KEF Korea Equity Fund, Inc.

 

 

 

 

KOREA EQUITY FUND, INC.

 

STATEMENT OF CHANGES IN NET ASSETS

 

 

 

 

 

 

 

 

NOTES TO FINANCIAL STATEMENTS (Unaudited)

 

APRIL 30, 2012

 

1. Significant Accounting Policies

 

Korea Equity Fund, Inc. (the “Fund”) is registered under the Investment Company Act of 1940 as a non-diversified, closed-end investment management company. The Fund was incorporated in Maryland on September 7, 1993 and investment operations commenced on December 3, 1993. The Fund’s investment objective is to seek long-term cap­ital appreciation through investments primarily in equity securities of South Korean companies.

 

In the opinion of management, all material adjust­ments, consisting of normal recurring adjustments, con­sidered necessary for a fair presentation have been in­cluded.

 

The accompanying financial statements have been pre­pared in accordance with U.S. generally accepted ac­counting principles (“GAAP”) and are stated in United States dollars. The following is a summary of the signifi­cant accounting and reporting policies used in preparing the financial statements.

 

(a) Valuation of Securities—Investments traded on stock exchanges are valued at the last sale price on the principal market on which such securities are traded as of the close of business on the day the securities are being valued or, lacking any sales, at the last available bid price. Securities traded in the U.S. over-the-counter market (as opposed to the over-the-counter market for foreign in­vestors in South Korea) are valued at the last reported sales price as of the close of business on such day the se­curities are being valued or, if none is available, at the mean of the bid and offer price at the close of the day or, if none is available, at the last reported sales price avail­able to the Fund. Securities for which market quotations are not readily available and restricted securities are val­ued in good faith at fair value using methods determined by the Board of Directors. Short-term debt securities which mature in 60 days or less are valued at amortized cost, which approximates fair value, if their original matu­rity at the date of purchase was 60 days or less, or by amortizing their value on the 61st day prior to maturity if their term to maturity at the date of purchase exceeded 60 days. Securities and other assets, including futures con­tracts and related options, are stated at market value or otherwise at fair value as determined in good faith by or under the direction of the Board of Directors of the Fund.

 

(b)   Foreign Currency Transactions—Transactions de­nominated in South Korean Won (“Won”) are recorded in the Fund’s records at the prevailing rate at the time of the transaction. Asset and liability accounts that are denomi­nated in Won are adjusted to reflect the current exchange rate at the end of the period. Transaction gains or losses resulting from changes in the exchange rate during the re­porting period or upon settlement of foreign currency transactions are included in the results of operations for the current period.

 

The net assets of the Fund are presented at the ex­change rate and market values on April 30, 2012. The Fund isolates that portion of the results of operations arising as a result of changes in the foreign exchange rates on in­vestments from the fluctuations arising from changes in the market prices of securities held at April 30, 2012, and such changes are included in net change in unrealized de­preciation on foreign currency transactions and translation on the statement of operations. Net realized foreign ex­change gains or losses include gains or losses arising from sales of portfolio securities, sales and maturities of short-term securities, currency gains or losses realized between the trade and settlement dates on securities transactions, the difference between the amounts of dividends, interest, and foreign withholding taxes recorded on the Fund’s books and the U.S. dollar equivalent of the amounts actu­ally received or paid.

 

(c)   Security Transactions, Investment Income, Distributions to Shareholders—Security transactions are accounted for on the trade date. Dividend income is recorded on the ex-dividend date and interest income is recorded on the accrual basis. Realized gains and losses on the sale of investments are calculated on a first in first out basis.

 

Distributions from net investment income and net real­ized capital gains are determined in accordance with Fed­eral income tax regulations, which may differ from GAAP. To the extent these “book/tax” differences are permanent in nature (i.e., that they result from other than timing of recognition—“temporary”), such amounts are reclassified within the capital accounts based on their Federal tax-basis treatment; temporary differences do not require re­classification. Dividends and distributions which exceed net realized capital gains for financial reporting purposes, but not for tax purposes, are reported as distributions in excess of net realized capital gains.

 

NOTES TO FINANCIAL STATEMENTS -- (Continued) (Unaudited)

 

(d)   Capital Account Reclassification—For the year ended October 31, 2011, the Fund’s accumulated net in­vestment loss was decreased by $1,629,727 and the ac­cumulated net realized loss was decreased by $1,629,727. The adjustments were a result of the reclassification of for­eign exchange losses, tax treatment of the realized gains/losses upon disposition of passive foreign invest­ment company stock, and net operating loss. These had no impact on net assets.

 

(e)   Income Taxes—A provision for United States income taxes has not been made since it is the intention of the Fund to continue to qualify as a regulated investment com­pany under the Internal Revenue Code and to distribute within the allowable time limit all taxable income to its shareholders.

 

Under South Korean tax laws, a withholding tax is im­posed on dividends and interest income at the rate of 16.5% and 13.2%, respectively, and such withholding taxes are reflected as a reduction of the related revenue. There is no withholding tax on realized gains.

 

The Fund evaluates tax positions taken or expected to be taken in accordance with GAAP, to determine whether the tax positions are “more-likely-than-not” of being sus­tained by the applicable tax authority. As of and during the six months ended April 30, 2012, the Fund did not have any liabilities for any uncertain tax positions. The Fund rec­ognizes interest and penalties, if any, related to uncertain tax positions as income tax expense in the statement of operations. During the six months, the Fund did not incur any interest or penalties.

 

(f)   Subscription for New Shares—As part of their annual corporate action matters, certain South Korean companies offer rights to their shareholders to subscribe to new shares which are eligible for a portion of the dividends paid on existing shares in the year of subscription. The Fund normally subscribes to new share offerings by South Korean companies.

 

(g)   Use of Estimates in Financial Statement Prepara­tion—The preparation of financial statements in accor­dance with GAAP requires management to make esti­mates and assumptions that affect the reported amounts and disclosures in the financial statements. Actual results could differ from these estimates.

 

(h)   Concentration of Risk—A significant portion of the Fund’s net assets consists of South Korean securities which involve certain considerations and risks not typically associated with investments in the United States. In addi­tion to the smaller size, less liquidity and greater volatility, the South Korean securities market is less developed than the U.S. securities market and there is often substantially less publicly available information about South Korean is­suers than there is about U.S. issuers. Future economic and political developments in South Korea could adversely affect the liquidity or value, or both, of securities in which the Fund is invested. Further, the Fund may be exposed to currency devaluation and other exchange rate fluctuations.

 

(i)   Indemnifications—Under the Fund’s organizational documents, its officers and directors are indemnified against certain liabilities arising from the performance of their duties to the Fund. Additionally, in the normal course of business, the Fund enters into contracts that contain a variety of representations which provide general indemnifi­cations. The Fund’s maximum exposure under these agreements is unknown as this would involve future claims that may be made against the Fund that have not yet occurred. However, based on the Fund’s experience, the Fund expects the risk of loss to be remote.

 

 

 

NOTES TO FINANCIAL STATEMENTS—(Continued) (Unaudited)

 

 

Nomura Asset Management U.S.A. Inc. (“NAM-U.S.A.” or the “Manager”) acts as the Manager of the Fund pur­suant to a management agreement. Under the agreement, the Manager provides all office space, facilities and per­sonnel necessary to perform its duties. Pursuant to such management agreement, the Manager has retained its parent company, Nomura Asset Management Co., Ltd. (“NAM”), as investment adviser for the Fund, and effective July 24, 2001, the shareholders approved NAM retaining its wholly-owned subsidiaries, Nomura Asset Management Hong Kong Limited (“NAM-Hong Kong”) and Nomura As­set Management Singapore Limited (“NAM-Singapore”), as investment sub-advisers for the Fund.

 

As compensation for its services to the Fund, the Man­ager receives a monthly fee computed at the annual rate of 0.85% of the Fund’s average weekly net assets. Under the management agreement, the Fund paid or accrued fees to the Manager of $462,942 for the six months ended April 30, 2012. Under the Investment Advisory Agreement, the Manager informed the Fund that NAM received sub-advi­sory fees of $121,318 from the Manager for the six months ended April 30, 2012. In addition, NAM-Hong Kong and NAM-Singapore received sub-advisory fees of $26,960 and $121,318, respectively. At April 30, 2012, the manage­ment fee payable to the Manager by the Fund was $72,303.

 

Certain officers and/or directors of the Fund are officers and/or directors of the Manager. Affiliates of No­mura Holdings, Inc. (the Manager’s indirect parent) did not earn any fees in commissions on the execution of portfo­lio security transactions for the six months ended April 30, 2012. The Fund pays each Director not affiliated with the Manager an annual fee of $12,000 plus $1,500 per meet­ing attended or $1,000 per telephone meeting attended, together with such Director’s actual expenses related to attendance at meetings. The Chairman of the Board, presently Rodney A. Buck, who is not affiliated with the Manager, is paid an additional annual fee of $5,000. The Chairman of the Audit Committee, presently David B. Chemidlin, receives an additional annual fee of $1,000. Such fees and expenses for unaffiliated Directors aggre­gated $60,060 for the six months ended April 30, 2012.

3.	Purchases and Sales of Investments

 

Purchases and sales of investments, exclusive of in­vestments in foreign currency and short-term securities, for the six months ended April 30, 2012 were $34,110,272 and $52,850,463, respectively.

 

4.	Rights Offering

 

The Fund issued to its shareholders of record as of the close of business on January 19, 2007 transferable Rights to subscribe for up to an aggregate of 2,803,000 shares of Common Stock of the Fund at a rate of one share of Com­mon Stock for three Rights held (“Primary Subscription”). During February 2007, the Fund issued a total of 2,803,000 shares of Common Stock on exercise of such Rights at the subscription price of $9.76 per share, compared to a net asset value per share of $12.30 and a market value per share of $10.79. A sales load of 3.75% was included in the subscription price. Offering costs of approximately $600,000 and the sales load were charged directly against the proceeds of the Rights Offering.

 

5.	Federal Income Taxes

 

As of October 31, 2011, net unrealized appreciation on investments for Federal income tax purposes was $30,922,544, consisting of $34,011,501 related to appreci­ated securities and $3,088,957 related to depreciated se­curities. The aggregate cost of investments, at October 31, 2011, for federal income tax purposes was $87,466,447.

 

At October 31, 2011 the components of accumulated earnings on a tax basis were as follows:

 

Undistributed ordinary income		$	3,661,136
Undistributed long term capital gains			23,071,272
Unrealized appreciation on investments and foreign currency transactions			30,973,590
Total accumulated earnings		$	57,705,999

 

For Federal income tax purposes, there was no distrib­ution for the fiscal year ended October 31, 2011 and October 31, 2010.

 

The Fund paid a dividend distribution of $3.065 per share to shareholders of record as of November 30, 2011 on January 18, 2012. The ex-dividend date was November 28, 2011. The distribution is comprised of short-term cap­ital gains of $0.46 and long-term capital gains of $2.605

per share. The dividend was paid in newly-issued shares of the Fund’s common stock. Shareholders had the option to request that their dividend be paid in cash in lieu of com­mon stock; however, the aggregate amount of cash distri­butions to all shareholders was limited to $8,951,244, which represented 33% of the aggregate dollar amount of the total distribution. The 1,973,003 distributed shares of common stock were valued at $9.21 per share, which was the trade-weighted average trading price of the Fund’s common stock on the New York Stock Exchange during the three-business day period ended January 9, 2012.

 

During the fiscal year ended October 31, 2011, the Fund fully utilized its capital loss carry forwards of $2,039,680 against current year net realized capital gains. The Fund does not have any capital loss carryforwards as of October 31, 2011.

 

6.	Fair Value Measurements

 

In accordance with GAAP, fair value is defined as the price that the Fund would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. GAAP also estab­lishes a framework for measuring fair value, and a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or lia­bility. Inputs may be observable or unobservable and refer broadly to the assumptions that market participants would use in pricing the asset or liability. Observable inputs re­flect the assumptions market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Fund. Unobservable in­puts reflect the Fund’s own assumptions about the as­sumptions that market participants would use in pricing the asset or liability developed based on the best informa­tion available in the circumstances. Each investment is as­signed a level based upon the observability of the inputs which are significant to the overall valuation. The three-tier hierarchy of inputs is summarized below.

 

·

Level 1—quoted prices in active markets for identical investments

 

·

Level 2—other significant observable inputs (includ­ing quoted prices for similar investments, interest rates, prepayment speeds, credit risk, etc.)

 

·

Level 3—significant unobservable inputs (including the Fund’s own assumptions in determining the fair value of investments)

 

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-06 “Improving Disclosures about Fair Value Measurements” (“ASU 2010-06”). ASU 2010-06 re­quires reporting entities to make new disclosures about amounts and reasons for significant transfers in and out of Level 1 and Level 2 fair value measurements as well as in­puts and valuation techniques used to measure fair value for both recurring and nonrecurring fair value measure­ments that fall in either Level 2 or Level 3, and information on purchases, sales, issuances and settlements on a gross basis in the reconciliation of activity in Level 3 fair value measurements. The new and revised disclosures are re­quired to be implemented for fiscal years beginning after December 2009 except for the disclosures surrounding purchases, sales, issuance and settlements, on a gross basis in the reconciliation of Level 3 fair value measure­ments, which are effective for fiscal years beginning after December 15, 2010. The Fund adopted the applicable por­tion of the ASU 2010-06 for the fiscal year ended October 31, 2011, and the impact of such adoption is limited to ad­ditional disclosures in the financial statements.

 

The following table summarizes the valuation of the Fund’s investments by the above fair value hierarchy levels as of April 30, 2012.

 

 

*Please refer to the Schedule of Investments for a breakdown of the valuation by industry type.

 

During the six months ended April 30, 2012, there were no transfers between Level 1 and Level 2.

 

During the six months ended April 30, 2012, the Fund did not hold any instrument which used significant unob­servable inputs (Level 3) in determining fair value.

 
NOTES TO FINANCIAL STATEMENTS—(Continued) (Unaudited)

 

 

The Board of Directors announced an enhanced Dis­count Management Plan on August 17, 2010 that provided for a tender offer of up to 20 percent of the Fund’s out­standing shares of common stock. The enhanced Plan also contemplates that the Board of Directors will annually evaluate whether, taking into account the Fund’s perfor­mance, trading discount from net asset value and other relevant factors, the Fund should make an additional ten­der offer for between 5 and 15 percent of its outstanding shares of common stock. On November 17, 2010, the Fund commenced a tender offer for up to 2,212,479 shares of its outstanding common stock at a price equal to 98 percent of the net asset value per share on the expira­tion date of the offer. The tender offer expired on Decem­ber 17, 2010, at which time the offer was oversubscribed. The Fund purchased the maximum number of shares cov­ered by the offer at a price of $12.79 per share, which rep­resented a price equal to 98 percent of the net asset value per share as of the close of trading on the New York Stock Exchange on December 17, 2010. As a result of the tender offer, $28,297,607 was distributed to the shareholders and there was a $0.06 increase to the net asset value per share.

 

The Fund’s intention to conduct a second tender offer was announced on June 7, 2011. This tender offer was for up to 10 percent of the Fund’s outstanding stock during the fourth quarter of 2011 if the Fund's stock traded at a specific discount during the third quarter of 2011. The stock did trade at the specific discount. The Fund com­menced an offer for up to 1,082,292 shares of its common stock on January 31, 2012. The offer expired on March 5, 2012, at which time the Fund purchased the maximum number of shares covered by the offer at a price of $10.33, which represented a price equal to 98 percent of the net asset value per share as of the close of trading on the New York Stock Exchange on March 5, 2012. As a result of the tender offer, $11,180,076 was distributed to the share­holders and there was a $0.02 increase to the net asset value per share.

8.	Recent Accounting Pronouncements

 

In May 2011, the FASB issued ASU No. 2011-04 "Amendments to Achieve Common Fair Value Measure­ment and Disclosure Requirements in GAAP and Interna­tional Financial Reporting Standards ("IFRS")”("ASU 2011- 04"). ASU 2011-04 includes common requirements for measurement of and disclosure about fair value between GAAP and IFRS. ASU 2011-04 will require reporting enti­ties to disclose the following information for fair value mea­surements categorized within Level 3 of the fair value hier­archy: quantitative information about the unobservable inputs used in the fair value measurement, the valuation processes used by the reporting entity and a narrative de­scription of the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs. In addition, ASU 2011-04 will require reporting entities to make disclosures about amounts and reasons for all transfers in and out of Level 1 and Level 2 fair value measurements. The new and revised disclosures are effective for interim and annual re­porting periods beginning after December 15, 2011. At this time, management is evaluating the implications of ASU No. 2011-04 and its impact on the financial statements.

 

On December 22, 2010, the Regulated Investment Company Modernization Act of 2010 (the "Act") was enacted, which changed various technical rules governing the tax treatment of regulated investment companies. The changes are generally effective for taxable years beginning after the date of enactment. One of the more prominent changes addresses capital loss carryforwards. Under the Act, each Fund will be permitted to carry forward capital losses incurred in taxable years beginning after the date of enactment for an unlimited period. However, any losses in­curred during those future taxable years will be required to be utilized prior to the losses incurred in pre-enactment taxable years, which carry an expiration date. As a result of this ordering rule, pre-enactment capital loss carryfor­wards may be more likely to expire unused. Additionally, post-enactment capital loss carryforwards will retain their character as either short-term or long-term capital losses rather than being considered all short-term as permitted under previous regulation.

 

 

Selected per share data and ratios for a share of common stock outstanding throughout each period: