960 and a 44.1% increase over President Cho’s purchase price of KRW 5,550.

The value of the 875,000 shares they bought for about KRW 4.6 billion, based on KRW 8,000 per share, reached KRW 7 billion. Compared with their purchase prices, this resulted in a paper gain of about KRW 1.37 billion for CEO Cho and about KRW 1.09 billion for President Cho, totaling approximately KRW 2.4 billion.

However, the brothers did not sell the Englewood Lab shares they had bought at that time and still hold them. Nevertheless, they are now disputing charges in court on the grounds of using undisclosed information in stock transactions. Article 174 of the Capital Market Act prohibits listed company affiliates and executives from using undisclosed material information acquired in the course of their work for stock trading, among other transactions.

Performance Improvement Also Considered "Material Information" — Supreme Court Precedents

In the trial, a key issue will be whether the performance data the brothers allegedly knew prior to their buying shares qualifies as "material information" under the Capital Market Act, and whether they used it for trading. "Material information" refers to information that could have a significant impact on an investor’s investment decision.

Past court precedents have recognized company performance improvement as "material information." According to a paper by former Prime Minister’s Office Civil Affairs Team Leader Shin Sanghoon in the 2020 journal "Studies in Securities Law" of the Korean Securities Law Association, the courts have used the standard of whether information has material value for a rational investor deciding to buy, hold, or sell shares.

The paper cites as examples recognized by courts as favorable material information: third-party paid-in capital increases, changes in largest shareholder, acquisitions of other companies, patent acquisitions, and "strong preliminary financial performance."

There is also a Supreme Court precedent similar to this case. In 1995, the Supreme Court recognized as material information data that showed a company director, during the estimation of the fiscal year-end financial results, knew sales and net profits were up 70.1% and 131.2% year-on-year, respectively, and relayed this to a friend who worked as a brokerage manager. The friend used this yet-to-be-public strong performance information for stock trading.

If found guilty, the severity of the penalty varies by the amount of unjust enrichment. At the time of the crime in 2018, the Capital Market Act specified that if the gains or avoided losses from using undisclosed material information exceeded KRW 500 million but were less than KRW 5 billion, the punishment would be imprisonment of at least three years. The fine would be at least three times and up to five times the gains or avoided losses. If the KRW 2.1 billion calculated by the prosecutors is also recognized by the court as unjust enrichment, this case would fall within the aggravated punishment range. However, guilt, the amount of unjust enrichment, and actual sentencing will ultimately be determined by the court.

The indictment of the two brothers was not separately disclosed to the market. The Korea Exchange views this case as not subject to mandatory disclosure. An official from the exchange stated, "Unlike embezzlement or breach of trust, which directly impact company assets, stock trading by individuals using undisclosed information is not considered to have a direct effect on company operations or finances."

Meanwhile, President Cho is responsible for global sales and management support divisions at Cosmecca Korea, while CEO Cho heads Englewood Lab, overseeing U.S. operations. Both brothers each hold a 3% stake in Cosmecca Korea. For the first half of this year, Cosmecca Korea’s sales reached KRW 411.2 billion, and operating profit was KRW 53.9 billion—up 46.8% and 52.8%, respectively, year-on-year. Net profit surged 99.4% to KRW 39.9 billion.

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