20-F 1 h04158e20vf.htm FORM 20-F e20vf
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As filed with the Securities and Exchange Commission on June 1, 2010
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 20-F
 
     
(Mark One)    
o
  REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
or
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2009
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
or
o
  SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number: 000-51138
 
GRAVITY CO., LTD.
(Exact name of registrant as specified in its charter)
 
     
N/A   The Republic of Korea
(Translation of registrant’s name into English)   (Jurisdiction of incorporation or organization)
 
 
 
 
Nuritkum Square Business Tower 15F, 1605 Sangam-Dong, Mapo-Gu,
Seoul 121-795, Korea
(Address of principal executive offices)
 
 
 
 
Heung Gon Kim
Chief Financial Officer
Nuritkum Square Business Tower 15F, 1605 Sangam-Dong, Mapo-Gu, Seoul 121-795, Korea
Telephone: 82-2-2132-7000
Fax: 82-2-2132-7070
(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)
 
 
 
 
Securities registered or to be registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common stock, par value Won 500 per share*
  The NASDAQ Global Market
American depositary shares, each representing one-fourth of a share of common stock
   
 
* Not for trading, but only in connection with the listing of American depositary shares on the NASDAQ Global Market pursuant to the requirements of the Securities and Exchange Commission.
 
Securities registered or to be registered pursuant to Section 12(g) of the Act: None
 
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None
 
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report: Shares, par value Won 500: 6,948,900
 
Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
         
Large accelerated filer o
       Accelerated filer o   Non-accelerated filer þ
 
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:
 
U.S. GAAP þ  International Financial Reporting Standards as used by the International Accounting Standards Board o  Other o
 
If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow:  Item 17 o     Item 18 o
 
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ


Table of Contents

 
TABLE OF CONTENTS
 
                 
PART I     6  
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS     6  
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE     6  
ITEM 3. KEY INFORMATION     6  
      Selected Financial Data     6  
      Capitalization and Indebtedness     8  
      Reasons for the Offer and Use of Proceeds     8  
      Risk Factors     8  
ITEM 4. INFORMATION ON THE COMPANY     27  
      History and Development of the Company     27  
      Business Overview     28  
      Organizational Structure     64  
      Property, Plants and Equipment     65  
      UNRESOLVED STAFF COMMENTS     65  
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS     65  
      Operating Results     66  
      Liquidity and Capital Resources     81  
      Research and Development, Patents and Licenses, etc.      83  
      Trend Information     83  
      Off-Balance Sheet Arrangements     83  
      Contractual Obligations     83  
      safe harbor     85  
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES     85  
      Directors and Senior Management     85  
      Compensation     87  
      Board Practices     87  
      Employees     89  
      Share Ownership     90  
ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS     92  
      Major Shareholders     92  
      Related Party Transactions     94  
      Interests of Experts and Counsel     97  
ITEM 8. FINANCIAL INFORMATION     97  
      Consolidated Statements and Other Financial Information     97  
      Significant Changes     99  
ITEM 9. THE OFFER AND LISTING     99  
      Offer and Listing Details     99  
      Plan of Distribution     100  
      Markets     100  
      Selling Shareholders     100  
      Dilution     100  
      Expenses of the Issue     101  


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ITEM 10. ADDITIONAL INFORMATION     101  
      Share Capital     101  
      Articles of Incorporation     101  
      Material Contracts     105  
      Exchange Controls     108  
      Taxation     109  
      Dividends and Paying Agents     120  
      Statement by Experts     120  
      Documents on Display     120  
      Subsidiary Information     120  
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK     121  
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES     122  
PART II     123  
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES     123  
    123  
ITEM 15. CONTROLS AND PROCEDURES     123  
ITEM 16. RESERVED     125  
      Audit Committee Financial Expert     125  
      Code of Ethics     125  
      Principal Accountant Fees and Services     125  
      Exemptions from the Listing Standards for Audit Committees     126  
      Purchases of Equity Securities by the Issuer and Affiliated Purchasers     126  
      Change in Registrant’s Certifying Accountant     126  
      Corporate Governance     126  
PART III     126  
ITEM 17. FINANCIAL STATEMENTS     126  
ITEM 18. FINANCIAL STATEMENTS     126  
ITEM 19. EXHIBITS     127  
 EX-4.76
 EX-4.77
 EX-4.78
 EX-4.79
 EX-4.80
 EX-4.81
 EX-4.82
 EX-4.83
 EX-4.84
 EX-4.85
 EX-4.86
 EX-4.87
 EX-4.88
 EX-8.1
 EX-12.1
 EX-12.2
 EX-12.3
 EX-13.1
 EX-13.2
 EX-13.3


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CERTAIN DEFINED TERMS
 
Unless the context otherwise requires, references in this annual report on Form 20-F, or annual report to:
 
  •  “ADRs” are to the American depositary receipts that evidence our ADSs;
 
  •  “ADSs” are to our American depositary shares, each of which represents one-fourth of a share of our common stock;
 
  •  “Government” is to the government of The Republic of Korea;
 
  •  “Gravity,” “the Company,” “we,” “us,” “our,” or “our company” are to Gravity Co., Ltd. and except as otherwise indicated or required by context, our subsidiaries;
 
  •  “Korea” or the “Republic” are to The Republic of Korea;
 
  •  “China” or the “PRC” are to the People’s Republic of China (excluding Taiwan, Hong Kong and Macau);
 
  •  “Taiwan” or the “ROC” are to Taiwan, the Republic of China;
 
  •  “US$,” “U.S. dollars,” “US dollars,” or “Dollars” are to the currency of the United States of America;
 
  •  “Won,” “Korean Won,” or “W,” are to the currency of The Republic of Korea;
 
  •  “Chinese Yuan” or “CNY” are to the currency of China;
 
  •  “Japanese Yen” or “JPY” are to the currency of Japan;
 
  •  “NT dollar” or “NT$” are to the currency of Taiwan;
 
  •  “Hong Kong dollar” or “HK$” are to the currency of Hong Kong; and
 
  •  “Thai Baht” or “THB” are to the currency of Thailand.
 
For your convenience, this annual report contains translations of certain Won amounts into U.S. dollars at the noon buying rate as quoted by the Federal Reserve Bank of New York for Won in effect on March 31, 2010, which was Won 1,131.2 to US$1.00. No assurance is given that any Won or dollar amounts could have been, or could be converted into dollars or Won as the case may be at such rate, or any other rate, or at all.
 
Discrepancies in tables between totals and sums of the amounts listed are due to rounding.
 
FORWARD-LOOKING STATEMENTS
 
This annual report for the year ended December 31, 2009 contains “forward-looking statements,” as defined in Section 27A of the U.S. Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the U.S. Securities Exchange Act of 1934, as amended, or the Exchange Act. The forward-looking statements are based on our current expectations, assumptions, estimates and projections about us and our industry, and are subject to various risks and uncertainties. Generally, these forward-looking statements can be identified by the use of forward-looking terminology such as “anticipate,” “believe,” “considering,” “depends,” “estimate,” “expect,” “intend,” “plan,” “planning,” “planned,” “predict,” “project,” “continue” and variations of these words, similar expressions, or that certain events, actions or results “will,” “may,” “might,” “should,” “would” or “could” occur, be taken or be achieved.
 
Forward-looking statements include, but are not limited to, the following:
 
  •  future prices of and demand for our products;
 
  •  future earnings and cash flow;
 
  •  estimated development and commercial launch schedule of our games in development;
 
  •  our ability to attract new customers and retain existing customers;
 
  •  the expected growth of the Korean and worldwide online gaming industry;


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  •  the effect that economic, political or social conditions in Korea have on the revenue generated from our online game product and our results of operations;
 
  •  the effect that the current global financial crisis and global economic recession will or may have on our business prospects, financial condition and results of operations; and
 
  •  our future business development and prospects, results of operations and financial condition.
 
We caution you not to place undue reliance on any forward-looking statement each of which involves risks and uncertainties. Although we believe that the assumptions on which our forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions could be incorrect. All forward-looking statements are based on our management’s current expectation, assumptions, estimates and projections of future events and are subject to a number of factors that could cause actual results to differ materially from those described in the forward-looking statements. Risks and uncertainties associated with our business include, but are not limited to, risks related to changes in the regulatory environment; technology changes; potential litigation and governmental actions; changes in the competitive environment; changes in customer preference and popular culture and trends, including the online gaming culture; political changes; recent global economic events including, but not limited to, the significant downturn in the global economic and financial markets and the tightening of the global credit markets, changes in business and economic conditions, fluctuations in foreign exchange rates, fluctuations in prices of our products, decreasing consumer confidence and slowing of economic growth generally, and other risks and uncertainties that are more fully described under the heading “Risk Factors” in this annual report, and elsewhere in this annual report. In light of these and other uncertainties, you should not conclude that we will necessarily achieve any plans and objectives or projected financial results referred to in any of the forward-looking statements. We undertake no obligation to update or revise any forward-looking statement to reflect future events or circumstances.


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PART I
 
ITEM 1.   IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
 
Not applicable.
 
ITEM 2.   OFFER STATISTICS AND EXPECTED TIMETABLE
 
Not applicable.
 
ITEM 3.   KEY INFORMATION
 
ITEM 3.A.   SELECTED FINANCIAL DATA
 
You should read the selected financial data below in conjunction with the financial statements and the related notes included elsewhere in this annual report. The selected financial data as of and for the years ended December 31, 2007, 2008 and 2009 are derived from our audited financial statements and related notes thereto are included elsewhere in this annual report. Our historical results do not necessarily indicate results expected for any future periods. Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP.
 
                                                 
    As of and for the Years Ended December 31,  
    2005     2006     2007     2008     2009     2009(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data,
 
    operating data and percentage)  
 
Statements of operations
                                               
Revenues:
                                               
Online games — subscription revenue
  W 11,249     W 8,420     W 9,405     W 12,576     W 12,674     US$ 11,204  
Online games — royalties and license fees
    37,375       26,123       24,698       30,110       34,037       30,090  
Mobile games
    1,664       3,840       4,063       6,882       7,882       6,968  
Character merchandising, animation and other revenue
    3,096       2,580       2,063       3,602       2,810       2,484  
                                                 
Total revenues
    53,384       40,963       40,229       53,170       57,403       50,746  
Cost of revenues
    16,038       17,746       19,479       27,772       21,170       18,715  
                                                 
Gross profit
    37,346       23,217       20,750       25,398       36,233       32,031  
Operating expenses:
                                               
Selling, general and administrative
    30,795       27,555       28,159       23,489       21,651       19,140  
Research and development
    9,219       9,239       5,761       2,145       1,799       1,590  
Impairment losses on investments
                8,619                    
Impairment losses on intangible assets
                871             280       248  
Litigation charges
          4,648                            
Proceeds from a former chairman due to fraud
          (4,947 )                        
Gain in disposal of assets held for sale
          (1,081 )                        
Settlement cost of litigation
                            1,649       1,458  
                                                 
Operating income (loss)
    (2,668 )     (12,197 )     (22,660 )     (236 )     10,854       9,595  
Other income (expense), net
    (787 )     2,265       3,441       6,030       2,108       1,863  
                                                 
Income (loss) before income tax expenses and equity in loss of related joint venture and partnership
    (3,455 )     (9,932 )     (19,219 )     5,794       12,962       11,458  
Income tax expenses (benefit)
    (817 )     12,069       2,916       3,379       4,544       4,017  
                                                 
Income (loss) before equity in loss of related joint venture and partnership
    (2,638 )     (22,001 )     (22,135 )     2,415       8,418       7,441  
Equity in loss of related joint venture and partnership
    394       1,106       1,026       5,119       1,424       1,259  


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    As of and for the Years Ended December 31,  
    2005     2006     2007     2008     2009     2009(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data,
 
    operating data and percentage)  
 
Income (loss) before cumulative effect of change in accounting principle
    (3,032 )     (23,107 )     (23,161 )     (2,704 )     6,994       6,182  
Cumulative effect of change in accounting principle, net of tax
          849                          
Net income (loss)
    (3,032 )     (22,258 )     (23,161 )     (2,704 )     6,994       6,182  
LESS: Net income (loss) attributable to the non-controlling interest
    (2 )     7       40       69       77       68  
                                                 
Net income (loss) attributable to Parent Company
  W (3,030 )   W (22,265 )   W (23,201 )   W (2,773 )   W 6,917     US$ 6,114  
                                                 
Earnings (loss) per share:
                                               
Before cumulative effect of change in accounting principle
  W (445 )   W (3,326 )   W (3,339 )   W (399 )   W 995     US$ 0.88  
Cumulative effect of change in accounting principle(2)
          122                          
Basic and diluted per share
  W (445 )   W (3,204 )   W (3,339 )   W (399 )   W 995     US$ 0.88  
Basic and diluted per ADS(3)
    (111 )     (801 )     (835 )     (100 )     249       0.22  
Weighted average number of shares outstanding (basic and diluted)
    6,803,147       6,948,900       6,948,900       6,948,900       6,948,900       6,948,900  
Balance sheet data:
                                               
Cash and cash equivalents
  W 25,874     W 35,314     W 53,588     W 53,168     W 51,333     US$ 45,379  
Total current assets
    109,428       88,203       72,667       72,550       82,899       73,284  
Property and equipment, net
    11,863       8,472       7,195       5,226       2,837       2,508  
Total assets
    144,857       122,561       96,921       95,935       102,438       90,557  
Total current liabilities
    19,448       16,192       10,106       8,397       8,248       7,291  
Total liabilities
    24,073       24,419       21,377       19,327       18,828       16,644  
Total parent company shareholders’ equity
    120,762       98,113       75,476       76,471       83,396       73,724  
Non-controlling interest
    22       29       68       137       214       189  
Total equity
    120,784       98,142       75,544       76,608       83,610       73,913  
Selected operating data and financial ratios (unaudited):
                                               
Gross profit margin(4)
    70.0 %     56.7 %     51.6 %     47.8 %     63.1 %     63.1 %
Operating profit margin(5)
    (5.0 )     (29.8 )     (56.3 )     (0.4 )     18.9       18.9  
Net profit margin(6)
    (5.7 )     (54.4 )     (57.7 )     (5.2 )     12.0       12.0  
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Accounting Standard Codification (ASC) 718, Compensation-Stock Compensation (formerly referenced as the Financial Accounting Standards Board’s (FASB) Statements of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment) was adopted in 2006.
 
(3) Each ADS represents one-fourth of a share of common stock.
 
(4) Gross profit margin for each period is calculated by dividing gross profit by total net revenues for each period.
 
(5) Operating profit margin for each period is calculated by dividing operating income (loss) by total net revenues for each period.
 
(6) Net profit margin for each period is calculated by dividing net income (loss) by total net revenues for each period.

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Exchange Rate Information
 
The following table sets forth information concerning the noon buying rate for the years 2005 through 2009 and for each month during the previous six months through May 14, 2010, expressed in Won per US dollar.
 
                                 
    At End of
  Average
       
Period
  Period   Rate(1)   High   Low
 
2005
  W 1,010.0     W 1,023.2     W 1,059.8     W 997.0  
2006
    930.0       950.1       1,002.9       913.7  
2007
    935.8       928.0       950.2       903.2  
2008
    1,262.0       1,105.8       1,507.9       935.2  
2009
    1,163.7       1,270.0       1,570.1       1,149.0  
November
    1,164.4       1,162.8       1,188.1       1,152.0  
December
    1,163.7       1,163.3       1,185.4       1,149.0  
2010
                               
January
    1,158.7       1,138.2       1,163.1       1,120.0  
February
    1,159.0       1,155.7       1,170.0       1,144.0  
March
    1,131.2       1,136.1       1,153.0       1,128.0  
April
    1,108.0       1,115.5       1,126.3       1,104.0  
May (through May 21, 2010)
    1,193.0       1,144.2       1,193.5       1,115.0  
 
Source: Federal Reserve Bank of New York.
 
 
Note:
 
(1) The average rates for the annual periods were calculated based on the average noon buying rate on the last day of each month during the period. The average rates for the monthly periods were calculated based on the average noon buying rate of each day of the month.
 
ITEM 3.B.   CAPITALIZATION AND INDEBTEDNESS
 
Not applicable.
 
ITEM 3.C.   REASONS FOR THE OFFER AND USE OF PROCEEDS
 
Not applicable.
 
ITEM 3.D.   RISK FACTORS
 
RISKS RELATING TO OUR BUSINESS
 
We currently depend on one online game product, Ragnarok Online, for most of our revenues.
 
Most of our revenues have been and are currently derived from a single online game product, Ragnarok Online, which was commercially introduced in August 2002 and currently commercially offered in 59 countries and markets. We derived Won 42,290 million (US$37,385 thousand) in revenues from Ragnarok Online in 2009 and Won 38,949 million in revenues from Ragnarok Online in 2008, representing approximately 73.7% and 73.3% of our total revenues in 2009 and 2008, respectively.
 
Ragnarok Online has been in the market for nearly eight years and has reached maturity in most of our principal markets. The life cycle of an online game generally lasts from four to seven years and reaches its peak popularity within the first two years of its introduction after which usage gradually stabilizes and begins to decrease over time. The number of users of Ragnarok Online worldwide reached its peak in the first quarter of 2005 and has continued to decline since such time. Our failure to maintain, improve, update or enhance Ragnarok Online in a timely manner or successfully introduce it in attractive new markets is likely to lead to a continual decline in Ragnarok Online’s user base and subscription revenues and royalties. This will likely lead to a decline in our overall revenues, which would materially and adversely affect our business, financial condition and results of operations.


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If we are unable to consistently and timely develop, acquire, license, launch, market or operate commercially successful online games in addition to Ragnarok Online, our business, financial condition and results of operations may be materially and adversely affected.
 
In order to grow our revenues and net income, we must develop, acquire, license, launch, market or operate commercially successful online games in addition to Ragnarok Online that will retain our existing users and attract new users. In addition to Ragnarok Online, we currently offer three other massively multiplayer online role playing games, or MMORPGs, Requiem, Emil Chronicle Online and R.O.S.E. Online, and one casual online game, Pucca Racing. We are currently conducting open beta testing of an MMORPG sequel to Ragnarok Online, Ragnarok Online II. We recently entered into license agreements to publish an MMORPG, tentatively named, Estar, which is being developed by Naru Entertainment Co., Ltd., a Korean company, and a web browser-based casual MMORPG called Canaan, which was developed by Xpec Entertainment Inc., a Taiwanese company, and is currently being localized and prepared for beta testing.
 
None of our other online games to date have proven to be as commercially successful as Ragnarok Online. We stopped offering Time N Tales, an MMORPG, in March 2009 as the game did not prove to be popular. We discontinued developing a massively multiplayer online game, Ice Age Online, for which we had licensed the right to use the theme, characters and storyline from 20th Century Fox Licensing & Merchandising, the trademark licensor. We stopped development around the end of 2009, as there were disagreements between us and the trademark licensor over the general concept of the game and the trademark licensor sent to us a written notice of termination of the license agreement in November 2009.
 
None of the games we currently offer are as successful as Ragnarok Online. In addition, we have experienced significant delays in and cost overruns related to the launch of many of our online games. For example, although we have been conducting open beta testing of Ragnarok Online II since May 2007 and had indicated our plan to release Ragnarok Online II at various times over the past few years, the launch of this game has been significantly delayed on a number of occasions for a variety of reasons, including as a result of technical difficulties and corrective actions taken in response to market feedback during the testing and development phase. While no assurance can be given that we will be able to meet our current anticipated launch date, we currently intend to launch Ragnarok Online II in the fourth quarter of 2010. Due to the continued delay in the launch of Ragnarok Online II, certain licensees of Ragnarok Online II have delayed remitting royalty payments otherwise payable for Ragnarok Online. Any continued delay in the launch schedule of Ragnarok Online II could result in financial losses, including termination of certain license agreements, which could damage our reputation and have a material adverse effect on our business, prospects, financial condition and results of operation.
 
In addition, no assurance can be given that when launched, Ragnarok Online II will gain market acceptance and popularity and be profitable for us. The success of Ragnarok Online II will be subject to many factors, including the quality, uniqueness and playability of the game and the launch by our competitors of other games that may gain more market acceptance than Ragnarok Online II. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS — As we introduce new games, we face the risk that a significant number of users of our existing games may migrate to our new games without any net gains in the overall user base or overall improvement to our total revenues.”
 
As we introduce new games, we face the risk that a significant number of users of our existing games may migrate to our new games without any net gains in the overall user base or overall total revenues.
 
We expect that as we introduce new games, a certain number of our existing users will migrate from our existing games to the new games. If the net gains in new users is significantly lower than our expectations, then our revenue growth and profitability is likely to be materially and adversely affected.
 
In particular, there is a high degree of uncertainty about the potential impact of the commercial launch of Ragnarok Online II on the user base of Ragnarok Online. While we believe that the game environment and the overall game experience of Ragnarok Online II will be meaningfully different from those of Ragnarok Online, we cannot assure you that the overall user base will grow and that the net migration away from Ragnarok Online will not be significant and detrimental to our total revenues and as a result our net income.


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We depend on our overseas licensees for a substantial portion of our revenues and rely on them to distribute, market and operate our games, and comply with applicable laws and government regulations.
 
In markets other than Korea, the United States, Canada, Australia, New Zealand, India, Russia, CIS countries, France and Belgium for Ragnarok Online; Korea, the Unites States, Canada, Russia, CIS countries and certain European countries for Requiem; the United States, Canada, Mexico and certain European countries for R.O.S.E. Online and Korea for Pucca Racing, in which we or our subsidiaries directly publish our games, we license our games to overseas operators or distributors for license fees and royalty payments based on a percentage of revenues generated from our games in such markets. Overseas license fees and royalty payments represented 79.9% of our total revenues in 2009 and 73.7% of our total revenue in 2008. In particular, we are heavily dependent on one licensee for a significant portion of our revenues. In 2009, 55.7% of our total revenues was derived from GungHo Online Entertainment, Inc., or GungHo, our licensee in Japan, which is also our majority shareholder. Deterioration in our relationships with licensees or material changes in the terms of our licenses with such licensees will likely have a material adverse effect on our business, prospects, financial condition and results of operations. In addition, as we are heavily dependent on certain licensees, deterioration or any adverse developments in the operations, including changes in senior management, of our overseas licensees may materially and adversely affect our business, financial condition and results of operations.
 
Further, our overseas licensees generally have the exclusive right to distribute our games in their respective markets for a term of two or three years and may also operate or publish other online games developed or offered by our competitors, while we may not be able to easily terminate the license agreements as the agreements do not specify particular financial or performance criteria that need to be met by our licensees. If our overseas licensees devote greater time and resources to marketing their proprietary games or those of our competitors, we may not be able to terminate our license agreements or enter into a new license agreement with a different licensee and our revenues and net profit would be adversely impacted. Also a failure to satisfy our obligation to provide technical and other consulting services to the licensees under the license agreement may negatively affect user satisfaction and loyalty and hinder our licensees’ efforts to increase market share, which may lead the licensees to focus their attention on our competitors’ games or request modifications to our licensing agreements, including our licensees terminating or not re-newing their relationship with us.
 
Our overseas licensees are responsible for remitting royalty payments to us based on a percentage of sales from our games after deducting certain expenses. Some licensees may be allowed to deduct certain expenses before calculating royalty payments depending on the terms of the applicable contract. Failure by our licensees to maintain a stable and efficient billing, recording, distribution and payment collection network in these markets may result in inaccurate recording of sales or insufficient collection of payments from these markets and may materially and adversely affect our financial condition and results of operations. Certain of our licensees in the past have failed to accurately report amounts due to us and have diverted certain payables to one of our former chairmen, in contravention of our license agreements. When the illicit payments were discovered, we audited the database of our licensees in Japan, Taiwan, Thailand, the Philippines and China to assess the amount embezzled by the former chairman. Although we have audit rights, pursuant to our license agreements, to ensure that proper payment amounts are being recorded and remitted, such activities can be disruptive and time consuming and as a result we do not exercise such rights on a regular basis. Although we have taken a number of steps to improve our internal controls and compliance procedures to prevent inaccurate reporting and illicit diversion of payments, we cannot ensure that such incidents will not occur again. Any future occurrence of such incidents may materially and adversely affect our business, financial condition and results of operations.
 
Furthermore, our overseas licensees are responsible for complying with local laws, including obtaining and maintaining the requisite government licenses and permits. Failure by our overseas licensees to do so may result in, among others, a suspension of service of our games in such market which may result in user complaints and decrease in use of our game which would likely have a material adverse effect on our business, financial condition and results of operations.


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GungHo, the publisher of our games in Japan, our largest market in terms of revenues, is our majority shareholder, which gives them control of our board of directors.
 
Since April 1, 2008, GungHo has been our largest shareholder and beneficially owns, as of the date hereof, 59.3% of our common shares. As a result, GungHo is able to exert significant control over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, including acquisitions, divestitures, strategic relationships and other matters, and may also exert significant control over decisions related to the status of our American depositary shares being eligible for quotation and trading on the NASDAQ Global market. In addition, as GungHo is also an online game developer, there may be conflicts of interest. For instance, GungHo may lead our management with strategies and efforts which benefit itself and its shareholders to the detriment of our other shareholders. GungHo may also compete directly or indirectly against us for users and customers or increased market share for its games. Furthermore, four of our registered Executive Directors, Mr. Toshiro Ohno, Mr. Kazuki Morishita, Mr. Yoshinori Kitamura and Mr. Kazuya Sakai currently serve as Executive Officer, President and Chief Executive Officer, Director and Executive General Manager, Director and Chief Financial Officer, respectively, of GungHo, and there may be conflicts of interest in the decisions made by our Board of Directors and senior management. See ITEM 7.B. “RELATED PARTY TRANSACTIONS — Relationship with GungHo Online Entertainment, Inc.”
 
We operate in a highly competitive industry and compete against many large companies.
 
Increased competition in the online game industry in our markets from existing and potential competitors could make it difficult for us to retain existing users and attract new users, and could reduce the number of hours users spend playing our current or future games or cause us and our licensees to reduce the fees charged to play our current or future games. In some of the countries in which our games are distributed, such as Korea, Japan and Taiwan, growth of the market for online games has continued to slow while competition remains strong. If we are unable to compete effectively in our principal markets, our business, financial condition and results of operations could be materially and adversely affected. Many companies worldwide are dedicated to developing and/or operating online games and compete across various markets and regions. We expect more companies to enter the online game industry and a wider range of online games to be introduced in our current and future markets. Our competitors in the MMORPG industry vary in size from small companies to very large companies with dominant market share such as NCsoft of Korea and Shanda of China. We also compete with online casual game and game portal companies such as NHN, Nexon, CJ Internet and Neowiz Games, all from Korea. In addition, we may face stronger competition from companies that produce package games, such as Activision Blizzard, Electronic Arts, Nintendo and Sony Computer Entertainment, some of which have already successfully entered the online gaming market and many of which have announced their intention to expand their game services and offerings over the Internet. For example, World of Warcraft, Activision Blizzard’s online game, was released in 2004 and has been one of the most popular games in the world. Electronic Arts co-developed with Neowiz Games and launched FIFA Online 2, a sports online game based on its best-selling package sports game franchise FIFA series, in Korea in 2007 and beta testing is conducted in China and South East Asian countries. Many of our competitors have significantly greater financial, marketing and game development resources than we have. As a result, we may not be able to devote adequate resources to develop, acquire or license new games, undertake extensive marketing campaigns, adopt aggressive pricing policies or adequately compensate our game developers or third-party game developers to the same degree as many of our competitors.
 
As the online game industry in many of our markets is rapidly evolving, our current or future competitors may more effectively adapt to the changing competitive landscape and market conditions and compete more successfully than us. In particular, online game products are becoming more similar to each other, thus becoming commoditized and undifferentiated. In this environment, larger companies with relative economies of scale have a clear advantage over smaller companies like ours, as they are able to develop games in a more cost efficient manner, diversify their risks with a broader category of games and genres and increase their chances of having widely popular games. In addition, any of our competitors may offer products and services that have significant performance, price, creativity or other advantages over those offered by us. These products and services may weaken the market strength of our brand name and achieve greater market acceptance than ours. In addition, any of our current or future competitors may be acquired by, receive investments from or enter into strategic relationships


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with larger, more well established and better-financed companies and therefore may be able to obtain significantly greater financial, marketing and game licensing and development resources than we can. See ITEM 4.B. “BUSINESS OVERVIEW — COMPETITION.”
 
Our investments in joint ventures or partnerships related to development of new online games may not be successful.
 
Since 2004 we have made investments in joint ventures and entered into partnership arrangements with third parties to invest in online games. In many cases, as we do not have significant investment or other control over such entities, the success of such joint ventures and partnership arrangements is heavily dependent on third parties and their investment decisions. In December 2005, we entered into a limited liability partnership agreement to invest an aggregate amount of JPY1,000 million in “Online Game Revolution Fund No. 1,” a limited liability partnership which purpose was to invest in online games. In 2005, 2006, 2008 and 2009, we made contributions of JPY100 million, JPY150 million, JPY642 million and JPY18 million, respectively, to the partnership. While as of December 31, 2009, we have a 16.39% interest in the partnership as a limited partner, we cannot significantly influence the partnership’s operation and financial or investment policies. We account for our partnership interest under equity method of accounting. We recorded our partnership interest as an equity loss equal to Won 1,026 million, Won 5,119 million Won 1,424 million in 2007, 2008 and 2009, respectively. We also invested US$9 million in May 2006 for the purchase of Series D preferred shares of Perpetual Entertainment, Inc., a game development company, which subsequently went into liquidation and we recognized the total investment amount of Won 8,619 million as impairment losses on investments in 2007.
 
If our partners or our investments in such joint ventures and partnerships are unable to manage their investments and develop promising online games, such joint ventures and partnerships will be unable to attain their investment objectives, which may materially and adversely affect the value of our investments and commitments and will likely have a material adverse affect on our business, financial condition and results of operation.
 
We have experienced frequent turnover among our senior management team and key employees in the past. Some of our senior managers and key employees have limited experience in our industry, which could materially and negatively affect our business prospects.
 
Some members of senior management members and other key employees have worked with us and in our industry for a relatively short period of time. Their unfamiliarity with many aspects of our business operations may adversely affect our business, prospects, financial condition and results of operation. Despite our efforts to stabilize the composition of our senior management, we cannot provide any assurance that we will be successful. Our business prospects must be considered in light of the risks and difficulties we have encountered in the recruiting and retaining qualified senior management. Our inability to successfully address these risks and difficulties could materially harm our business prospects, financial condition and results of operations.
 
If we fail to hire and retain skilled and experienced game developers or other key personnel to design and develop new online games and additional game features, we may be unable to achieve our business objectives.
 
In order to meet our business objectives and maintain our competitiveness, we need to attract and retain qualified employees, including skilled and experienced online game developers. We compete to attract and retain key personnel with other companies in the online game industry as well as in the broader entertainment, media and Internet industries, many of which offer superior compensation arrangements and career opportunities. In addition, our ability to train and integrate new employees into our operations may not meet the changing demands of our business. We cannot assure you that we will be able to attract and retain qualified game developers or other key personnel, and successfully train and integrate them to achieve our business objectives, which could materially harm our business prospects. For example, during the development of Ragnarok Online II, certain key online game developers left, which negatively affected our ability to launch Ragnarok Online II in a timely fashion.


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Undetected programming errors or flaws in our games could harm our reputation or decrease market acceptance of our games, which would materially and adversely affect our business prospects, reputation, financial condition and results of operations.
 
Our current and future games may contain programming errors or flaws, which may become apparent only after their release. In addition, our online games are developed using programs and engines developed by and licensed from third party vendors, which may include programming errors or flaws over which we have little or no control. If our users have negative experiences with our games related to or caused by undetected programming errors or flaws, they may be less inclined to continue subscriptions for our games or recommend our games to other potential users.
 
While we have not experienced any material disruptions to our business from such errors or flaws in our games or in the programs and engines that we use to develop our games, these risks are inherent to our industry and, if realized, could severely harm our reputation, cause our users to cease playing our games, divert our resources or delay market acceptance of our games, any of which could materially and adversely affect our business, financial condition and results of operations.
 
Unexpected network interruptions, security breaches or computer virus attacks could harm our business and reputation.
 
Failure to maintain satisfactory performance, reliability, security and availability of our network infrastructure, whether maintained by us or by our licensees, may cause significant harm to our reputation and negatively impact our ability to attract and maintain users. Major risks relating to our network infrastructure include:
 
  •  any breakdowns or system failures, including from fire, flood, earthquake, typhoon or other natural disasters, power loss or telecommunications failure, resulting in a sustained shutdown of all or a material portion of our servers;
 
  •  any disruption or failure in the national or international backbone telecommunications network, which would prevent users in certain countries in which our games are distributed from logging onto or playing our games for which the game servers are located in other countries; and
 
  •  any security breach caused by hacking, loss or corruption of data or malfunctions of software, hardware or other computer equipment, and the inadvertent transmission of computer viruses.
 
Hacking” involves efforts to gain unauthorized access to information or systems or to cause intentional malfunctions or loss or corruption of data, software, hardware or other computer equipment. Hackers, if successful, could misappropriate proprietary information or cause disruptions in our service. We may have to spend significant capital and human resources to fix any damage to our system. In addition, we cannot ensure that any measures we take against computer hacking will be effective. A well-publicized computer security breach could significantly damage our reputation and materially and adversely affect our business.
 
We have been subject to denial of service attacks that have caused portions of our network to be inaccessible for limited periods of time but did not cause material losses or damages. Although we take a number of measures to ensure that our systems are secure and unaffected by security breaches, including ensuring that our servers are hosted at physically secure sites, limiting access to server ports, and using firewalls, passwords, and encryption technology, we cannot ensure that the measures we have implemented will be effective against all hacking efforts.
 
In addition, computer viruses may cause delays or other service interruptions on our systems and expose us to a material risk of loss or litigation and possible liability. We may be required to expend significant capital and other resources to protect our Web sites against the threat of such computer viruses and to alleviate any problems resulting from such viruses. Moreover, if a computer virus affecting our system is highly publicized, our reputation could be materially damaged and our visitor traffic may decrease.
 
Any of the foregoing factors could reduce our users’ satisfaction, harm our business and reputation and have a material adverse effect on our financial condition and results of operations.


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Electronic embezzlement could lessen the popularity of our online games and adversely affect our reputation and our results of operations.
 
Despite security measures, some of our employees or licensees’ employees with high-level security access to our network, or other employees who hack into or otherwise gain unauthorized access to certain sectors of our network, may succeed in breaching internal security systems and engage in electronic embezzlement by creating or diverting game money used in our online games and engaging in a public or private sale of the game money for their personal financial benefit. For example, from October 2005 to March 2006, a Ragnarok Online game master at GungHo hacked into his superior’s account which enabled the game master to create game money. The game master sold game money for cash in an aggregate of JPY58 million, which caused price inflation in the game and disrupted the balance of game play among the different players in Japan. GungHo dismissed the game master and implemented disciplinary action for high level executives. Although we have internal security procedures in place designed to prevent electronic embezzlement and have not had any recent incident of electronic embezzlement, we cannot assure you that we or our overseas licensees will be successful in preventing all electronic embezzlement. We have taken a number of procedures to prevent electronic embezzlement, including installing security programs designed to prevent counterfeiting and modification of program files, but cannot assure you such procedures will be sufficient to prevent new methods to engage in electronic embezzlement. Incidents of electronic embezzlement may negatively impact the reputation of our games, which may materially and adversely affect our business, financial condition and results of operations.
 
Cheating by users of online games could lessen the popularity of our online games and adversely affect our reputation and our results of operations.
 
We have experienced numerous incidents where users were able to modify the published rules of our online games. Although these users did not gain unauthorized access to our systems, they were able to modify the rules of our online games during game play in a manner that allowed them to cheat and disadvantage our other online game users, for example, by utilizing auto-run programs that enabled the games to be continuously and automatically played without user participation, which allowed the users to accrue in-game points quickly, causing many other players to stop using the game and shortening the game’s lifecycle. Such unauthorized manipulation of our games may negatively impact the image and users’ perception of our games and damage our reputation. Although we have taken a number of steps to deter our users from cheating when playing our online games, including spot checks, monitoring of game play by game masters to check for suspicious activity, we cannot assure you that we or our licensees will be successful or timely in taking the corrective steps necessary to prevent users from modifying the terms of our online games.
 
Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
 
Our intellectual property such as copyrights, service marks, trademarks and trade secrets are critical to our business. Unauthorized use of the intellectual property used in our business, whether owned by us or licensed to us, may materially and adversely affect our business and reputation. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, customers, business partners and others to protect our intellectual property rights. Despite certain precautions taken by us, it may be possible for third parties to obtain and use our intellectual property without authorization.
 
Since the commercialization of Ragnarok Online in August 2002, we have discovered that the server-end software of Ragnarok Online has been consistently and unlawfully released in most of the countries and markets in which Ragnarok Online is offered. This enables unauthorized parties to set up local server networks to operate Ragnarok Online, which may result in the diversion of a significant number of paying users. We designate certain employees to be responsible for detecting such illegal servers. In Korea, we report offenders to the relevant enforcement authority for possible prosecution relating to crimes on the Internet. In markets outside of Korea, we cooperate with and rely on our licensees to seek enforcement actions against operators of illegal servers. For example, in Japan, we submitted a written accusation to the Tokyo Metropolitan Police Department in October 2009, in cooperation with GungHo, our licensee in Japan, charging a server operator of illegally operating a Ragnarok Online server, and the matter is currently under investigation by the Tokyo Metropolitan Police


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Department. We may incur considerable costs in the future in order to remedy software piracy of our sever software and to enforce our rights against the operators of unauthorized server networks.
 
The validity, enforceability, enforcement mechanisms and scope of protection of intellectual property in Internet-related industries are uncertain and evolving. In particular, the laws and enforcement regimes of Korea, Japan, Taiwan, Thailand, China and certain other countries in which our games are distributed are uncertain or may not protect intellectual property rights to the same extent as do the laws and enforcement procedures of the United States. Moreover, litigation may be necessary in the future to enforce our intellectual property rights. Such litigation could result in substantial costs and diversion of our resources, disruption of our business, and have a material adverse effect on our business, prospects, financial condition and results of operations.
 
We may be subject to claims with respect to the infringement of intellectual property rights of others, which could result in substantial costs and diversion of our financial and management resources.
 
We cannot be certain that our online games do not or will not infringe upon patents, copyrights or other intellectual property rights held by third parties. We may become subject to legal proceedings and claims from time to time relating to the intellectual property of others. If we are found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property, and we may be required to pay penalties, fines and pay for unauthorized use of such intellectual property and we may need to incur additional license fees or be forced to develop alternative technology or obtain other licenses. We may incur substantial expenses in defending against these third party infringement claims, regardless of their merit. In addition, certain of our employees were recruited from other online game developers, including current and potential competitors. To the extent these employees have been and are involved in the development of our games that are similar to the games they helped develop at their former employers, we may become subject to claims that we or such employees have improperly used or disclosed trade secrets or other proprietary information. Although we are not aware of any pending or threatened claims of this type, if any such claims were to arise in the future, litigation or other dispute resolution procedures might be necessary to retain our ability to offer our current and future games, which could result in substantial costs and diversion of our financial and management resources.
 
Successful infringement or licensing claims against us may result in substantial monetary damages, which may materially disrupt our business operations and have a material adverse effect on our reputation, business, financial condition and results of operations.
 
We may not be able to successfully implement our growth and profit improvement strategies.
 
We are pursuing a number of growth and profit improvement strategies, including the following:
 
  •  distributing games developed in-house;
 
  •  publishing games acquired from or developed by third parties through licensing arrangements;
 
  •  offering our games in countries where we currently have little or no presence;
 
  •  optimizing our marketing and research and development expenditures;
 
  •  cross-selling our popular online games through other lines of businesses, such as mobile games, console games, animation and character merchandising; and
 
  •  pursuing joint ventures with game development companies.
 
We cannot assure you that we will be successful in implementing any of these strategies. Certain of our strategies relate to new services or products, such as game business related to internet protocol television, for which there are no established markets, or in which we lack experience and expertise. If we are unable to successfully implement our growth and profit improvement strategies, our revenues, profitability and competitiveness may be materially and adversely affected.


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We have limited business insurance coverage and any business interruption could have a material adverse effect on our business.
 
While we carry insurance coverage against certain risks, such as fire, flood and earthquake, in respect of our principal assets, including offices and equipment, as well as directors’ and officers’ liability insurance, we do not separately maintain casualty and liability insurance against litigation, risks or disruptions related to our business. The occurrence of any natural disaster, fire, power loss, telecommunications failure, break-ins, sabotage, computer viruses, intentional acts of Internet vandalism, human error or other similar events may damage our facilities or network servers and disrupt the operation of our business. As we do not carry sufficient natural disaster or business interruption insurance to compensate us for all types or amounts of loss that could arise, any damage or disruption from such events might result in our incurring substantial costs and the diversion of our resources, and have a material adverse effect on our business, financial condition and results of operation. See ITEM 4.B. “BUSINESS OVERVIEW — INSURANCE.”
 
Slow growth or contractions in the Internet café industry in Korea may affect our ability to target a core group of users.
 
According to the 2009 report issued by the Korea Creative Content Agency, an industry, non-profit organization that promotes exporting of Korean culture, the growth of the Internet café industry started to stabilize from 2000 although the total number of personal computers, or PCs, in Internet cafés continues to increase steadily. The number of Internet cafés slightly increased in 2008 after a short period of decrease in 2007 due to certain legal developments such as the Enforcement Decree of the Building Act, which placed limitations on the space for Internet cafés, the School Health Act, which prohibited the entry of certain facilities into the school environment clean-up zone and the Mandatory Registration of Businesses Supplying Games which was enforced by the government to regulate “speculative” gambling places. While we believe that there was no significant change in the number of Internet cafés in operation in 2009, as the Korean government enforces its regulations to tighten control over businesses that provide Internet and computer game facilities, the number of Internet cafés and as a result the total number of PCs at Internet cafés is expected to gradually decrease in the long term. Internet cafés have traditionally been the largest consumer and served as a medium of the game industry in Korea and any future reduction in the number of Internet cafés may shrink the size of the overall game market in Korea and adversely affect our ability to target a core group of potential users who prefer playing online games, in particular, MMORPGs, at Internet cafés.
 
The high cost to access the Internet access in certain markets may impede our entry into new markets.
 
Our growth potential in many of the markets in which our games are currently distributed or which we intend to enter, such as Southeast Asia and CIS countries, may be limited as the penetration rates for personal computers in such markets are relatively low and the cost of Internet access relative to the per capita income is higher when compared to some of our principal markets such as Korea and Japan. If we are unable to successfully enter and develop new markets for our games, our growth and profit improvement strategies, our revenues, profitability and competitiveness may be materially and adversely affected.
 
Occurrence of widespread public health problems could adversely affect our business and results of operations.
 
During 2003, some online game operators in China experienced declining growth of their online game revenues which they believe resulted from the closure of Internet cafés in Beijing and elsewhere to prevent the spread of SARS, or severe acute respiratory syndrome. In April 2009, a new strain of influenza A virus subtype H1N1, commonly referred to as “swine flu,” was first discovered in Mexico and quickly spread to other parts of the world. A renewed outbreak of SARS or another widespread public health problem, such as swine flu or avian influenza, in China or in other countries may prevent our customers from accessing Internet cafés and may adversely affect our prospects, business and operating results.


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A worldwide health crisis from any known or unknown causes and the response and the reaction from the health authorities of each country may impact our operations in a number of ways, including, among other things:
 
  •  quarantines or closures of some of our offices which would severely disrupt our operations;
 
  •  the sickness or death of our officers and key employees; and
 
  •  closure of Internet cafés and other public areas where people access the Internet.
 
Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business, financial condition and results of operations.
 
Some of our minority shareholders were very active in making demands in the past and requests on our management and our management may be required to expend substantial time, effort and resources to respond to such demands and requests.
 
Certain of our minority shareholders in and outside of Korea have made various demands on our management, including with respect to our corporate governance practices. For example, certain of our minority shareholders formed a committee in March 2006 named the Gravity Committee for the Fair Treatment of Minority Shareholders, or the Minority Shareholders Committee, which is still in existence as of the date of this report. The committee has since made a number of requests, including a request to inspect our financial documents and review decisions made by our management concerning transactions entered into with certain parties, and to pursue legal action if the committee views such transactions to have been entered into improperly. In the future, our management may be required to expend substantial time, effort and resources to respond to such requests from our minority shareholders, including the Minority Shareholders Committee, which may negatively impact the ability of our management to address business challenges and operational requirements facing us, and adversely affect our business, financial condition and results of operations.
 
We may be required to take significant actions that are contrary to our business objectives in order to avoid being deemed an investment company as defined under the Investment Company Act of 1940, as amended.
 
Generally, the Investment Company Act of 1940, or the ’40 Act, provides that a company is not an investment company and is not required to register under the ’40 Act as an investment company if the company is primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting or trading in securities. We believe that we are engaged primarily and directly in the businesses of providing online game services, and consequently, that we are not an investment company as that term is defined under the ’40 Act. At the same time, the determination of whether we are “primarily” engaged in a non-investment business may depend partly upon the composition of our assets. In particular, under certain circumstances we could become subject to registration as an investment company if we owned “investment securities” (as defined in the ’40 Act) having a value in excess of 40% of our total assets (exclusive of cash items and U.S. government securities). We do not currently own investment securities in excess of this threshold (for this purpose, we treat a bank deposit that may be withdrawn earlier than on its maturity date upon demand without penalty against the principal amount of the deposit as a cash item rather than as a security). In the future, we nonetheless could be required to take actions to avoid the requirement to register as an investment company, such as shifting a significant portion of our short-term investment portfolio into low-yielding bank deposits or other short-term securities which are not considered to be securities due to their liquidity and certain other characteristics. These types of investments may reduce the amount of interest on other income that we could otherwise generate from our investment activities. In addition, we may need to acquire additional income or loss generating assets that we might not otherwise have acquired or forego opportunities to acquire minority interests in companies that could be important to our strategy.
 
The ’40 Act also contains regulations with respect to investment companies, including restrictions on their capital structure, operations, transactions with affiliates and other matters which would be incompatible with our operations. If we were to be deemed an investment company in the future, we would effectively be precluded from making public offerings of securities in the United States. In addition to disciplinary actions, such as SEC


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enforcement actions seeking monetary damages, we could also be subject to administrative or legal proceedings and any contracts to which we are a party that violate the ’40 Act or the rules thereunder might be rendered unenforceable or subject to rescission.
 
Our status as a passive foreign investment company (“PFIC”) in 2009 and potentially other years could result in adverse U.S. tax consequences for you.
 
In light of the nature of our business activities and our holding of a significant amount of cash, short-term investments, and other passive assets after our initial public offering, we may have been since our initial public offering a PFIC for U.S. federal income tax purposes. In particular, due to the deterioration of the trading price of our ADSs, we believe that we were a PFIC in 2008 and 2009, and there is a significant risk that we will continue to be a PFIC in 2010. If we are a PFIC for any taxable year during which you hold our ADSs or common shares, you could be subject to adverse U.S. federal income tax consequences. You are urged to consult your tax advisors concerning the U.S. federal income tax consequences of holding our ADSs or common shares if we are considered a PFIC in any taxable year. See ITEM 10.E. “TAXATION — U.S. FEDERAL INCOME TAX CONSIDERATIONS — Passive foreign investment companies.
 
In the current year and in prior years, we have identified material weaknesses in our internal controls over financial reporting. If we fail to achieve and maintain an effective system of internal controls over financial reporting, we may be unable to accurately report our financial results or do so on a timely basis or reduce our ability to prevent or detect fraud, and investor confidence and the market price of our ADSs may be adversely affected.
 
We have identified material weaknesses in our internal control over financial reporting in current year and prior years. Most recently, in connection with the audit of our financial statements prepared under U.S. GAAP for the year ended December 31, 2009, we have identified a material weakness (as defined under both the U.S. Securities and Exchange Commission, or SEC, Management’s Report on Internal Control Over Financial Reporting, and Standards of the Public Company Accounting Oversight Board (United States)) in our system of internal control over financial reporting. In addition, our management assessed the effectiveness of our internal controls over financial reporting and disclosure controls and procedures as of December 31, 2009 pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act, and related SEC rules, respectively and concluded that our internal control over financial reporting and disclosure controls and procedures were not effective as of December 31, 2009. Management has identified the following material weakness in our internal control over financial reporting as of December 31, 2009:
 
  •  Lack of monitoring controls over significant transactions at a subsidiary level.  We did not design or operate effective monitoring controls over significant transactions at a subsidiary level. Specifically, the internal control over the accuracy and completeness of the severance benefits and approval of the related benefit distribution to a former director at the subsidiary level was not effective.
 
This material weakness could result in a misstatement of the aforementioned accounts and disclosures that would result in a material misstatement to our consolidated financial statements that would not be prevented or detected. After considering this material weakness, among other matters, our Chief Executive Officer and Chief Financial Officer have also concluded, most recently as of December 31, 2009, that our disclosure controls and procedures were not effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required. Furthermore, we are subject to the Sarbanes-Oxley Act, which requires us to, among other things, maintain an effective system of internal controls over financial reporting, and requires our management to provide a certification on the effectiveness of our internal controls on an annual basis. Additionally, our independent registered public accounting firm must provide an audit opinion on the effectiveness of our internal control over financial reporting.
 
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confidence and the market price of our ADSs may be adversely affected. See ITEM 15. “CONTROLS AND PROCEDURES” for additional discussion concerning our material weakness and changes in internal control.
 
Rapid technological developments and changes in market environment may limit our ability to recover game development, acquisition or licensing costs and adversely affect our financial condition and results of operations due to impairment loss.
 
The online game industry is subject to rapid technological developments and changes in market environment, which could render our online games under development and commercialized games obsolete or unattractive to users. Any resulting failure to recover capitalized development, acquisition or licensing costs and the recognition of impairment loss for such costs may materially and adversely affect our financial condition and results of operations.
 
RISKS RELATING TO OUR REGULATORY ENVIRONMENT
 
Our online operations and businesses are subject to regulation in certain of the countries in which our games are distributed, such as Korea, China, Taiwan, Japan and Thailand, the changes of which are difficult to predict, and the uncertainties in interpretation and enforcement of rules in such counties may limit the protections available to us.
 
The regulatory and legal regimes in many of the countries in which our games are distributed have yet to establish a sophisticated set of laws, rules or regulations designed to regulate the online game industry. However, in many of our principal markets, such as Korea, China, Taiwan and Thailand, legislators and regulators have implemented or indicated their intention to implement laws and regulations with respect to issues such as user privacy, defamation, pricing, advertising, taxation, promotions, financial market regulation, consumer protection, content regulation, quality of products and services, and intellectual property ownership and infringement that may directly or indirectly impact our activities. The impact of such laws and regulations on our business and results of operations is difficult to predict as many such laws and regulations are constantly changing. However, as we might unintentionally violate such laws or such laws may be modified and new laws may be enacted in the future, any such developments, or developments stemming from enactment or modification of other laws, could increase the costs of regulatory compliance, force changes in business practices or otherwise have a material adverse effect on our business, financial condition and results of operations. Further, if the cost of regulatory compliance increases for our licensees as a result of regulatory changes, our licensees may seek to reduce royalties and license fees payable to us, which may materially and adversely affect our business, results of operations and financial condition.
 
Korea
 
A draft amendment to the National Health Promotion Act was submitted to the National Assembly in February 2009. The draft amendment, among others, proposes to designate certain public facilities including Internet cafés as non-smoking areas. If the draft amendment is adopted in the extra session of the National Assembly, it will cause significant changes in the operation of Internet cafés, which currently operate both smoking and non-smoking sections. The number of Internet cafés in Korea is already gradually decreasing and the enactment of the proposed amendment may further reduces the number of Internet cafés operated by small business owners and have a materially adversely affect on our business, financial condition and results of operation. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS — Slow growth or contractions in the Internet café industry in Korea may affect our ability to target a core group of users.” See also ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS — Korea” for detailed discussion regarding Korean laws that affect our operations.
 
China
 
The Chinese government, through various regulatory authorities, heavily regulates the Internet sector, which includes the online game industry. In addition, there are uncertainties in the interpretation and application of existing Chinese laws, regulations and policies regarding the activities of Internet companies and businesses in China. Any violations of current and future laws and regulations could materially and adversely affect our and our Chinese licensee’s business, financial condition and results of operations. See ITEM 4.B. “BUSINESS


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OVERVIEW — LAWS AND REGULATIONS — China” for detailed discussion regarding Chinese laws that affect our operations.
 
Taiwan
 
In Taiwan, the game industry and online game companies are subject to various laws and regulations on different aspects, including, among others, consumer protection, rating system for protection of children and juveniles, Internet cafés, intellectual property and privacy protection.
 
Currently there is no national law specifically regulating the operation of Internet cafés in Taiwan. However, several municipalities and counties of Taiwan, such as Taipei City, Taipei County, Taoyuan County, Tainan City, Nantou County, and Kinmen County, have promulgated ordinances imposing restrictions on Internet cafés. In order to have Internet cafés regulated under a national legislation rather than by different municipalities and counties ordinances, the ROC Ministry of Economic Affairs as well as some legislators propose to regulate all Internet cafés located in Taiwan under a national legislation to be enacted. It is unclear, however, whether or when the above proposals will be passed by the Legislative Yuan and what restrictions will be imposed on Internet cafés. If the future laws and regulations have an impact on the Internet cafés, the growth of the Internet cafés industry in Taiwan may be affected and adversely affect our business, financial condition and result of operations. See ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS — Taiwan” for detailed discussion regarding Taiwanese laws that affect our operations.
 
Thailand
 
Although there is no specific law or regulation that directly governs the online game industry in Thailand, new legislation was passed in June 2008 to impose certain restrictions to control operators of game shops (i.e., places where people can play games, including Internet cafés that provide game services) and limit access to game shops by users under 18 years of age. These restrictions include limitations on the business days and hours, location and building structure of game shops as well as the daily playing time of games and curfew hours for users under 18 years of age to enter game shops and Internet cafés. According to the Ministerial Regulation of Ministry of Culture Re: Permission and Operation of Video Shops B.E. 2552 (2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 pm and 8:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during school term breaks prescribed by the competent registrar. For users aged from 15 years to 18 years, the access times are limited to between 2:00 pm and 10:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during school term breaks as prescribed by the competent registrar. See ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS — Thailand” for detailed discussion regarding Thai laws that affect our operations.
 
United States and Japan
 
See ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS” for detailed discussion regarding U.S. and Japanese laws that may materially impacted our operations.
 
Our online games may be subject to governmental restrictions or ratings systems, which could delay or prohibit the release of new games or reduce the existing and potential scope of our user base.
 
Legislation is periodically introduced in many of the countries in which our games are distributed to establish a system for protecting consumers from the influence of graphic violence and sexually explicit materials contained in various types of games. For instance, Korean law requires online game companies to obtain ratings classifications and implement procedures to restrict access of online games to certain age groups. Similar mandatory ratings systems and other regulations affecting the content and distribution of our games have been adopted or are under review in Taiwan, China, the United States and other markets for our online games. In the future, we may be required to modify our game content or features or alter our marketing strategies to comply with new governmental regulations or ratings assigned to our current or future games, which could delay or prohibit the release of new games or upgrades and reduce the existing and potential scope of our user base. Moreover, uncertainties regarding


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governmental restrictions or ratings systems applicable to our business could give rise to market confusion, thereby materially and adversely affecting our business, financial condition and results of operations.
 
Restrictions and controls on currency exchange in Korea and in certain countries in which our games are distributed may limit our ability to effectively utilize revenues generated in Won to fund our business activities outside Korea or expenditures denominated in foreign currencies, and may limit our ability to receive and remit revenues effectively.
 
The existing and any future restrictions on currency exchange in Korea, including Korean exchange control regulations, may restrict our ability to convert Won into foreign currencies under certain emergency circumstances, such as natural calamities, wars, conflicts of arms or grave and sudden changes in domestic or foreign economic circumstances, difficulties in Korea’s international balance of payments and international finance and obstacles in carrying out currency policies, exchange rate policies and other Korean macroeconomic policies. Such restrictions may limit our ability to effectively utilize revenues generated in Won to fund our business activities outside Korea or expenditures denominated in foreign currencies.
 
In addition, the governments in certain markets in which our games are distributed, including Thailand, Taiwan and China, impose controls on the convertibility of local currency into foreign currencies and, in some cases, the remittance of currency outside their countries. Under current foreign exchange control regulations of certain markets, shortages in the availability of foreign currency may restrict the ability of our overseas licensees to pay license fees and royalties, most of which are paid in U.S. dollars, to us. Restrictions on our ability to receive license fees, royalties and other payments from our licensees would adversely affect our financial condition and liquidity.
 
Adverse changes in the withholding tax rates in the countries from which we receive license fees and royalties could adversely affect our net income.
 
We may be subject to income withholding in countries where we derive revenues. Such withholding is made by our overseas licensees at the current withholding rates in such countries. To the extent Korea has a tax treaty with any such country, the withholding rate prescribed by such tax treaty will apply. Under the Corporation Tax Law of Korea, we are entitled to and recognize a capped tax credit computed based on the amount of income withheld overseas when filing our income tax return in Korea. Accordingly, the amount of taxes withheld overseas may be offset against taxes payable in Korea.
 
The tax rates on royalties pursuant to tax treaties that Korea entered into have not changed recently other than with regards to the limited tax rates in Thailand. While this tax rate change is not adverse for us, any adverse changes in tax treaties between Korea and the countries from which we receive license fees and royalties, such as with the rate of withholding tax in the countries in which our games are distributed or in Korean tax law enabling us to recognize tax credits for taxes withheld overseas, could adversely affect our net income.
 
RISKS RELATING TO OUR MARKET ENVIRONMENT
 
Our businesses may be adversely affected by developments affecting the economies of the countries in which our games are distributed.
 
Our future performance will depend in large part on the economic growth of our principal markets. Our top geographic markets in terms of revenues were Japan, Korea, the United States and Canada, Taiwan, Hong Kong and Macau, and Russia and CIS countries, representing 55.7%, 20.1%, 10.1%, 3.3% and 2.3%, respectively, of our total revenues in 2009. Accordingly, our business, prospects, financial condition and results of operations are subject to the economic, political, legal and regulatory conditions and developments in these countries. Adverse economic developments in such markets may have an adverse effect on the number of our subscribers and our revenues and have a material adverse effect on our results of operations.
 
Deterioration in global economic conditions in the recent global downturn has weakened the economies of the countries in which our games are distributed. Many countries for the foreseeable future may continue to experience economic slowdowns and recessionary pressures, including difficulty in securing credit in the global financial markets and decreased consumer confidence and discretionary spending. While the recent global economic


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developments did not yet have a material adverse effect on us, continuing deterioration or delayed recovery in global economic conditions could materially and adversely affect our business, financial condition and results of operations.
 
Fluctuations in exchange rates could result in foreign currency exchange losses.
 
In most of the countries in which our games are distributed, the revenues generated by our licensees are denominated in local currencies, which include the U.S. dollar, Japanese Yen, Euro, NT dollar, the Thai Baht and Chinese Yuan. In 2009, approximately 79.9% of our revenues were denominated in foreign currencies, primarily in the U.S. dollar and Japanese Yen. As the revenues denominated in local currencies, other than the U.S. dollar, Japanese Yen and Euro, are converted into the U.S. dollar for remittance of monthly royalty payments to us, any depreciation of the local currencies against the U.S. dollar will result in reduced license fees and monthly royalty payments in U.S. dollar terms and may materially and adversely affect our financial condition and results of operations.
 
While we receive monthly royalty revenues from our overseas licensees in foreign currencies, substantially all of our costs are denominated in Won. Our financial statements are also prepared and presented in Won. We receive monthly royalty payments from our overseas licensees based on a percentage of revenues confirmed and recorded at the end of each month applying the foreign exchange rate applicable on such date. While, in 2009, we enjoyed increased royalty revenues due to the strengthening of the Japanese Yen against the Korean Won by approximately 26.4% from 2008 to 2009, appreciation of the Won against the Japanese Yen or other foreign currencies will result in foreign currency losses that may materially and adversely affect our financial condition and results of operations. See ITEM 5.A. “OPERATING RESULTS — OVERVIEW — Foreign currency effects.”
 
As of December 31, 2009, we have not entered into any outstanding foreign currency forward exchange contract. We may enter into hedging transactions in the future to mitigate our exposure to foreign currency exchange risks, but we may not be able to do so in a timely or cost-effective manner, or at all.
 
Increased tensions with North Korea could adversely affect us and the price of our ADSs.
 
Relations between Korea and North Korea have been tense over most of Korea’s history and the Demilitarized Zone between the two countries is the most fortified border in the world. In October 2004, the United States and Korea agreed to a phased downsizing of the number of American troops stationed in Korea from 37,500 to 25,000 by the end of 2008, as part of worldwide U.S. troop realignment plans. However, in April 2008, the presidents of the U.S. and Korea reached an agreement to maintain the current U.S. troop level of 28,500, halting the planned withdrawal of 3,500 more U.S. troops.
 
The level of tension between Korea and North Korea has fluctuated and may increase or change abruptly as a result of current and future events, including ongoing contacts at the highest levels of the governments of Korea, North Korea and the United States. North Korea, Korea, the United States, China, Japan and Russia entered an accord in February 2007, whereby North Korea would begin to disable its nuclear facilities in return for fuel oil and aid. After several months of alleged non-compliance by North Korea and other related disputes among the parties, North Korea shut down its sole functioning nuclear reactor in Yongbyon and allowed the inspection team of the International Atomic Energy Agency to visit North Korea to monitor the shutdown and sealing of the facilities in July 2007. At the six-party talks in Beijing in October 2007, North Korea agreed to disable its nuclear facility at Yongbyon by the end of the year in a process overseen by a U.S.-led international team and to disclose all of its nuclear programs in return for one million tons of heavy fuel oil and lifting of sanctions by the United States. North Korea complied with disabling its nuclear facility at Yongbyon and the United States and other parties initiated delivery of the heavy fuel oil. However, North Korea failed to address an alleged plutonium-based program, uranium-enrichment program and other nuclear proliferation activities in Syria and North Korea missed the December 31, 2007 deadline to disclose the entirety of its nuclear programs.
 
In April 2008, North Korea and the United States agreed to draft two separate declarations, a public one that would address the plutonium-based program, and another classified one that would include the issues of uranium-enrichment program and proliferation. After breakdowns in negotiations, in September 2008, North Korea announced it was preparing to restore and restart its nuclear facility in Yongbyon. In October 2008, the


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United States agreed to remove North Korea from its list of countries that sponsor terrorism after North Korea agreed to again allow international inspectors access to declared nuclear sites in North Korea and to resume disabling its nuclear facility in Yongbyon. In January 2009, North Korea nullified all political and military agreements with South Korea. In March 2009, in response to two-week long joint military exercises between the United States and South Korea, North Korea placed its military in combat ready mode and stated that it would not guarantee the safety of civilian aircraft that approached its airspace during the duration of the joint military exercises. In April 2009, North Korea launched a long-range rocket over the Pacific Ocean and in May 2009, it announced that it had conducted a second nuclear test and tested short-range missiles. United Nations Security Council unanimously passed a resolution in June 2009 that condemned North Korea for its actions and decided to tighten sanctions against North Korea.
 
The level of tension between Korea and North Korea has been elevated in recent months as a result of a chain of incidents in the western shore of Korea, near Baengnyeong Island. In November 2009, patrol ships from Korea and North Korea exchanged fire, resulting in casualties for North Korea. Both sides exchanged fire in the same region again in January 2010. Tensions rose higher after the sinking of a Korean naval vessel in March 2010, from an explosion that killed 46 sailors. The Korean government made an official announcement in May 2010 that a North Korean torpedo attack caused the damage. In addition, there recently has been increased uncertainty with respect to the future of North Korea’s political leadership and concern regarding its implications for economic and political stability in the region.
 
We cannot assure you that recent events will not lead to an escalation of tension with North Korea. Any further increase in geopolitical tensions, resulting from testing of long-range nuclear missiles, continuing nuclear programs by North Korea, transition of power in leadership in North Korea, a break-down in existing contacts or an outbreak in military hostilities could adversely affect our business, prospects, financial condition and results of operations and could lead to a decline in the market value of our ADSs.
 
Disruptions in Taiwan’s political environment could seriously harm our business and operations in Taiwan.
 
In 2009 and 2008, we derived 3.3% and 4.3%, respectively, of our total revenues from our licensee in Taiwan, Hong Kong and Macau, which was added as a service territory in October 2009. The Chinese government asserts that it has sovereignty over Taiwan as well as mainland China and does not recognize the legitimacy of the government of Taiwan. The Chinese government has indicated that it may use military force to gain control over Taiwan if Taiwan declares independence or a foreign power interferes in Taiwan’s internal affairs. In response, the Taiwanese government promulgated the Referendum Law on December 31, 2003, last amended on May 27, 2009, allowing referenda on a range of issues to be proposed and voted upon. The law allows a referendum on key constitutional issues in the event that Taiwan faces a military attack from a foreign power and its sovereignty is threatened.
 
In March 2008, a new president in Taiwan was elected, President Ma Ying-jeou, who has supported the cultivation of better relations with mainland China. For instance, from July 2008, Taiwan has lifted the ban on Chinese person’s visiting in Taiwan with certain limitations. In December 2008, Taiwan re-established regular direct transportation links with mainland China that had been shut since 1949, including regularly scheduled commercial flights and shipping and mail. Further, Taiwanese government has partially unwound the restrictions on the investment in Taiwan by Chinese companies and person and several new regulations in connection therewith have been passed. For the purpose to further the finance cooperation, Taiwan has entered into a Memorandum of Understanding regarding cross-strait financial supervision with mainland China on November 16, 2009, which becomes effective on January 16, 2010. Also, Taiwan and China governments are in the progress of negotiating the Economic Cooperation Framework Agreement to be entered into for enjoying the custom benefit. Although recent trends may be beneficial to Taiwan’s economy, the history between Taiwan and mainland China has been marked with uncertainties. Deteriorations in the relationship between Taiwan and China and other factors affecting Taiwan’s political environment may materially and adversely affect our Taiwanese licensee’s business and our results of operations.


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RISKS RELATING TO OUR AMERICAN DEPOSITARY SHARES
 
The public shareholders of our ADSs may have more difficulty protecting their interests than they would as shareholders of a U.S. corporation.
 
Our corporate affairs are governed by our articles of incorporation and by the laws and regulations governing Korean corporations. The rights and responsibilities of our shareholders and members of our Board of Directors under Korean law may be different from those that apply to shareholders and directors of a U.S. corporation. For example, minority shareholder rights afforded under Korean law often require the minority shareholder to meet minimum shareholding requirements in order to exercise certain rights. Under applicable Korean law, a shareholder must own at least (i) one percent of the total issued shares to bring a shareholders’ derivative lawsuit, (ii) three percent to demand convocation of an extraordinary meeting of shareholders, demand removal of directors or inspect the books and related documents of a company, (iii) ten percent to apply to the court for dissolution if there is gross improper management or a deadlock in corporate affairs likely to result in a significant and irreparable harm to the company or to apply to the court for a reorganization in the case of an insolvency and (iv) 20 percent to block a small-scale share exchange or a small merger that may be approved only by a board resolution. In addition, while the facts and circumstances of each case will differ, the duty of care required of a director under Korean law may not be the same as the fiduciary duty of a director of a U.S. corporation. Although the “business judgment rule” concept exists in Korea, there is insufficient case law or precedent to provide guidance to the management and shareholders as to how it should be applied or interpreted. Holders of our ADSs may have more difficulty protecting their interests against actions of our management, members of our Board of Directors or controlling shareholders than they would as shareholders of a U.S. corporation.
 
Any dividends paid on our common shares will be in Won and fluctuations in the exchange rate between the Won and the U.S. dollar may affect the amount received by you.
 
If and when we declare cash dividends, the dividends will be paid to the depositary for the ADSs in Won and then converted by the depositary into U.S. dollars pursuant to the deposit agreement that governs the rights and obligations of the holders of ADSs. Fluctuations in the exchange rate between the Won and the U.S. dollar will affect, among other things, the U.S. dollar amounts you will receive from the depositary as dividends. Holders of ADSs may not receive dividends if the depositary does not believe it is reasonable or practicable to do so. In addition, the depositary may collect certain fees and expenses, at the sole discretion of the depositary, by billing the holders of ADSs for such charges or by deducting such charges from one or more cash dividends or other cash distributions from us to be distributed to the holders of ADSs.
 
Your ability to deposit or withdraw common shares underlying the ADSs into and from the depositary facility may be limited, which may adversely affect the value of your investment.
 
Under the terms of our deposit agreement, holders of our common shares may deposit such shares with the depositary’s custodian in Korea and obtain ADSs, and holders of our ADSs may surrender the ADSs to the depositary and receive our common shares. However, to the extent that a deposit of common shares exceeds the difference between:
 
  •  the aggregate number of common shares we have consented to be deposited for the issuance of ADSs (including deposits in connection with offerings of ADSs and stock dividends or other distributions relating to ADSs); and
 
  •  the number of common shares on deposit with the custodian for the benefit of the depositary at the time of such proposed deposit,
 
such common shares will not be accepted for deposit unless (i) our consent with respect to such deposit has been obtained or (ii) such consent is no longer required under Korean laws and regulations or under the terms of the deposit agreement.
 
Under the terms of the deposit agreement, no consent is required if the common shares are obtained through a dividend, free distribution, rights offering or reclassification of such shares. Under the terms of the deposit agreement, we have consented to any deposit to the extent that, after the deposit, the aggregate number of deposited


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common shares does not exceed 3,552,229 common shares or any greater number of common shares we determine from time to time (i.e., as a result of a subsequent offering, stock dividend or rights offer), unless the deposit is prohibited by applicable laws or violates our articles of incorporation; provided, however, that in the case of any subsequent offer by us or our affiliates, the limit on the number of common shares on deposit shall not apply to such offer and the number of common shares issued, delivered or sold pursuant to the offer (including common shares in the form of ADSs) shall be eligible for deposit under the deposit agreement, except to the extent such deposit is prohibited by applicable laws or violates our articles of incorporation or, in the case of any subsequent offer by us or our affiliates, we determine with the depositary to limit the number of common shares so offered that would be eligible for deposit under the deposit agreement in order to maintain liquidity of the shares in Korea as may be requested by the relevant Korean authorities. We might not consent to the deposit of any additional common shares. As a result, if a holder surrenders ADSs and withdraws common shares, the holder may not be able to subsequently deposit the common shares to obtain ADSs.
 
You may not be able to exercise preemptive rights or participate in rights offerings and as a result, you may experience dilution in your ownership percentage in us.
 
The Korean Commercial Code and our articles of incorporation require us to offer shareholders the right to subscribe for new common shares in proportion to their existing ownership percentages whenever new common shares are issued, except under certain circumstances as provided in our articles of incorporation. See ITEM 10.B. “ARTICLES OF INCORPORATION — Preemptive rights and issuance of additional shares.”
 
Such exceptions include offering of new shares:
 
  •  through a general public offering;
 
  •  to the members of the employee stock ownership association;
 
  •  upon exercise of a stock option;
 
  •  in the form of depositary receipts;
 
  •  to induce foreign direct investment necessary for business in accordance with the Foreign Investment Promotion Act of Korea;
 
  •  for the purpose of raising funds on an emergency basis;
 
  •  to certain companies under an alliance arrangement; or
 
  •  by a public offering or to cause underwriters to underwrite new shares for the purpose of listing them on any stock exchange.
 
Accordingly, if we issue new shares to non-shareholders based on such exceptions, existing holders of ADSs will be diluted. If none of the above exemptions is available under Korean law, we may be required to grant subscription rights when issuing additional common shares. However, under U.S. law, we would not be able to make those rights available in the United States unless we register the securities to which the rights relate or an exemption from the registration requirements of the Securities Act is available. Under the deposit agreement governing the ADSs, if we offer rights to subscribe for additional common shares, the depositary under the deposit agreement, after consultation with us, may make such rights available to you or dispose of such rights on behalf of you and make the net proceeds available to you or, if the depositary is unable to take such actions, it may allow the rights to lapse with no consideration to be received by you. The depositary is generally not required to make available any rights under any circumstances. We are under no obligation to file a registration statement under the Securities Act to enable you to exercise preemptive rights in respect of the common shares underlying the ADSs, and we cannot assure you that any registration statement would be filed or that an exemption from the registration requirement under the Securities Act would be available. Accordingly, you may not be entitled to exercise preemptive rights and may thereby suffer dilution of your interests in the Company.


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You will not be treated as our shareholder and you will not have shareholder rights such as the voting rights applicable to a holder of common shares.
 
As an ADS holder, we are not obligated to and we will not treat you as one of our shareholders and therefore, you will not have the rights of a shareholder. Korean law and our articles of incorporation govern the rights applicable to our shareholder. The depositary will be treated as the shareholder of the common shares underlying your ADSs. As a holder of ADSs, you will have ADS holder rights, which is governed by deposit agreement among us, the depositary and you, as an ADS holder. Upon receipt of the necessary voting materials, you may instruct the depositary to vote the number of shares your ADSs represent. The depositary will notify you of shareholders’ meetings and arrange to deliver our voting materials to you only when we deliver them to the depositary with sufficient time under the terms of the deposit agreement. If there is a delay or loss of the proxy materials, we cannot ensure that you will receive voting materials or otherwise learn of an upcoming shareholders’ meeting to ensure that you may instruct the depositary to vote your shares. In addition, the depositary and its agents are not responsible for failing to carry out voting instructions or for the manner of carrying out voting instructions.
 
You would not be able to exercise dissent and appraisal rights unless you have withdrawn the underlying common shares from the depositary facility and become a holder of our common stock.
 
In some limited circumstances, including the transfer of the whole or any significant part of our business, our acquisition of a part of the business of any other company having a material effect on our business, or our merger or consolidation with another company, dissenting shareholders have the right to require us to purchase their shares under Korean law. However, if you hold our ADSs, you will not be able to exercise such dissent and appraisal rights unless you have withdrawn the underlying common shares from the depositary facility and become our direct shareholder prior to the record date for the shareholders’ meeting at which the relevant transaction is to be approved.
 
We may amend the deposit agreement and the American Depositary Receipts without your consent for any reason and, if you disagree, your option will be limited to selling the ADSs or withdrawing the underlying securities.
 
We may agree with the depositary to amend the deposit agreement and the ADRs without your consent for any reason. If an amendment adds or increases fees or charges, except for taxes and other governmental charges or expenses of the depositary, for registration fees, facsimile costs, delivery charges or similar items, or prejudices a substantial right of ADS holders, it will not become effective for outstanding ADRs until 30 days after the depositary notifies ADS holders of the amendment. At the time an amendment becomes effective, you are considered, by continuing to hold your ADSs, to agree to the amendment and to be bound by the ADRs and the deposit agreement as amended. If you do not agree with an amendment to the deposit agreement or the ADRs, your option is limited to selling the ADSs or withdrawing the underlying securities. No assurance can be given that the sale of ADSs would be made at a price satisfactory to you in such circumstances. In addition, the common shares underlying the ADSs are not listed on any stock exchange in Korea. Your ability to sell the underlying common shares following withdrawal and the liquidity of the common shares may be limited.
 
You may be subject to Korean withholding tax.
 
Under Korean tax law, if you are a U.S. investor, you may be subject to Korean withholding taxes on capital gains and dividends with respect of the ADSs unless an exemption or a reduction under the income tax treaty between the United States and Korea is available. Under the Korea-United States tax treaty, capital gains realized by holders that are residents of the United States eligible for treaty benefits will not be subject to Korean taxation upon the disposition of the ADSs. However, under the Korea-United States tax treaty, the following holders are not eligible for such tax treaty benefits: (i) in case the holder is a United States corporation, if by reason of any special measures, the tax imposed on such holder by the United States with respect to such capital gains is substantially less than the tax generally imposed by the United States on corporate profits, and 25% or more of the holder’s capital is held of record or is otherwise determined, after consultation between competent authorities of the United States and Korea, to be owned directly or indirectly by one or more persons who are not individual residents of the United States and (ii) in case the holder is an individual, if such holder maintains a fixed base in Korea for a period or periods aggregating 183 days or more during the taxable year and the holder’s ADSs or common shares giving rise


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to capital gains are effectively connected with such fixed base or such holder is present in Korea for a period or periods of 183 days or more during the taxable year.
 
You may have difficulty bringing an original action or enforcing any judgment obtained outside Korea against us and our directors and officers who are not U.S. persons.
 
We are organized under the laws of Korea, and most of our directors and officers reside outside of the United States. While we have a wholly-owned subsidiary in the United States, most of our assets and the assets of such persons are located outside of the United States. As a result, it may not be possible for you to effect service of process within the United States upon these persons or to enforce against them or us court judgments obtained in the United States that are predicated upon the civil liability provisions of the federal securities laws of the United States or of the securities laws of any state of the United States. There is doubt as to the enforceability in Korea, either in original actions or in actions for enforcement of judgments of United States courts, of civil liabilities predicated on the federal securities laws of the United States or the securities laws of any state of the United States.
 
The transfer, sale or availability for sale of substantial amounts of our ADSs could adversely affect their market price.
 
GungHo beneficially owns 59.3% of our common shares. If GungHo decides to sell or transfer substantial amounts of our common shares into the form of ADSs in the public market or if there is a perception of their intent to sell, the market price of our ADSs could be materially and adversely affected and could materially impair our future ability to raise capital through offerings of our ADSs.
 
ITEM 4.   INFORMATION ON THE COMPANY
 
ITEM 4.A.   HISTORY AND DEVELOPMENT OF THE COMPANY
 
We were incorporated as a company with limited liability under Korean law on April 4, 2000 under the legal name of Gravity Co., Ltd. Following our initial public offering of 8,000,000 ADSs, each representing one-fourth of one share of our common stock, par value Won 500 per share on February 8, 2005, our ADSs were listed on the NASDAQ Stock Market’s the NASDAQ Global Market, formerly the NASDAQ National Market, under the symbol “GRVY.”
 
In March 2003, we established Gravity Interactive, LLC, our wholly-owned subsidiary in the United States. The name of Gravity Interactive, LLC was changed on January 1, 2006 to Gravity Interactive, Inc., or Gravity Interactive. In January 2004, we acquired 50% of the voting shares of Gravity Entertainment Corporation, or Gravity Entertainment, formerly RO Production Co., Ltd., our subsidiary in Japan. In October 2004, we obtained from GungHo, then the other 50% shareholder of RO Production Co., Ltd., their ownership interest in RO Production Co., Ltd., which made Gravity Entertainment our wholly-owned subsidiary. RO Production Co., Ltd. changed its corporate name to Gravity Entertainment on February 5, 2005. In April and May 2005, we acquired an aggregate of 88.15% equity interest in TriggerSoft Corporation, or TriggerSoft, which developed our R.O.S.E. Online game. TriggerSoft went into liquidation proceedings in Korea in May 2007 and the liquidation was completed in October 2007. In November and December 2005, we acquired an aggregate of 96.11% of the total shares of NeoCyon, Inc., or NeoCyon, which provides mobile multimedia services in Korea. In August 2006, we founded Gravity EU SASU, or Gravity EU, a wholly-owned subsidiary based in France, and in September 2006, we acquired 100% of the voting shares of Gravity CIS, Inc. formerly Mados, Inc., from Cybermedia International, Inc., a former subsidiary of NeoCyon. On November 21, 2007, the name of Gravity CIS, Inc. was changed to Gravity CIS Co., Ltd., or Gravity CIS. In May 2007, we established Gravity Middle East & Africa FZ-LLC, or Gravity Middle East & Africa, a wholly-owned subsidiary in Dubai. Gravity Middle East & Africa has been in the process of liquidation since September 2008. In October 2007, we founded Gravity RUS Co., Ltd., or Gravity RUS, a Russia-based subsidiary, and acquired 99.99% of the voting shares, and transferred 100% of the voting shares of Gravity CIS to Gravity RUS in December 2007. In October 2007, we formed L5 Games Inc., or L5 Games, a game development studio in the U.S., which is a wholly-owned subsidiary of Gravity Interactive. L5 Games has been in the process of liquidation since August 2008. On April 1, 2008, GungHo acquired shares of our common stock, after which it became our largest shareholder, beneficially owning approximately 52.4% of our common shares. GungHo


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subsequently purchased our ADSs and beneficially owns approximately 59.3% of our common shares as of March 31, 2010.
 
Our registered office is located at Nuritkum Square Business Tower 15F, 1605 Sangam-Dong, Mapo-Gu, Seoul, Korea 121-795. Our telephone number is (822) 2132-7000. Our main Web site is at http://www.gravity.co.kr. Our address for service of process in the United States is Gravity Interactive, 13160 Mindanao Way, Marina Del Rey, California 90292.
 
ITEM 4.B.   BUSINESS OVERVIEW
 
OVERVIEW
 
We are a leading developer and publisher of online games in Japan, Brazil, the Philippines, Indonesia, Singapore, Malaysia, Thailand, Russia and Taiwan based on the number of peak concurrent users, or PCU, as compiled from various statistical data available from public sources in such countries. We are based in Korea and we currently offer five online games worldwide and have one online game in development and two online games developed or being developed by third parties for which we have entered into license agreements. Our principal product, Ragnarok Online, is commercially offered in Korea and 58 other countries and markets. Requiem is commercially offered in Korea, the United States, Canada and 62 other countries. Emil Chronicle Online is commercially offered in Korea, Thailand, Hong Kong, Taiwan, Indonesia, Singapore and Malaysia. R.O.S.E. Online is commercially offered in the United States, Canada, Mexico and 40 other countries. Pucca Racing is commercially offered in Korea. We also offer a number of mobile games and license the merchandizing rights of character-related products based on our online games. We intend to diversify our online game offering by developing online games internally as well as publishing additional online games developed by third parties. We are also expanding our business by providing our games on multiplatform devices, such as Nintendo DS.
 
In Korea, we directly manage all aspects of game operations, such as marketing, operation, billing and customer service. For certain countries and markets, our subsidiaries directly manage such game operations. Gravity Interactive, our wholly-owned subsidiary in the United States, is responsible for all aspects of Ragnarok Online game operations in the United States, Canada, Australia, New Zealand and India, for all aspects of Requiem game operations in the United States, Canada and 39 European countries and for all aspects of R.O.S.E. Online game operations in the United States, Canada, Mexico and 40 European countries. Gravity CIS and Gravity EU, our subsidiaries, are responsible for Ragnarok Online game operations in Russia and CIS countries, and in France and Belgium, respectively. In the countries where we and our wholly-owned subsidiaries, Gravity Interactive, Gravity CIS and Gravity EU, manage game operations, our game revenues, including both subscription-based fee revenues and micro-transaction based revenues, are recorded as subscription revenues.
 
In the rest of the countries in which our games are offered, our overseas licensees are responsible for all aspects of game operations in their respective markets in close cooperation with us. Our license agreements have an initial term of two or three years and are subject to renewal every year once the initial term expires. We rely on the initial license fees and the ongoing royalties from our overseas licensees for a significant portion of our revenues. The ongoing royalties are based on a percentage of revenues generated by our overseas licensees from the subscriptions to our games in their respective markets.


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The following table sets forth a summary of our consolidated statements of operations showing revenues from our online games (by type of revenue and geographic market), mobile games, and character merchandising and other revenue as a percentage of total net revenues for the periods indicated.
 
                                                         
    Year Ended December 31,  
    2007     2008     2009     2009(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Online game revenues(2):
                                                       
Subscriptions:
                                                       
Korea
  W 6,238       15.5 %   W 7,463       14.0 %   W 4,951       8.6 %   US$ 4,377  
United States/Canada(3)
    2,608       6.5       3,607       6.8       5,785       10.1       5,114  
Others
    559       1.4       1,506       2.9       1,938       3.4       1,713  
Royalties and license fees:
                                                       
Japan
    17,849       44.4       23,353       43.9       28,089       48.9       24,831  
Taiwan/Hong Kong(4)
    2,345       5.8       2,210       4.1       1,827       3.2       1,615  
Thailand
    1,034       2.6       970       1.8       1,104       1.9       976  
Others
    3,470       8.6       3,577       6.7       3,017       5.3       2,668  
                                                         
Subtotal
    24,698       61.4       30,110       56.5       34,037       59.3       30,090  
                                                         
Mobile game revenues
    4,063       10.1       6,882       12.9       7,882       13.7       6,968  
Character merchandising and other revenues
    2,063       5.1       3,602       6.9       2,810       4.9       2,484  
                                                         
Total revenues
  W 40,229       100.0 %   W 53,170       100.0 %   W 57,403       100.0 %   US$ 50,746  
                                                         
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Online game revenues include revenues from Ragnarok Online, R.O.S.E. Online, Requiem, Emil Chronicle Online, Pucca Racing, Time N Tales and from two games offered through STYLIA, our casual online game portal site. We discontinued offering games through STYLIA in September 2008. We discontinued offering Time N Tales in March 2009.
 
(3) Subscription revenues in the United States and Canada, as shown on this table, also include subscription and other types of game revenues generated in other countries managed by Gravity Interactive. The license agreement for Ragnarok Online with Gravity Interactive was amended in January 2008 to include Australia and New Zealand as countries serviced by Gravity Interactive, and in September 2009 to include India as a country serviced by Gravity Interactive. The license agreement for Requiem with Gravity Interactive was amended in December 2009 to include the United Kingdom and 38 other European countries serviced by Gravity Interactive.
 
(4) The license agreement for Ragnarok Online with Game Flier International Corporation, which manages Ragnarok Online service in Taiwan and Hong Kong, was amended in October 2009 to include Macau as a service territory.
 
OUR PRODUCTS
 
We currently have four product lines: MMORPGs, casual online games, mobile games, and game-related products and services, including animation and character-based merchandise. Revenues from our principal product, Ragnarok Online, accounted for 73.7% of our total revenues in 2009, compared with 73.3% of our total revenues in 2008. We are seeking to diversify our revenue sources by offering additional MMORPGs, casual online games, and other products and services, including mobile games.


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Massively multiplayer online role playing games (MMORPGs)
 
MMORPG is a genre of computer role playing games in which a large number of players interact with one another within a virtual game world.
 
The following table summarizes the MMORPGs that we currently offer and currently in development, and those games licensed from third party developers.
 
             
            Date of Commercial
Title
 
Description
 
Game Source
 
Launch/Testing(2)
 
Ragnarok Online
  Action adventure with 150 levels of skill upgrades, which features two-dimensional characters in three-dimensional backgrounds(1)   Developed in-house   Launched in August 2002
R.O.S.E. Online
  Three-dimensional action adventure with seven independent storylines   Originally licensed from third party developer; currently owned by us(3)   Launched in January 2005
Requiem
  Three-dimensional action adventure   Developed in-house   Launched in October 2007
Emil Chronicle Online
  Three-dimensional action adventure   Licensed from third party developer   Launched in August 2007
Ragnarok Online II
  Three-dimensional sequel to Ragnarok Online   Being developed in-house by the Company   Open beta testing since May 2007. Currently expected to launch in the fourth quarter of 2010
Estar (tentative title)
  Three-dimensional action adventure   Licensed from third party developer   Not determined
Canaan
  Web browser-based casual   Licensed from third party developer   Currently expected to launch in the third quarter of 2010
 
 
Notes:
 
(1) A game with such features is generally referred to in the industry as a 2.5 dimensional game.
 
(2) The actual date of commercial launch of games in each country is dependent on a variety of factors, including technical viability and durability, availability of in-house development capability, market conditions, beta testing results and availability of licensing partners in various jurisdictions, among others.
 
(3) We acquired an aggregate of 88.15% equity interest in TriggerSoft, which developed R.O.S.E. Online in April and May 2005. TriggerSoft was liquidated in October 2007.
 
Ragnarok Online
 
Ragnarok Online is commercially offered in Korea and 58 other countries and markets since its commercial launch in August 2002. We began to commercially offer Ragnarok Online in 20 new countries in 2009, including India and countries in the Middle East and Northern Africa. Ragnarok Online represented 73.7% of our total revenues or Won 42,290 million (US$37,385 thousand) in 2009, compared with 73.3% of our total revenues or Won 38,949 million in 2008. See ITEM 4.B. “BUSINESS OVERVIEW— OUR MARKETS — Overseas markets.”


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The following are revenues generated by Ragnarok Online for the periods indicated:
 
                                     
        Year Ended December 31,  
Revenue Type
 
Country
  2007     2008     2009     2009(1)  
        (In millions of Won and thousands of US$)  
 
Online game-subscription revenue
  Korea   W 5,143     W 5,971     W 4,156     US$ 3,674  
    United States/ Canada(2)     2,103       2,693       3,794       3,354  
    Others     558       1,198       1,046       924  
                                     
      Subtotal     7,804       9,862       8,996       7,952  
                                     
Online game-royalties and license fees
  Taiwan/Hong Kong(3)     2,345       1,706       1,452       1,284  
    Japan     16,791       23,326       28,089       24,831  
    Thailand     981       679       819       724  
    Philippines     655       699       707       625  
    China     613       472       336       297  
    Indonesia     358       322       362       320  
    Europe     419       446       408       360  
    Singapore/Malaysia     109       63       57       51  
    Australia/New Zealand(2)     1                    
    Brazil     547       971       1,057       935  
    India(2)     152       26              
    Chile     209       186              
    Vietnam     130       191              
    Middle East/Africa                 7       6  
                                     
      Subtotal     23,310       29,087       33,294       29,433  
                                     
         Total   W 31,114     W 38,949     W 42,290     US$ 37,385  
                                     
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Subscription revenues in the United States and Canada, as shown on this table, also include subscription and other types of game revenues generated in other countries managed by Gravity Interactive. Such revenues from other countries constitute a minor portion of the revenues recorded as subscription revenues from the United States and Canada. The license agreement for Ragnarok Online with Gravity Interactive was amended in January 2008 to include Australia and New Zealand as countries serviced by Gravity Interactive, and in September 2009 to include India as a country serviced by Gravity Interactive. Revenues generated in such countries prior to the respective amendment to the license agreement were shown as Online game royalties and license fees.
 
(3) The license agreement for Ragnarok Online with Game Flier International Corporation, which manages Ragnarok Online service in Taiwan and Hong Kong, was amended in October 2009 to include Macau as a service territory.


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The table below provides for the periods indicated, the peak concurrent users and average concurrent users of Ragnarok Online since the first quarter of 2007, in each of our principal markets for Ragnarok Online.
 
                                                                                                 
    Taiwan/Hong Kong   Thailand   Japan   China   Korea   USA/Canada
    PCU(1)   ACU(2)   PCU   ACU   PCU   ACU   PCU   ACU   PCU   ACU   PCU   ACU
 
1Q 2007
    78,516       45,993       27,491       19,061       78,053       34,504       14,691       8,516       10,338       5,177       6,538       4,042  
2Q 2007
    56,663       34,455       19,408       13,673       77,151       35,633       11,986       5,809       8,046       4,721       6,468       3,363  
3Q 2007
    39,983       28,097       12,931       8,562       66,441       23,975       10,108       5,541       7,997       4,575       4,604       2,491  
4Q 2007
    34,982       24,935       63,445       38,511       60,788       24,018       7,760       3,936       7,854       4,562       4,638       2,648  
1Q 2008
    36,429       29,893       63,316       25,942       61,800       24,674       8,609       4,469       6,785       3,219       4,334       2,469  
2Q 2008
    34,747       26,364       14,996       9,709       57,348       22,908       7,393       3,856       10,146       3,518       4,288       2,396  
3Q 2008
    40,574       27,097       22,850       12,687       57,515       22,401       6,979       3,273       9,192       4,357       3,700       2,122  
4Q 2008
    30,128       21,292       30,455       20,707       59,470       24,109       5,342       2,476       6,306       3,052       4,661       2,354  
1Q 2009
    27,686       20,351       28,761       22,628       58,171       24,554       5,942       2,861       6,127       3,211       4,908       3,181  
2Q 2009
    27,616       20,678       47,679       36,445       57,387       23,038       5,378       2,571       6,975       2,641       5,093       3,300  
3Q 2009
    37,066       23,599       47,310       31,636       54,671       21,331       6,351       3,162       7,610       3,525       5,634       3,758  
4Q 2009
    27,803       19,274       31,883       24,603       59,800       21,817       4,877       2,247       6,949       3,319       5,128       3,332  
1Q 2010
    29,089       22,437       31,042       24,253       52,585       20,232       5,447       2,529       6,502       3,091       4,933       3,298  
 
 
Notes:
 
(1) PCU, or peak concurrent users, represents the highest number of users of Ragnarok Online during the specified time period as recorded on the servers for the various countries.
 
(2) ACU, or average concurrent users, represents the average number of concurrent users of Ragnarok Online during the specified time period as recorded on the servers for the various countries.
 
(3) We believe that the number of users as measured by PCU or ACU (i) is reflective of our active user base and (ii) is correlated to revenues as revenues from an online game depend on the number of users as well as time spent playing the game. However, PCU and ACU are not measures under accounting principles generally accepted in Korea, or Korean GAAP, or U.S. GAAP and should not be construed as an alternative to operating income or another measure of performance determined in accordance with Korean GAAP or U.S. GAAP. Other companies may determine PCU or ACU differently than we do.
 
We obtained an exclusive license from Mr. Myoung-Jin Lee to use the storyline and characters from his cartoon titled “Ragnarok” for the development of Ragnarok Online including for animation and character merchandising. We paid Mr. Lee an initial license fee of Won 40 million and are required to pay royalties based on a percentage of adjusted revenues (net of value-added taxes and certain other expenses) or net income generated from the use of the Ragnarok brand through January 2033.
 
Ragnarok Online is an action adventure-based MMORPG that combines cartoon-like characters, community-oriented themes and combat features in a virtual world within which thousands of players can interact with one another. By combining the highly interactive and community-oriented themes and features, such as marriages and organization of guilds, we believe we are able to create user loyalty from our users who favor games that provide social interaction in a virtual setting.
 
Other key features of Ragnarok Online include the following:
 
  •  players may assume an ongoing role, or alter-ego, of a particular game character, each with different strengths and weaknesses. In Ragnarok Online, the user starts as a “novice” and undergoes training in a specialized mapped game zone to become familiar with the game features. Once that stage is completed, the user can choose from six basic characters, each with a distinct combination of different traits;
 
  •  as each game character advances in challenge levels, the character can enter into a greater range of mapped game zones and develop into a more sophisticated game character in terms of game attributes and special powers;


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  •  Ragnarok Online characters may visually express the users’ mood and emotions by using emotive icons that appear within a bubble above the characters’ heads. We believe that this feature significantly expands the interface for user interaction and elevates the level of social reality of the game;
 
  •  game features may be traded or sold within the game, and game characters may simulate real-life experiences such as marriage, group fights and joining a guild. In addition, players may communicate with each other through in-game chatting or instant messaging;
 
  •  special events are held from time to time to stimulate community formations. For example, we periodically host “fortress raids” whereby players are encouraged to organize themselves into a team to compete against other teams to capture a fortress within a set time; and
 
  •  the game has no preordained ending and is designed to continuously evolve in terms of plots, mapped game zones and character attributes through enhancements from time to time.
 
We believe that the personal computer, or PC, configurations required to run Ragnarok Online are lower than or similar to many other competing MMORPGs, which we believe has facilitated our successful entry into and expansion of Ragnarok Online in many of the developed and developing countries in which Ragnarok Online is distributed. Also, we believe the community based features, such as marriages and organization of guilds, builds user loyalty from our users who favor games that provide social interaction in a virtual setting. We believe that our decision to balance three-dimensional graphics and game functions with prevailing technological standards with a combination of two-dimensional characters, which requires lower PC configurations than three-dimensional MMORPG has helped to increase the popularity of Ragnarok Online, in particular in certain jurisdictions which does not have access to the more technological updated PC technology as a result of cost and other limitations. The recommended minimum PC configuration for Ragnarok Online is Pentium III 1.6 GHz, 256 MB RAM and 32 MB graphics card. Ragnarok Online can be accessed through a dial-up modem as well as broadband Internet.
 
R.O.S.E. Online
 
R.O.S.E. Online, which was commercially launched in January 2005, represented 1.1% of our total revenues or Won 604 million (US$534 thousand) in 2009, compared with 1.4% of our total revenues or Won 766 million in 2008.
 
The following are revenues generated by R.O.S.E. Online for the periods indicated:
 
                                     
        Year Ended December 31,  
Revenue Type
 
Country
  2007     2008     2009     2009(1)  
        (In millions of Won and thousands of US$)  
 
Online game-subscription revenue
  United States/Canada/Mexico   W 505     W 444     W 604     US$ 534  
                                     
      Subtotal     505       444       604       534  
                                     
Online game-royalties and license fees
  Japan     1,058       27              
    Indonesia     72                    
    Philippines     125                    
    China           136              
    Vietnam           60              
    Taiwan           99              
                                     
      Subtotal     1,255       322              
                                     
         Total   W 1,760     W 766     W 604     US$ 534  
                                     
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
R.O.S.E. Online, a three-dimensional game, is the first online game developed by a third party that we published pursuant to an exclusive publishing license agreement. R.O.S.E. Online was developed by TriggerSoft


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Corporation, or TriggerSoft, in close coordination with our in-house game development team. In May 2005, we acquired control of TriggerSoft to enhance our ability to update and improve R.O.S.E. Online on a more effective and timely basis and gained ownership of R.O.S.E. Online after liquidation of TriggerSoft in 2007.
 
In the United States, Canada and Mexico, we have been offering commercial service of R.O.S.E. Online since 2005 and all rights for R.O.S.E. Online in such countries have been transferred to our wholly-owned subsidiary, Gravity Interactive in June 2007. In February 2010, we entered into a game transfer agreement with Gravity Interactive and transferred to it all the rights of R.O.S.E. Online in Switzerland, Norway, Denmark, Ireland, Spain, Sweden, the United Kingdom, Iceland, Finland, France, Germany, Greece, Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Hungary, Italy, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Albania, Andorra, Bosnia and Herzegovina, Liechtenstein, Moldova, Monaco, Montenegro, San Marino, Serbia, Vatican City State, Croatia, Former Yugoslav Republic of Macedonia and Turkey and Gravity Interactive has been offering commercial service of R.O.S.E. Online in these countries since then.
 
Requiem
 
Unlike Ragnarok Online, which does not emphasize violent themes, we designed Requiem to showcase user-to-user combat. Requiem provides players with a variety of combat systems, which allow them to accumulate experience and reward points to be used when they buy special items designed for combats.
 
We commercially launched Requiem in Korea in October 2007 and in the United States, Canada, Armenia, Azerbaijan, Belorussia, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine and Uzbekistan in June 2008. In December 2009, we entered into an amendment to the license and distribution agreement with Gravity Interactive, our licensee for Requiem in the United States and Canada, to include Switzerland, Norway, Denmark, Ireland, Spain, Sweden, the United Kingdom, Iceland, Finland, France, Germany, Greece, Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Hungary, Italy, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Albania, Andorra, Bosnia and Herzegovina, Liechtenstein, Moldova, Monaco, Montenegro, San Marino, Serbia, Vatican City State, Croatia, Former Yugoslav Republic of Macedonia and Turkey as countries serviced by Gravity Interactive, which was further amended in March 2010 to exclude Moldova, where Requiem is already commercially offered by our wholly-owned subsidiary, Gravity CIS. Requiem has been commercially offered in these countries since December 2009. We entered into global service agreements with AsiaSoft Corporation Public Co., Ltd. in December 2009 for markets in Thailand, Vietnam, Singapore and Malaysia, and with PT. Lyto Datarindo Fortuna in February 2010 for Indonesian market, pursuant to which we offer Requiem directly to the local markets to generate subscription revenues and pay service fees to AsiaSoft Corporation Public Co., Ltd. and PT. Lyto Datarindo Fortuna for services related to marketing and billing, among others. We commercially offered Requiem in Thailand, Vietnam, Singapore and Malaysia in March 2010 and Indonesia in April 2010. We also entered into a license and distribution agreement for Requiem in Taiwan, Hong Kong and Macau with Game Flier International Corporation in March 2010 and Requiem has been commercially offered in these markets since May 2010.
 
Requiem represented 4.9% of our total revenues or Won 2,838 million (US$2,509 thousand) in 2009, compared with 3.3% of our total revenues or Won 1,743 million in 2008.
 
The following are revenues generated by Requiem for the periods indicated:
 
                                     
        Year Ended December 31,  
Revenue Type   Country   2007     2008     2009     2009(1)  
        (In millions of Won and thousands of US$)  
 
Online game-subscription revenue
  Korea   W 644     W 964     W 559     US$ 494  
    United States/Canada(2)           470       1,387       1,226  
    Russia/CIS countries           309       892       789  
                                     
      Total   W 644     W 1,743     W 2,838     US$ 2,509  
                                     


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Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Includes subscription and other types of game revenues generated in other countries serviced by Gravity Interactive, Switzerland, Norway, Denmark, Ireland, Spain, Sweden, the United Kingdom, Iceland, Finland, France, Germany, Greece, Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Hungary, Italy, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Albania, Andorra, Bosnia and Herzegovina, Liechtenstein, Monaco, Montenegro, San Marino, Serbia, Vatican City State, Croatia, Former Yugoslav Republic of Macedonia and Turkey. Such revenues from other countries constitute a minor portion of the revenues recorded as subscription revenues from the United States and Canada.
 
Emil Chronicle Online
 
We commercially launched Emil Chronicle Online in Korea, Thailand, Hong Kong, Taiwan, Indonesia, Singapore and Malaysia in August 2007, September 2007, June 2008, August 2008, September 2009 and October 2009, respectively. Emil Chronicle Online is the first online game developed by GungHo Online Entertainment, Inc., the publisher of Ragnarok Online in Japan, which is our controlling and majority shareholder. Emil Chronicle Online is an animation style game based on the chronicles of three races: Emils, Titanians and Dominions, that offers various characters and avatars for players to enjoy. We entered into a software licensing agreement with GungHo in December 2005 for the right to publish and distribute Emil Chronicle Online worldwide, except for Japan. In November 2006, we entered into a license and distribution agreement with Infocomm Asia Holdings Pte. Ltd., or Infocomm Asia, to distribute Emil Chronicle Online in Singapore, Malaysia, Brunei, Thailand, the Philippines, Indonesia, Vietnam, Australia and New Zealand. In February 2007, we and Infocomm Asia granted the distribution rights of Emil Chronicle Online in Thailand to Onenet Co., Ltd. In July 2008, we amended the agreement with Infocomm Asia to cancel its rights to distribute Emil Chronicle Online in Singapore, Malaysia, Brunei, the Philippines, Indonesia, Vietnam, Australia and New Zealand. In December 2008, we entered into license and distribution agreements with Run Up Game Distribution and Development Sdn. Bhd. for distribution of Emil Chronicle Online in Singapore and Malaysia and in February 2009 with PT. Wave Wahana Wisesa for distribution in Indonesia. We entered into license and distribution agreements for Emil Chronicle Online in China with a wholly-owned subsidiary of The9 Limited in January 2007, which was terminated in January 2010. We entered into license and distribution agreements for Emil Chronicle Online in Taiwan and Hong Kong with GameCyber Technology Ltd. in August 2007. The amount of revenues from Emil Chronicle Online in 2009 represented 1.4% of our total revenues and that in 2008 represented 1.8% of our total revenues.
 
Ragnarok Online II
 
Ragnarok Online II is a sequel to Ragnarok Online and an MMORPG expected to have enhanced character and community features. Ragnarok Online II includes pastel-type graphics, advanced character customization and detailed monsters and non-player characters. Ragnarok Online II also adopts cartoonist Mr. Myoung-Jin Lee’s original drawings from his comic book Ragnarok and music from Kanno Yoko, a well-respected composer in the animation industry. We currently have 32 designers, 15 programmers and 13 game planners dedicated to the development of Ragnarok Online II. We have been conducting open beta testing of Ragnarok Online II since May 2007 and continue to upgrade and develop Ragnarok Online II in response to market feedback received during the testing and development phase. We have entered into license and distribution agreements for Ragnarok Online II with six licensees in ten countries, including Thailand, Japan, Taiwan, Philippines, Singapore, Malaysia, Vietnam, China, Indonesia and Brazil beginning from the end of 2006. While we currently expect to launch the game in the fourth quarter of 2010, no assurance can be given that we can meet this anticipated launch date or, if there is any further delay in the launch date, such delay would not result in termination of any of the existing license agreements for Ragnarok Online II. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS— If we are unable to consistently and timely develop, acquire, license, launch, market or operate commercially successful online games in addition to Ragnarok Online, our business, financial condition and results of operations may be materially and adversely affected.”


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Estar (tentative title)
 
In November 2009, we entered into a publishing agreement with Naru Entertainment Co., Ltd., an online game developer based in South Korea, to publish Estar game worldwide. Estar is expected to be an MMORPG targeting male game users from their teens through their thirties.
 
Canaan
 
In January 2010, we entered into a license agreement with Xpec Entertainment Inc., a Taiwanese game developer, to publish Canaan in Korea. Canaan is a web browser-based casual MMORPG, which is played on a web browser and which does not require any client-side software to be installed. Canaan is currently serviced in Taiwan, China, Hong Kong and Macau. While we currently expect to launch the game in the third quarter of 2010, no assurance can be given that we can meet this anticipated launch date.
 
Time N Tales
 
We commercially launched Time N Tales in July 2006 under a publishing agreement entered into with Ndoors Corp., a Korean online game developer, in November 2005. The amount of revenues from Time N Tales in 2009 and 2008 represented less than 1% of our total revenues in 2009 and 2008, respectively. We terminated our agreement with Ndoors Corp in January 2009 and stopped offering Time N Tales in March 2009.
 
Casual online games
 
Casual online games can fit in to any genre and have any type of game play. They are targeted at mass audience of casual online gamers and generally distinguished by simple rules and lack of commitment required in contrast to more complex and hardcore MMORPGs. Currently, we commercially offer one casual online game, Pucca Racing.
 
Pucca Racing
 
We commercially launched Pucca Racing in Korea and in Thailand in September 2007 and March 2008, respectively and ceased offering commercial service in Thailand in March 2010. Pucca Racing was co-developed by us and Vooz Co., Ltd., which originally designed the Pucca characters. We entered into license and distribution agreements for Pucca Racing in Thailand with Ini 3 Digital Co., Ltd. in January 2008, in Taiwan and Hong Kong with M-etel Co., Ltd. in October 2008, which were terminated in February 2010. The amount of revenues from Pucca Racing in 2009 and 2008 represented less than 1% of our total revenues in each of 2009 and 2008.
 
Mobile games
 
As compared to MMORPGs, mobile games, which are played using mobile phones and other mobile devices, have shorter game playtime and less complex user-game interaction. We believe that mobile games, due to such characteristics, provide less-experienced users with a means to become familiar with both game playing and the game culture without making a substantial commitment in time and resources. As a result, we believe that mobile games allow us to target a broader audience of users, help us to expand the online game culture beyond Internet cafés and users’ homes and act as an effective marketing tool to attract new users to our MMORPGs. We develop and distribute our mobile games through our subsidiary in Korea, NeoCyon, Inc.


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The following are revenues generated from our mobile business for the periods indicated:
 
                                         
    Year Ended December 31,  
Country   2007     2008     2009     2009(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
  W 3,673     W 4,573     W 4,931       62.6 %   US$ 4,360  
Japan
    390       2,309       2,951       37.4       2,608  
                                         
Total
  W 4,063     W 6,882     W 7,882       100.0 %   US$ 6,968  
                                         
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
Game-related products and services
 
Animation
 
Gravity Entertainment, our Japanese subsidiary, entered into an agreement with G&G Entertainment Inc. and three other Japanese media and entertainment companies for the production and distribution of 26 half-hour episode animation series based on the storyline and characters of Ragnarok Online. The series was produced by Gravity Entertainment and broadcast on television in nine countries from 2004 through 2007. The animation series of Ragnarok Online has been sold in DVD and VOD (video on demand) formats in North America since March 2006 and it has also been distributed in Europe. Our revenues from our animation business were negligible in 2009, and Won 255 million in 2008, which represented less than 1% of our total revenues in 2009 and 2008, respectively.
 
Game character merchandising
 
In order to optimize the commercial opportunities presented by the popularity of Ragnarok Online and its characters, we and our licensees have been marketing dolls, stationery and other character-based merchandise, as well as game manuals, monthly magazines and other publications, based on the game. We currently have arrangements with three Korean vendors and two overseas vendors in Japan and Brazil to license Ragnarok Online’s animation and game characters in Korea and 11 overseas countries. In Japan, we have been conducting game character merchandising by selling game packages, which package our online game software in DVD format for PC users, in connection with game distribution. We have also entered into arrangements to license Emil Chronicle Online, Requiem and Ragnarok Online II in Korea.
 
The total amount of license fees from our contracts with Korean vendors was approximately Won 119 million (US$105 thousand) in 2009, compared with Won 101 million in 2008, and the total amount of license fees from our contracts with overseas vendors was approximately Won 798 million (US$706 thousand) in 2009, compared with Won 992 million in 2008. We intend to expand our character marketing for our new games as they are launched.
 
The following are revenues generated from game character merchandising for the periods indicated:
 
                                         
    Year Ended December 31,  
Country   2007     2008     2009     2009(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
  W 377     W 101     W 119       13.0 %   US$ 105  
Japan
    470       975       798       87.0       706  
Taiwan/Hong Kong
          17                    
                                         
Total
  W 847     W 1,093     W 917       100.0 %   US$ 811  
                                         
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.


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Multiplatform and Internet protocol television games
 
In December 2006, we entered into a licensing agreement with GungHo Online Entertainment, Inc. to develop and distribute Ragnarok DS, a Nintendo DS version of Ragnarok Online. Ragnarok DS was released in Japan, Korea and the United States and Canada in December 2008, June 2009 and February 2010, respectively.
 
We are also expanding our business by providing our online games on internet protocol television, or IPTV. In September 2008, we entered into a licensing agreement with Iconix Entertainment Co., Ltd. to develop and publish an IPTV game based on Iconix’s 3D TV animation series “Pororo: The Little Penguin.” We commercially launched “Pororo Game,” an IPTV game in September 2009.
 
The amount of revenues from multiplatform device and Internet protocol television games in 2009 represented less than 1% of our total revenues in 2009.
 
OUR MARKETS
 
Japan, Korea, the United States and Canada, Taiwan and Hong Kong, and Russia and CIS countries were our biggest geographic markets in 2009 in terms of revenue. Each of these markets is serviced either by us or a distribution company. We directly manage game operations in Korea, and our wholly-owned subsidiaries, Gravity Interactive and Gravity CIS manage game operations in other countries including the United States and Canada, and Russia and CIS countries. For Ragnarok Online, GungHo Online Entertainment, Inc. is our licensee for Japan and Game Flier International Corporation is our licensee for Taiwan, Hong Kong and Macau. For Emil Chronicle Online, GameCyber Technology Ltd. is our licensee for Taiwan and Hong Kong.
 
The following table sets forth a summary of our consolidated statement of operations showing revenues by geographic area for the periods indicated and the percentage represented by such revenues for year ended December 31, 2009.
 
                                         
    Year Ended December 31,  
Countries   2007     2008     2009     2009(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Japan
  W 18,899     W 27,037     W 31,991       55.7 %   US$ 28,281  
Korea
    11,119       14,009       11,544       20.1       10,205  
United States/Canada(2)
    2,614       3,620       5,800       10.1       5,127  
Taiwan/Hong Kong(3)
    2,369       2,301       1,887       3.3       1,668  
Russia and CIS countries
    489       1,078       1,298       2.3       1,148  
Others
    4,739       5,125       4,883       8.5       4,317  
                                         
Total
  W 40,229     W 53,170     W 57,403       100.0 %   US$ 50,746  
                                         
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Revenues in the United States and Canada, as shown on this table, also include subscription and other types of game revenues generated in other countries managed by Gravity Interactive. Such revenues from other countries constitute a minor portion of the revenues recorded as subscription revenues from the United States and Canada. The license agreement for Ragnarok Online with Gravity Interactive was amended in January 2008 to include Australia and New Zealand as countries serviced by Gravity Interactive, and in September 2009 to include India as a country serviced by Gravity Interactive. The license agreement for Requiem with Gravity Interactive was amended in December 2009 to include the United Kingdom and 38 other European countries serviced by Gravity Interactive.
 
(3) The license agreement for Ragnarok Online with Game Flier International Corporation, which manages Ragnarok Online service in Taiwan and Hong Kong, was amended in October 2009 to include Macau as a service territory.


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Korea
 
In Korea, we commercially launched and began to charge subscribers for Ragnarok Online in August 2002, R.O.S.E. Online in January 2005, which service was terminated in April 2007, Love Forty and TV Boyz in June 2006, which services were terminated in September 2008, Time N Tales in July 2006, which service was terminated in March 2009, Emil Chronicle Online in August 2007, Pucca Racing in September 2007 and Requiem in October 2007. Our game subscribers in Korea consist of individual PC account subscribers and Internet café subscribers. Individual PC account subscribers are individuals who log on to our game servers from places other than Internet cafés, such as from home or work, whereas Internet café subscribers are commercial businesses operating Internet café outlets equipped with multiple PCs that provide broadband Internet access to their customers who typically prefer to play the most up-to-date versions of online games. Most Internet cafés charge their customers PC usage and Internet access fees that generally range from Won 700 to Won 1,200 per hour and subscribe to various online games. Over 5,600 and 6,400 Internet cafés offered our games in Korea according to our internal data as of December 31, 2009 and 2008, respectively. In order to offer our games, an Internet café typically purchases minimum game hours from us. The subscription collected from Internet cafés accounted for 13.6% and 14.6% of our subscription revenues in Korea in 2009 and 2008, respectively.
 
Overseas markets
 
Ragnarok Online is commercially offered in the following 58 overseas countries and markets: Japan, China, Taiwan, Hong Kong, Macau, United States, Canada, Australia, New Zealand, India, Singapore, Malaysia, Thailand, the Philippines, Indonesia, Germany, Austria, Switzerland, Italy, Turkey, Brazil, France, Belgium, Vietnam, Armenia, Azerbaijan, Belorussia, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, Uzbekistan, United Arab Emirates, Jordan, Kuwait, Syria, Bahrain, Qatar, Palestine, Oman, Lebanon, Libya, Sudan, Mauritania, Iraq, Yemen, Iran, Egypt, Algeria, Morocco and Tunisia. Ragnarok Online is distributed through local game operators and distributors, except for the countries in which our subsidiaries directly publish Ragnarok Online such as Gravity Interactive in the United States, Canada, Australia, New Zealand and India; Gravity CIS in Russia and CIS countries; and Gravity EU in France and Belgium. In June 2008, we amended our license and distribution agreement with Gravity EU to include the United Kingdom, Finland, Sweden, Norway, Ireland, Scotland, Denmark and Spain as service territories and currently plan to conduct closed beta testing of Ragnarok Online in these countries.
 
The following table lists the overseas countries in which Ragnarok Online is commercially offered through our licensees, the names of the licensees, the dates of the license agreements, and the commercial launch date and expiry date of the license agreements.
 
                 
        Date of
  Date of
   
        License
  Commercial
   
Country   Licensee   Agreement   Launch   Date of Expiry
 
Japan
  GungHo Online Entertainment, Inc.   July 2002   December 2002   September 2012(1)
Taiwan/Hong Kong/Macau(2)
  Game Flier International Corporation(3)   May 2002   October 2002   October 2011(4)
Thailand
  AsiaSoft Corporation Public Co., Ltd.   June 2002   March 2003   March 2012(5)
China
  Shengqu Information Technology (Shanghai) Co., Ltd.(6)   July 2005   May 2003   August 2010
Singapore/Malaysia(7)
  Game Flier (Malaysis) Sdn. Bhd.(8)   May 2003   April 2004   October 2011(9)
Philippines
  Level Up! Inc.   March 2003   September 2003   August 2010
Indonesia
  PT. Lyto Datarindo Fortuna(10)   April 2004   November 2003   February 2012(11)
Europe(12)
  Burda:ic GmbH   November 2003   April 2004   October 2010(13)
Brazil
  Level Up! Interactive S.A.   August 2004   February 2005   March 2011(14)
Vietnam
  AsiaSoft Corporation Public Co., Ltd.   July 2008   April 2007   December 2010
Middle East and Africa(15)
  Tahadi Games Ltd.   January 2009   December 2009   December 2012
 
 
Notes:
 
(1) Renewed in September 2009.


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(2) Governed under a single license agreement covering three markets. Macau was included in the most recent agreement.
 
(3) Game Flier International Corporation is a wholly-owned subsidiary of Soft-World International Corporation, former licensee in Taiwan and Hong Kong.
 
(4) Renewed in October 2009.
 
(5) Renewed in March 2010.
 
(6) Shengqu is a wholly-owned subsidiary of Shanda Interactive Entertainment Ltd.
 
(7) Governed under a single license agreement covering both markets.
 
(8) Game Flier (Malaysis) Sdn. Bhd. is a wholly-owned subsidiary of Soft-World International Corporation.
 
(9) Renewed in October 2009.
 
(10) Previously with a different licensee.
 
(11) Renewed in February 2010.
 
(12) Represents MMORPG operations in Germany, Austria, Switzerland, Italy and Turkey. A single operator services these five countries under one license agreement.
 
(13) Renewed in April 2010.
 
(14) Renewed in March 2009.
 
(15) Represents MMORPG operations in United Arab Emirates, Saudi Arabia, Jordan, Kuwait, Syria, Bahrain, Qatar, Palestine, Oman, Lebanon, Libya, Sudan, Mauritania, Iraq, Yemen, Iran, Egypt, Algeria, Morocco and Tunisia. A single operator services in 19 countries except Saudi Arabia under one license agreement. Although Saudi Arabia is included as service territory in the license agreement with Tahadi Games Ltd., Ragnarok Online is not commercially offered in Saudi Arabia. We are currently in the process of conducting open beta testing of the game and intend to offer commercial service of the game in Saudi Arabia in the near future.
 
R.O.S.E. Online is currently commercially offered in the United States, Canada, Mexico and 40 other countries. Emil Chronicle Online is currently commercially offered in Thailand, Hong Kong, Taiwan, Indonesia, Singapore and Malaysia. Requiem is commercially offered in the United States, Canada and 62 other countries. See ITEM 4.B. “BUSINESS OVERVIEW — OUR PRODUCTS.”
 
Our licensees pay us:
 
  •  an initial license fee for initial set-up costs, technical support and advisory services that we provide until commercial launch; and
 
  •  ongoing royalty payments based on a percentage of revenues generated from subscription of the game they service in the respective overseas markets.
 
In addition, if the license agreement is renewed, we typically negotiate a renewal license fee. The license agreements may be terminated in the event of bankruptcy or a material breach by either party, including by us if the licensee fails to pay royalty fees in a timely manner.
 
PRICING STRUCTURE AND PAYMENT SYSTEM
 
Our overseas licensees generally develop, after consultation with us, a retail pricing structure for the users of the game they service in their respective markets. Pricing structures are determined primarily based on the cost of publishing and operating the game, the playing and payment patterns of the users, the pricing of competing games in a given market and the purchase power parity of consumers in that market. Since the launch of Ragnarok Online in August 2002, we have tracked and accumulated user data generated from our user base, which provide us with an extensive database to analyze user patterns and establish pricing for other markets. The pricing for Ragnarok Online has remained generally stable in each of our markets since the respective dates of Ragnarok Online’s commercial launch in those markets.
 
In December 2006, we started to apply a micro-transaction system (or sale of virtual in-game items model) as an additional business model, by providing virtual item shops in the games where players can purchase a wide array


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of items to customize, personalize and enhance their characters and game playing experiences. The micro-transaction model has been introduced in all the countries and markets where Ragnarok Online is serviced. In addition, since January 2007, we have opened free-to-play servers, which only applies the micro-transaction model, in all the countries and markets where Ragnarok Online is serviced except Japan, France, Belgium, Germany, Austria, Switzerland, Italy and Turkey to encourage the players to download and play Ragnarok Online without paying subscription fees or buying playing time and to purchase in-game items pursuant to our micro-transaction model. In Russia and CIS countries, Vietnam, United Arab Emirates, Jordan, Kuwait, Syria, Bahrain, Qatar, Palestine, Oman, Lebanon, Libya, Sudan, Mauritania, Iraq, Yemen, Iran, Egypt, Algeria, Morocco and Tunisia, we offer our game services with the micro-transaction model only. We also intend to extend free-to-play servers into other markets. The amount of revenue generated from micro-transactions as a percentage of revenue per month from each country varies monthly. For example, in 2009, the approximate percentage of revenue derived from micro-transactions accounted for 25.8% of total royalty revenues for Japan, 68.1% of total revenues for the United States and Canada, 69.7% of total royalty revenues for Taiwan, Hong Kong and Macau, 76.8% of total royalty revenues for Thailand, 65.8% of total revenues for Russia and CIS countries and 58.8% of total revenues for Korea. The pricing for Ragnarok Online in Korea and our principal overseas markets, Japan, the United States and Canada, Taiwan, Hong Kong and Macau, Thailand and China are set forth below:
 
Korea
 
Individual PC subscribers in Korea can choose from a number of alternative payment options, including charges made through mobile or fixed telephone service provider payment systems, prepaid cards, gift certificates, online credit card payments and bank transfers. We pay a commission in the range of 1.8% to 15% to third parties to process payments. These third parties bear the delinquency risk associated with payments from subscribers.
 
Subscription-based fee model
 
We determine the pricing plan for Ragnarok Online in Korea. We offer separate pricing plans to Internet cafés and individual PC account subscribers. Our subscribers have an option to pay an hourly fee or a flat monthly fee. The following table sets forth our published pricing plans in Korea for Ragnarok Online access as of December 31, 2009.
 
                 
    Subscription Fees
 
Individual PC users
               
Flat-fee rate
    1 month     W 19,800  
      2 months       37,600  
      3 months       53,500  
      6 months       101,000  
Hourly-fee rate
    5 hours       3,300  
      20 hours       8,800  
 
                 
    Number of PCs   Flat Fee per PC
 
Internet cafés(1)
               
Hourly-fee rate
    300 hours     W 69,300  
      600 hours       138,600  
      1,000 hours       231,000  
      2,000 hours       462,000  
 
 
Note:
 
(1) Actual monthly and hourly-rate fees may vary depending on discounts we offer based on volume of use by the subscriber.
 
Approximately 86.4% of our revenues from Ragnarok Online in Korea in 2009 were derived from subscriptions by individual PC users and the remaining 13.6% was derived from Internet cafés.


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Micro-transaction model
 
We have applied a micro-transaction model in Korea since April 2007. Game users buy RO Cash, the currency of the money used in Ragnarok Online which enable them to buy game items. The price range of each of the game items is between Won 200 and 9,800 for paid servers and between Won 250 and 14,700 for free-to-play servers.
 
Japan
 
Users in Japan typically pay for access to Ragnarok Online with credit cards or cyber money, which is increasingly becoming a popular payment method in Japan.
 
Subscription-based fee model
 
Our licensee in Japan, GungHo offers only one rate for Ragnarok Online and charges JPY1,500 per 30 days of unlimited use.
 
Micro-transaction model
 
We have applied a micro-transaction model in Japan since December 2006. Game users buy points which enable them to buy game items. The range of the game items is between JPY50 and 1,500(1).
 
         
Points     
  Retail Price(1)
 
10,000 points
    JPY 1,000  
21,000 points
    2,000  
32,500 points
    3,000  
55,000 points
    5,000  
112,000 points
    10,000  
 
 
Note:
 
(1) For your reference only, as of March 31, 2010, the noon buying rate of Japanese Yens to U.S. dollars quoted by the Federal Reserve Bank of New York was JPY93.4 to US$1.00.
 
The United States and Canada
 
Gravity Interactive, our wholly-owned subsidiary in the United States, permits users to access Ragnarok Online using credit cards, money orders, wire and/or bank transfers and Gravity Game Card, a prepaid card.
 
Subscription-based fee model
 
The following table sets forth Gravity Interactive’s published basic pricing for Ragnarok Online access in the United States and Canada as of December 31, 2009:
 
         
Hours or Month
  Retail Price
 
30 hours
  US$ 7.99  
1 month
    9.99  
3 months
    26.99  
6 months
    47.99  
 
The following table sets forth Gravity Interactive’s published basic pricing for the Gravity Game Card.
 
         
Subscription Plan
  Retail Price
 
14 Day Plan
  US$ 5 Gravity Game Card  
45 Day Plan
  US$ 15 Gravity Game Card  
90 Day Plan
  US$ 30 Gravity Game Card  


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Micro-transaction model
 
We have applied a micro-transaction model in the United States and Canada since June 2007. Game users buy points which enable them to buy game items through credit cards and wire and/or bank transfers. The range of the game items is between US$0.15 and 15 for paid servers and between US$0.2 and 19 for free-to-play servers. The following table sets forth our licensee’s published basic pricing for points of Ragnarok Online in the United States and Canada as of December 31, 2009.
 
         
Points    
  Retail Price
 
500 points
  US$ 4.99  
1,050 points
    9.99  
1,650 points
    14.99  
2,300 points
    19.99  
5,200 points
    39.99  
10,400 points
    74.99  
 
In addition, the following table sets forth Gravity Interactive’s published basic pricing for the Gravity Game Card to be used only for buying points for users of a micro-transaction model.
 
         
Points    
  Retail Price
 
525 points
  US$ 5 Gravity Game Card  
1,650 points
  US$ 15 Gravity Game Card  
3,900 points
  US$ 30 Gravity Game Card  
 
Taiwan, Hong Kong and Macau
 
In Taiwan, Hong Kong and Macau, most users purchase prepaid debit point cards to access Ragnarok Online. The prepaid cards can be purchased online, by mobile phones or at convenience stores, Internet cafés and at other locations. Taiwan has Web sites dedicated to selling prepaid cards for various uses, including online game payments, which is also used by users in Hong Kong to change their prepaid cards and to buy points.
 
Subscription-based fee model
 
Our licensee in Taiwan, Hong Kong and Macau, Game Flier International Corporation, generally does not offer a separate subscription plan for Internet café outlets. Our licensee in Taiwan, Hong Kong and Macau currently offers approximately 200 different rates for Ragnarok Online.
 
The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in Taiwan as of December 31, 2009:
 
         
Points(1) or Days
  Retail Price(2)
 
150 points
  NT$ 150  
350 points
    350  
400 points
    400  
450 points
    450  
500 points
    500  
1,000 points
    1,000  
30 days
    350  


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The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in Hong Kong as of December 31, 2009:
 
         
Points(1)
  Retail Price(3)
 
50 points
  HK$ 12  
150 points
    39  
350 points
    88  
400 points
    98  
450 points
    113  
1,000 points
    250  
 
 
Notes:
 
(1) Each time a user logs onto Ragnarok Online, 20 points are deducted. After a user’s playtime exceeds 12 hours, additional 20 points are deducted for every 12 hours of use.
 
(2) For your reference only, as of March 31, 2010, the noon buying rate of NT dollars to U.S. dollars quoted by the Federal Reserve Bank of New York was NT$31.73 to US$1.00.
 
(3) For your reference only, as of March 31, 2010, the noon buying rate of Hong Kong dollars (HK$) to U.S. dollars quoted by the Federal Reserve Bank of New York was HK$7.7647 to US$1.00.
 
Micro-transaction model
 
We have applied a micro-transaction model in Taiwan and Hong Kong since December 2006. Game users buy points which enable them to buy game items. The price range of each of the game items is between NT$1 and 899 for paid servers and between NT$1 and 999 for free-to-play servers. Users in Hong Kong and Macau also buy points based on NT dollars.
 
Thailand
 
Our licensee in Thailand, Asiasoft Corporation Public Co., Ltd., permits users to access Ragnarok Online through prepaid cards or by mobile and electronic payment. Most of the users use prepaid cards to access Ragnarok Online. Each prepaid card has a specified maximum number of hours or days of use. Users can purchase prepaid cards from automated teller machines, Internet cafés or convenience stores.
 
Subscription-based fee model
 
The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in Thailand as of December 31, 2009:
 
                 
Hours or Days
  Points   Retail Price(1)
 
5 hours
    2,800       THB 28  
10 hours
    5,500       55  
20 hours
    8,900       89  
40 hours
    15,900       159  
15 days
    18,900       189  
20 days
    24,500       245  
No limit within 30 days
    34,900       349  
40 days
    45,000       450  
No limit within 90 days
    88,800       888  
 
 
Note:
 
(1) For your reference only, as of March 31, 2010, the noon buying rate of the Thai Bahts to U.S. dollars quoted by the Federal Reserve Bank of New York was THB32.36 to US$1.00.


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Micro-transaction model
 
We have applied a micro-transaction model in Thailand since February 2007. Game users buy points which enable them to buy game items. The price range of each of the game items is between THB 0.01 and 600.
 
China
 
In China, Ragnarok Online can be accessed through prepaid cards. The prepaid card system was introduced to take account of the limited availability of online and credit card payment systems in China. A majority of Ragnarok Online players purchase prepaid debit point cards at Internet cafés or retail game outlets or purchase prepaid online credits by directly paying at Internet cafés, which in turn purchase online credits from our China licensee, Shengqu Information Technology (Shanghai) Co., Ltd., a wholly-owned subsidiary of Shanda Interactive Entertainment Limited. Game users can choose between buying hours or days to play since each prepaid card contains a network access password to access Ragnarok Online from a PC at home or at an Internet café and to buy points which enable them to buy game items. Our licensee in China currently offers two different cards: (i) the Shanda Point Card, of which points and hours or days can be used for any game that our licensee publishes and (ii) the Ragnarok Point Card, of which points and hours or days are for Ragnarok Online only. Each prepaid card can be recharged through the licensee’s Web site.
 
The following table sets forth our licensee’s published basic pricing for the Shanda Point Card in China as of December 31, 2009:
 
                 
Points           
  Hours or Day   Retail Price(1)
 
150 points
    25 hours       CNY 10  
450 points
    75 hours       30  
No limit within 30 days
    30 days       45  
 
The following table sets forth our licensee’s published basic pricing for the Ragnarok Point Card as of December 31, 2009.
 
                 
Points           
  Hours or Day   Retail Price(1)
 
60 points
    10 hours       CNY 5  
150 points
    25 hours       10  
No limit within 7 days
    7 days       15  
450 points
    75 hours       30  
No limit within 30 days
    30 days       45  
 
In addition, the following table sets forth our licensee’s published basic pricing for the Ragnarok Point Card to be used only for buying points for users of a subscription-based fee model as of December 31, 2009.
 
         
Points           
  Retail Price(1)
 
500 points
    CNY 5  
1,000 points
    10  
3,500 points
    35  
4,500 points
    45  
10,000 points
    100  
30,000 points
    300  
50,000 points
    500  
100,000 points
    1,000  
 
 
Note:
 
(1) For your reference only, as of March 31, 2010, the noon buying rate of Chinese Yuan to U.S. dollars quoted by the Federal Reserve Bank of New York was CNY6.8258 to US$1.00.


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Subscription-based fee model
 
Ragnarok Online access prices were set significantly lower in China than in Korea to take into account the prevailing pricing structure of other online games in the Chinese market as well as relatively low consumer spending levels.
 
Micro-transaction model
 
We have applied a micro-transaction model in China since January 2007. Game users buy points which enable them to buy game items. The price range of each of the game items is between CNY 1 and 588 for paid servers and between CNY1 and 888 for free-to-play servers.
 
GAME DEVELOPMENT AND PUBLISHING
 
We expect the online game industry to be characterized by increasing demand for sophisticated or original games with the most up-to-date technologies and/or innovative game design. In response, we intend to expand our game offerings by continuing to develop in-house additional high quality games with the latest technologies and/or innovative game design and by publishing such new games developed by us or licensed or acquired from renowned third party developers.
 
To prepare for the commercial launch of a new game, we conduct “closed beta testing” for the game to fix technical problems, which is followed by a period of “open beta testing” in which we allow registered users to play the game free of charge. During these testing periods, users provide us with feedback and our technical team seeks to address any technical problems and programming flaws that may compromise a stable and consistent game playing environment. Closed beta testing usually takes three to six months for MMORPGs but may take significantly more time if material problems are detected. Open beta testing of MMORPGs usually takes three to six months before commercial launch. We generally commence our other marketing activities for the game during the open beta testing stage. For overseas markets, we also localize the language and content of our games to tailor the game to local cultural preferences.
 
In-house game development
 
Our game development department is divided into two categories of development teams: one is dedicated to MMORPGs and the other is dedicated to casual online games in operation or under development. As of March 31, 2010, we employed a total of 231 game developers. We developed Ragnarok Online, Requiem and Pucca Racing in-house. In order to remain competitive, we are focusing our in-house game development efforts on enhancing the game experience and on developing new games, which include MMORPGs incorporating the latest technologies (including software improving the communication and interaction between players), and casual online games which are becoming popular among younger users and female users. We currently have one MMORPG, Ragnarok Online II, under in-house development. Ice Age Online, a massively multiplayer online game, was under development until the end of 2009 when we stopped developing the game as there were disagreements over the general concept of the game between the trademark licensor, 20th Century FOX Licensing & Merchandizing, and the Company and we received a written notice of termination of license agreement in November 2009.
 
Publishing
 
We also seek opportunities to publish games developed by third parties if we determine such games have potential to become a commercial success. Our publishing and licensing processes include the following:
 
  •  Preliminary screening.  Our preliminary screening process for a game usually includes preliminary review and testing of the game and discussions with the game developer on technological and operational aspects.
 
  •  In-depth examination, analysis and commercial negotiation.  Once a game passes the preliminary screening, we thoroughly review and test the game, conduct a cost analysis, develop operational and financial projections and formulate a preliminary game operating plan. We then begin commercial negotiations with the developer.


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  •  Game rating and regulatory registration and approval.  Once a license agreement to publish and distribute a game is signed, we submit an application to the Game Rating Board to obtain a game rating. This process generally takes approximately 15 days. We also typically register our intellectual property rights in Korea under our license agreements, such as copyright and trademark, with the relevant Korean government agency. Our overseas subsidiaries or licensees follow similar procedures in their respective markets where the games we license are commercially offered.
 
  •  Testing and marketing.  Once the required registration and approvals are obtained, we conduct closed beta testing and open beta testing of the new game and assist the licensor with the development of the game.
 
Our business group within the strategy office takes lead in conducting preliminary screenings to select games for potential distribution and commercial negotiations process. The games initially screened by our publishing team are additionally evaluated or tested by other teams, such as the development team and quality management team, for a second opinion. Once a license agreement is finalized, we generally create a specific team for the selected game within the marketing department to work with and guide the licensor through the beta testing and marketing process for a successful launch of the game.
 
MARKETING
 
We employ a variety of traditional and online marketing programs and promotional activities, including in-game events, in-game marketing and offline events. Due to the close-knit nature of the online game community, we believe that word-of-mouth is an important medium for the promotion of our games.
 
In Korea, five independent promotional agents currently promote our online games to Internet cafés pursuant to agency agreements. Under these agreements, each promotional agent is granted non-exclusive promotion rights within a specified geographical area. The agent is generally paid a monthly base commission between 10% and 30% of revenues received from Internet cafés in the allocated area. The commission percentage varies according to the amount of revenues.
 
We conduct a variety of marketing programs and online and offline events to target potential subscribers accessing the Internet from home. Our main marketing efforts include advertising on Web site portals and in online game magazines, conducting online promotional events, participating in trade shows and entering into promotional alliances with Internet service providers. We spent Won 1,137 million (US$1,005 thousand) on advertising and promotions in 2009, compared with Won 1,483 million in 2008.
 
We frequently organize in-game events, such as “fortress raids” for our users, which we believe encourages the development of virtual communities among our users and increases user interest in our games. We also host from time to time in-game tournaments in which users can compete against each other either as a team or individually. In addition, we use in-game events to introduce users to new features of our games. We organized 17 in-game events for Ragnarok Online users in 2009, compared with 20 such in-game events in 2008. In November 2009, we hosted in Yokohama, Japan, with GungHo Online Entertainment, Inc., our licensee in Japan, the Ragnarok World Championship, an offline competition event at which approximately 98 people, comprised of our game users and representatives from 14 teams representing 38 countries and approximately 60 representatives of our 13 licensees, participated in person. The event was visited by approximately 15,000 visitors. The event included Ragnarok Game Marketing Forum, where we and our licensees shared development plans, marketing strategies and success cases, and numerous programs for users.
 
In most of our overseas markets, marketing activities are principally conducted by our overseas subsidiaries or licensees and typically consist of advertising on Web site game portals and online game magazines and through television commercials, as well as hosting online and offline promotional events. The licensees are responsible for the costs associated with such advertising and promotional activities. For example, GungHo Online Entertainment, Inc., our licensee in Japan, hosts User Symposium annually since 2004, where the invited users of Ragnarok Online share information with the publisher. GungHo also hosts Ragnarok Thank-You Festival, which includes Ragnarok Online Japan Championship, game conference and costume-play stage and other programs for users. Ragnarok Thank-You Festival has been an annual event since 2005 and its 2009 event was attended by approximately 6,000 visitors. Level Up! Inc., our licensee in the Philippines, and PT. Lyto Datarindo Fortuna, our licensee in Indonesia,


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among others, also host similar marketing events, namely, Level Up! Live and Lyto Festival, respectively. AsiaSoft Corporation Public Co., Ltd., our licensee in Thailand, also hosts offline event annually to celebrate anniversaries of Ragnarok Online game service in Thailand since 2004, which includes Ragnarok Online Thailand Championship and other promotional events. In addition, from time to time our licensees also market our games through sponsoring promotional events jointly with other local game publishers in order to reach a broader local audience.
 
Our licensees are selected in part on the basis of their marketing capabilities, including the size and scope of their distribution networks. In regions where we have a limited network or presence such as the Middle East and Central Asia, we believe that conducting marketing through our licensees is more effective and cost-efficient than direct marketing by us in light of the established brand recognition and marketing networks of our licensees and their comparative advantage in identifying and taking advantage of the cultural and other local preferences of overseas users. However, in more strategic markets where we anticipate considerable growth such as the United States, we also believe that it is important to enhance our own direct publishing network for online game services.
 
GAME SUPPORT AND CUSTOMER SERVICE
 
We are committed to providing superior customer service to our users directly and through our licensees. As of December 31, 2009, 18 employees were game masters, or persons who are in charge of testing, updating and providing server maintenance for online games, as well as dealing with customer complaints, 34 employees were members of our domestic customer service team and 51 employees were members of our overseas customer support team. With the diversification of our game offering and in order to better serve our users, we expect to continue to expand the size of our customer service team.
 
In Korea, we provide customer service for our online games through bulletin boards of the Web sites of our online games, call centers, email and facsimile and at our walk-in customer service center. Our bulletin boards of the Web sites of our online games allow our customers to post questions to, and receive responses from, other users and our support staff. In our overseas markets, our licensees administer customer service through varying combinations of bulletin boards of the Web sites of our online games, call centers, email and facsimile, with assistance from time to time from our overseas customer support staff.
 
In addition to providing customer service to our users, our customer service staff also collect user comments with respect to our games and generate daily and weekly reports for our management and operations that summarize important issues raised by users as well as how such issues have been addressed.
 
NETWORK AND TECHNOLOGY INFRASTRUCTURE
 
We have designed and assembled a game server network and information management system in Korea to allow centralized game management on a global basis. Our system network is designed to speedily accommodate a growing subscriber base and demand for faster game performance. Our game server architecture runs multiple servers on a parallel basis to readily accommodate increased user traffic through deployment of connection to servers, which permits us to route users in the same country to servers with less user traffic. Each of these servers is linked to our information systems network to ensure rapid implementation of game upgrades and to facilitate game monitoring and supervision.
 
We maintain our server hardware in a single climate-controlled facility at KT Mokdong Internet Computing Center in Mok-1Dong, Yangcheon-Gu, Seoul, Korea and our other system hardware in our offices in Seoul. As of March 31, 2010, our server network for our game operations in Korea and global service of Requiem (in Thailand, Vietnam, Singapore, Malaysia and Indonesia) consisted of a total of 677 servers.
 
In overseas markets, our overseas subsidiaries or licensees own or lease the servers necessary to establish the server network for the online games and we assist them with initial assembly and installation of operating game servers and optimizing their systems network for game operations in their respective markets. While the overseas system architectures are modeled on our system architecture in Korea, they are also tailored to meet the specific needs of each market. When we install and initialize a game in an overseas market, we generally dispatch network engineers and database technicians from Korea to assist with assembly and operation of the system network and game servers. Following installation, we typically station two to five of our technicians and customer support staff


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in that market to assist with on-site game operation and technical support. Our overseas subsidiaries and licensees are responsible for providing database and other game information backup.
 
Our game management software can program the game content to include localized features such as virtual map zones specific to each market. These features can be updated at the host country level in order to encourage development of a communal spirit among the users from the same country.
 
COMPETITION
 
We compete primarily with other MMORPG developers and distributors in each of our markets. In addition, we compete against providers of games on various platforms, such as console games, handheld games, arcade games and mobile games. We compete primarily on the basis of the quality of the online game experience offered by us to our users, which depends on a number of factors, including our ability to do the following:
 
  •  hire and retain creative personnel to develop games that appeal to our users;
 
  •  maintain an online game platform that is stable and is not prone to server shutdowns, connection problems or other technical difficulties;
 
  •  provide timely and responsive customer service; and
 
  •  establish payment systems that are secure and efficient.
 
Competition in Korea
 
The online game market in Korea is comprised of massively multiplayer online game market, casual online game market and portal-based online game market. As many of our competitors have significantly greater financial, marketing and game development resources than we have, we face intense competition in the online game industry. We expect competition will continue to be strong as the number of domestic massively multiplayer online game developers in Korea increases in the future and the online game industry begins to consolidate into a small number of leading MMORPG companies due to the high cost of game development, marketing and distribution networks, which is likely to drive unsuccessful MMORPG providers to go out of business or be acquired by other successful game providers.
 
Currently, the leading providers of massively multiplayer online games in Korea, based on the number of peak concurrent users, are NCsoft Corporation, or NCsoft, CJ Internet Corporation, or CJ Internet, Neowiz Games and Activision Blizzard according to data available from various public sources. NCsoft released Aion in November 2008, which became the most popular MMORPG in Korea as of March 31, 2010, based on statistical information from the Korea Creative Content Agency. NCsoft’s Lineage, which was released in 1998, and Lineage II, a sequel to the original Lineage in 2003, gained dominant popularity and have maintained both a large number of players and a loyal user base in Korea. CJ Internet commercially launched Sudden Attack in 2006, which is the most popular massively multiplayer online first person shooter game in Korea. Neowiz Games released Special Force, a massively multiplayer online first person shooter game, in 2004 and FIFA Online 2, a soccer game which was co-developed with Electronic Arts in 2007. Neowiz Games has also been developing additional online games with Electronic Arts, its second largest shareholder, who owns approximately 11.5 percent of its common shares. The leading companies in the market for casual online games include Nexon, which is developed for Maple Story and Kart Rider, and YD Online, publisher of the dance game, Audition. The leading providers of portal-based online games in Korea are NHN Corporation, operating under the brand portal of Hangame, CJ Internet, operating under the brand portal of NetMarble, and Neowiz Games, operating under the brand portal of Pmang.
 
Competition in overseas markets
 
In each of the overseas markets in which Ragnarok Online is distributed, we face strong competitive pressures. For example, Japan’s large game market is primarily driven by console games although online games are gaining popularity among Japanese game users. Consequently, many Japanese console game developers, such as Square Enix Holdings Co., Ltd., or Square Enix, Capcom Entertainment, Inc., or Capcom, and Koei Tecmo Holdings Co., Ltd., or Koei Tecmo, have expanded their businesses to online game development with their well-known brands and


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advanced overall game development systems, which have resulted in more intense competition in the Japanese online game market. For example, Square Enix developed and released Final Fantasy XI, an online game, as part of its Final Fantasy series and Capcom developed and released Monster Hunter Frontier Online, an action online game based on its best-selling package game Monster Hunter Frontier, in June 2007. Koei also developed and released online games based on its best-selling package games such as Nobunaga’s Ambition Online, Uncharted Waters Online, Dynasty Warriors Online and Sangokushi Online. Taiwan’s online game industry has demonstrated significant growth in recent years with the market dominated by games developed in China and Korea. Our principal competitors in Taiwan include Activision Blizzard, NCsoft and Nexon Corporation. Thailand is also a fast growing online game market in Asia, where we believe that Ragnarok Online is the dominant online game based on the number of peak concurrent users, as reported by local game magazines and our licensee’s reports. There are many online game developers and distributors in China such as Tencent, Inc., which publishes Dungeon Fighter Online and Cross Fire, and Shanda Interactive Entertainment, whose principal product is Mir II.
 
Competition from other game platforms
 
We also compete against PC- and console-based game developers that produce popular package games, such as Electronic Arts, Nintendo, Activision Blizzard and Sony Computer Entertainment, and game console manufacturers such as Microsoft, Sony Computer Entertainment and Nintendo, all of which also have their own console game development studios. In May 2002, Sony Computer Entertainment started distributing its PlayStation 2 game consoles equipped with a network adapter to enable online gaming and in November 2002, Microsoft started an online game service for its Xbox Live consoles. Microsoft launched an enhanced version of its console platform in November 2005 with the Xbox360 and the latest version of Xbox Live offers more games that are aimed at the casual player and foster cooperation. Sony Computer Entertainment launched an enhanced version of its console platform in November 2006 with the PlayStation 3, which provide services for online games. Nintendo launched its Wii console platform in November 2006, which access the Internet and lets users compete online against others. A number of PC-based game developers are also introducing online features to their PC-packaged games, such as team plays or users-to-users combat features. Moreover, handheld game consoles are also popular among game users. In November 2004, Nintendo launched Nintendo DS and has made modest changes, adding bigger screens or a slimmer model, to the DS. Sony Computer Entertainment’s PSP Go was released in October 2009 that allows user to play games downloaded from Sony’s online marketplace.
 
In addition, games for Apple’s iPhone and iPod Touch are surging in popularity and competing with portable devices made solely for playing games. The Apple device users can access a number of videogames available for download at its App Store.
 
Competition in the online game market is expected to remain intense as established game companies with significant financial resources seek to enter the industry. For a discussion of risks relating to competition, See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS — We operate in a highly competitive industry and compete against many large companies.”
 
INSURANCE
 
We maintain medical and accident insurance for our employees to the extent required under Korean law, and we also maintain fire and general commercial insurance with respect to our facilities. We do not have any business liability or disruption insurance coverage for our operations in Korea. We maintain a directors’ and officers’ liability insurance policy covering certain potential liabilities of our directors and officers. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS — We have limited business insurance coverage and any business interruption could have a material adverse effect on our business.”
 
INTELLECTUAL PROPERTY
 
Our intellectual property is an essential element of our business. We rely on intellectual property such as copyrights, trademarks and trade secrets, as well as non-competition, confidentiality and license agreements with our employees, suppliers, licensees, business partners and others to protect our intellectual property rights. Our employees are generally required to sign agreements acknowledging that all inventions, trade secrets, works of


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authorship, developments and other processes generated by them on our behalf are our property, and assigning to us any ownership rights that they may claim in those works. With respect to copyrights and computer program rights created by our employees within their employment scope and which are made public bearing our name, we are not required to pay any additional compensation to our employees.
 
In developing Ragnarok Online, we obtained an exclusive license from Mr. Myoung-Jin Lee to use the storyline and characters from his cartoon titled Ragnarok for the production of online games, animation and character merchandising. See ITEM 4.B. “BUSINESS OVERVIEW — OUR PRODUCTS — Massively multiplayer online role playing games (MMORPGs) — Ragnarok Online.”
 
We are the registered owner of eight registered software copyrights to seven games: Ragnarok Online, Ragnarok Online II, R.O.S.E. Online, Pucca Racing, Requiem, W Baseball and Arcturus, each of which has been registered with the Korea Software Copyright Committee. We no longer commercially offer Arcturus, a PC-based, stand-alone game and have decided to cease commercialization of W Baseball. As of March 31, 2010, we owned over 66 registered domain names, including our official Web site and domain names registered in connection with each of the games we offer. We had 92 registered discrete trademarks at patent and trademark offices in 47 countries as of March 31, 2010. We had three design patents and two analogous design patents, which are variations of the two design patents, registered with the Korea Intellectual Property Office, and registered copyrights covering 11 game characters and three online game business model patents and 8 patents pending with the Korea Intellectual Property Office, in each case as of March 31, 2010.
 
SEASONALITY
 
Usage of our online games has typically increased slightly around the New Year’s holiday and other holidays, in particular during winter and summer school holidays.
 
LAWS AND REGULATIONS
 
We are subject to many laws and regulations in the different countries in which we operate. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR REGULATORY ENVIRONMENT.” A general overview of the material laws and regulations that apply to our business are provided below for the countries from which we derive a significant portion of our revenues.
 
Korea
 
The Korean game industry and online game companies operating in Korea are subject to the following laws and regulations:
 
The Act on Promotion of the Game Industry
 
In January 2007, the National Assembly amended the Act on Promotion of the Game Industry, or the Promotion Act, which became effective on April 20, 2007. Under the amended Article 21 of the Promotion Act, online games are classified into four categories: “suitable for users of all ages,” “suitable for users 12 years of age or older,” “suitable for users 15 years of age or older” and “suitable for users 18 years of age or older.” The 15 years of age or older category was added between the 12 years of age and 18 years of age categories to increase ratings flexibility. Pucca Racing has been classified as “suitable for users of all ages.” Emil Chronicle Online and Ragnarok Online II have been classified as “suitable for users 12 years of age or older.” Ragnarok Online has been classified as “suitable for users 12 years of age or older” except for one server where player-versus-player combat is allowed, which has been classified as “suitable for users 18 years of age or older.” Requiem has been classified as “suitable for users 18 years of age or older.”
 
The amendment to the Promotion Act includes for the first time the definition of the term “speculative game.” A speculative game refers to a game that permits betting and offers monetary loss or profit that is determined by chance. Elements that may cause a game to be considered a speculative game include the existence of game money used as a means for betting or purchasing game items (items used within the game for progression in the game) that become the subject of exchange with respect to the game money. The Supreme Court decision No. 2007-4702


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rendered on October 26, 2007 provided that the determination of whether a business is speculative or not requires a comprehensive consideration of the following factors: the purpose of use, the method and appearance of use, whether money or gifts exchangeable with money are distributed as a result of using the business, the degree and scale thereof, and whether gifts are actually exchanged into cash. Although the new rules and Supreme Court decision are intended to provide more clarity for the determination of whether a game is deemed speculative or not, because our games involve transactions with game items, we may have to expend much effort to ensure that we are in compliance with the new rules.
 
A game provider has to report any modification in the content of a game to the Game Rating Board, which may require the game to be reclassified depending on the scope of the modification. If the Game Rating Board determines that the game is speculative, it can deny any classification, in which case the game will be prohibited. According to Article 1(2) of the Enforcement Decree of the Promotion Act newly established on May 16, 2007, any games in which money or items of value are collected from a multiple number of persons and profits or losses are allocated based on winnings or losses determined by chance, fall under speculative games. According to Article 16(2) of the Enforcement Decree of the Promotion Act newly established at the same time, so long as certain guidelines are followed, a provision of a gift equivalent to a customer price of Won 5,000 or less, with respect to games that are classified as “suitable for users of all ages,” is not deemed to be an act that encourages gambling.
 
Under the Promotion Act, as partially amended on December 21, 2007, the Minister of Culture, Sports and Tourism may order information and communication service providers to refuse, stop, or restrict the offering of games if such games are unrated, contents are different from those submitted for rating, were denied rating as speculative games, or were manufactured or distributed by a person not registered for operation of manufacturing or distributing games for profit-making. Game Rating Board undertakes examination of the information and communications service providers and provides recommendation of correction to the providers as necessary. The information and communications service providers are required to implement the corrective measures recommended within 7 days and report the results thereof to the chairman of the Game Rating Board or the Minister of Culture, Sports and Tourism.
 
The Game Rating Board published the ‘2008 Yearbook for Classification of Game Ratings’ for the first time in September 2008 and the ‘2009 Yearbook for Classification of Game Ratings’ in June 2009 in order to provide information on industry trends. The Yearbooks include data on ratings and classifications of various games released in Korea and the results of the examination of the information and communications service providers during year 2007 and 2008. The Game Rating Board published the Yearbook to improve fairness and transparency in inspecting games and to provide industry participants with guidelines on ratings inspection as well as basic information on the development of the game industry.
 
Prior to a partial amendment on January 1, 2010, the Promotion Act provided that governmental support for the Game Rating Board will be provided until December 31, 2009 and the task of rating games will thereafter be privatized. However, based on the decision that the required social conditions for such privatization are not yet established, the Promotion Act, as partially amended on January 1, 2010, promoted the sustained rating of games and operation of supplementary administrative tasks by extending the date for the provision of governmental support until December 31, 2011.
 
On April 12, 2010, for the purpose of preventing gaming addiction among adults and teenagers and to promote a constructive gaming culture, the Ministry of Culture, Sports and Tourism introduced the “Measures for the Prevention and Alleviation of Excessive Gaming,” which includes the following: (i) expanded applicability of the exhaustion system (a program in which the rate at which items are acquired in a game decreases as a person plays the game longer, and this system is closely related to the game scenario), (ii) selective shutdown system for games played by teenagers (a system in which a teenager’s gaming time can be selectively managed between midnight and 8:00 am with the consent of a parent), (iii) establishment of a fund for the prevention of excessive gaming, and (iv) regulation of internet Web sites that deal in cash transaction of in-game items.
 
As a result, starting as early as the end of 2010, it is anticipated that the system for the restriction of teenager access to online games during late night hours (midnight to 8:00am) will be implemented based on selective preference, and the exhaustion system which is currently applied to 4 games (none of which are our games) will be


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applied to additional 15 games (none of which are our games) within the year. The provision completely prohibiting the transaction of in-game items, which has been the subject of controversy, has been excluded from this proposal, because it was expected to cause substantial side effects. Instead, the focus has shifted to an approach to reinforce the responsibilities of brokers dealing in transactions involving in-game items through continued monitoring and detection of illegal items.
 
The Korean government is planning to codify such excessive gaming prevention measures, but since no specific proposals have been created, it is necessary to monitor the future developments.
 
The Telecommunications Business Act
 
Under the Telecommunications Business Act, a person who intends to run a value-added telecommunications business must report to the Korea Communications Commission, or KCC, which has the authority to accept and monitor such reports. We are classified as a value-added telecommunications service provider such that we are required to prepare and submit statistical reports regarding, among others, the current status of facilities, subscription records and current status of users to the KCC upon its request. The KCC is responsible for compiling information and formulating telecommunications policies under this Telecommunications Business Act. In addition, we are required to report any transfer, takeover, suspension or closing of our business activities to the KCC, which may cancel our registration or order us to suspend our business for a period of up to one year if we fail to comply with its rules and regulations.
 
According to Article 21 of the Telecommunications Business Act, however, any person who intends to operate a value-added telecommunications business using small-scale telecommunications facilities is exempted from the obligation to report to the KCC. Before this Article was amended on May 11, 2007, small scale value-added telecommunications business operators had difficulty entering the market because only key telecommunications business operators, such as telephone and Internet service providers, could be exempted from such obligations. The amendment is expected to relieve burdens associated with entering the value-added telecommunications business industry and facilitate its growth, which may result in intensified competition between online game service business operators.
 
The Act on Consumer Protection for Transactions through Electronic Commerce
 
Under this Act, we are required to take necessary measures to maintain the security of consumer information related to our electronic settlement services. We are also required to notify consumers when electronic payments are made and to indemnify consumers for damages resulting from misappropriation of consumer information by third parties. We believe that we have instituted appropriate safety measures to protect consumers against data misappropriation. To date, we have not experienced material disputes or claims in this area.
 
This Act was partially amended on March 22, 2010, and the amendment became effective on the same day. The amendment allows a company to avoid liability under the Act if it has exercised proper care in the management or supervision of its employees.
 
The Act on Promotion of Information and Communications Network Utilization and Information Protection, or Information Protection Act
 
Under the Information Protection Act, we are permitted to gather personal information relating to our subscribers within the scope of their consent. We are, however, generally prohibited from using personal information or providing it to third parties beyond the purposes disclosed in our subscriber agreements. Disclosure of personal information without consent from a subscriber is permitted only if it is necessary for the settlement of information and communication service charges or is expressly permitted by this or any other statute.
 
We are required to indemnify users for damages occurring as a result of our violation of the foregoing restrictions, unless we can prove the absence of willful misconduct or negligence on our part. We believe that we have instituted appropriate measures and are in compliance with all material restrictions regarding internal mishandling of personal information.


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Penalty surcharges are imposed on any telecommunications enterprises violating the regulation on the protection of personal information to recover any unfair profits gained by such enterprises, and some conducts, such as collection of personal information of users without their consent, are the subject of criminal punishment. Any telecommunications enterprises violating its obligation to protect personal information by collecting, using, disclosing such information without consent, and not complying with protective measures, may be imposed with surcharges not exceeding 1% of the sales relevant to the conduct of violation in consideration of the details, degree, period, the number of times, and the scale of gained profits.
 
The Information Protection Act was partially amended on March 17, 2010, and the amendment became effective on the same day. The amendment allows a company to avoid liability under the Act if it has exercised proper care in the management or supervision of its employees.
 
The Korean Civil Code and the Act on the Establishment and Management of the Korea Communications Commission
 
Pursuant to the Korean Civil Code, contracts entered into with persons under 20 years of age without parental consent may be invalidated. Under the Act on the Establishment and Management of the Korea Communications Commission, the KCC was established to oversee services relating to broadcasting and communications and also to deliberate and resolve matters concerning the protection of users’ information and communications. As a result, telecommunication service contracts and online game user agreements are required to specifically set forth procedures for rescinding service contracts, which may be entered into by persons under 20 years of age without parental consent.
 
In November 2003, the KCC issued an order addressed to 15 major online game companies in Korea, including the Company, to regulate certain business practices relating to the settlement of service charges involving persons under 20 years of age. The KCC raised concerns about the ability of persons under 20 years of age to subscribe to online game services without parental consent by settling charges payable to online game companies through settlement systems operated by fixed-line or broadband service providers. The order required online game companies to implement more specific and effective procedures to ensure, where relevant, that parental consent has been specifically obtained.
 
Although only a small number of our current subscribers are using the settlement options mentioned in the KCC order, we are enhancing our age verification and parental consent procedures for players using the relevant settlement options. We do not expect compliance with the KCC order to be burdensome.
 
Copyright Act and Computer Programs Protection Act, or Copyright Act
 
The Copyright Act, which was amended on April 22, 2009, was established by combining the “Copyright Act” on the protection of general works and the “Computer Programs Protection Act” on the protection of computer program works in order to maintain the consistency of copyright protection policies and seek an efficient administration thereof. In addition, the Korea Copyright Commission was established by combining the existing Copyright Commission and the Korea Software Copyright Committee, thereby improving the protection of copyrights and the efficiency in its operation. The amended Copyright Act also includes essential elements of the abolished Computer Programs Protection Act and, in connection with computer program works, restrictions on software copyrights, decompilation of computer programs, and the establishment of the exclusive right to issue computer programs as a special case apart from other kinds of works.
 
Juvenile Protection Act
 
The Juvenile Protection Act, as amended on February 29, 2008, prescribes the establishment of the Juvenile Protection Commission under the authority of the Minister of the Ministry of Health and Welfare in Korea, or MOHW, formerly known as the Ministry for Health, Welfare and Family Affairs, which has the authority to designate the types of media harmful to juveniles. Under the Juvenile Protection Act, any person who intends to sell, lend or distribute media materials harmful to juveniles or provides them for viewing or utilization is required to confirm the age of the intended user, and shall not sell, rent or distribute such materials, or provide them for viewing


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or utilization, to juveniles. A person in violation may be punished by imprisonment for a maximum of three years or by a fine not exceeding Won 20 million.
 
On March 4, 2009, MIHWAF issued a public notice announcing that “Web sites for trading items” are considered “harmful mass media” to juveniles based on the findings of Juvenile Protection Commission that such websites for trading online game items are likely to encourage gambling and speculation and negatively influence juveniles. In the public notice, MIHWAF prohibited any person under the age of 19 from visiting a website for trading online game items, effective from March 19, 2009.
 
A Web site for trading items is a Web site which offers the services of brokerage or agency for trading of tangible or intangible things gained from online games as prescribed in the Promotion Act. A Web site for trading items needs to specify on its Web site that access is not allowed for juveniles, and any person visiting such Web site is required to go through the adult certification process. Any Web site operator found to be operating such Web site in breach of the requirements under the public notice is subject to a maximum of 3 years of imprisonment or a maximum fine of Won 20 million. On June 3, 2009, Item Bay Co., Ltd., one of the leading Web sites in Korea for trading online game items, initiated an administrative proceeding against MIHWAF seeking cancellation of MIHWAF’s public notice. Item Bay Co., Ltd. argued that “game items are purchased by users at their own discretion depending on their necessity, and remote from speculative activity. Therefore, Web sites for trading online game items do not fall under media harmful to juveniles.”
 
While we offer virtual in-game items for sale to our users on the game Web sites that we operate in Korea, we do not broker the trade of such game items or any other tangible or intangible acquisitions obtained by using online games among our users, and currently do not fall under the category of “Web site for trading items”. In Korea, however, juveniles account for a significant percentage of online game users. As they are now prohibited from visiting Web sites for trading items, including virtual in-game items, such prohibition may materially and adversely affect the online game industry in general, which may well have a material adverse affect on our business, financial condition and results of operation.
 
The Special Tax Treatment Control Law
 
From 2002 to 2007, we were entitled to a reduced corporate income tax rate of 13.75%, which is 50% of the statutory tax rate, under the Special Tax Treatment Control Law. This reduced tax rate applies to certain designated small- and medium- sized venture companies operating in Korea for a period of six years from the year such companies generate income after being designated as a venture company. We were entitled to such reduced tax rate for the fiscal year ended December 31, 2007 but we were not entitled to this reduced tax rate since 2008. Our statutory income tax rate in 2009 was 24.2%. Beginning in 2012, we will be subject to a 22% tax rate due to an amendment to the Corporate Tax Law of Korea (following an amendment to the Korean tax law in 2008, the reduced tax rate of 22% was due to become effective starting in 2010, but the effective date was postponed for another 2 years through an amendment to the Corporate Tax Law of Korea at the end of 2009 after the Korean government’s financial burden became an issue). See ITEM 5.A. “OPERATING RESULTS — OVERVIEW.”
 
Taiwan
 
The Taiwanese game industry and online game companies operating in Taiwan are subject to the following material laws and regulations:
 
Consumer protection
 
As a result of increasing disputes between online game companies and consumers in Taiwan, on February 17, 2006, the ROC Ministry of Economic Affairs promulgated a model consumer contract that online game companies are encouraged to adopt and on December 13, 2007, the ROC Ministry of Economic Affairs promulgated certain standard provisions that must be included in a consumer contract (the “Mandatory Provisions”) that online game companies must adopt, which include, among others, customers’ right to request a full refund of packaged or downloaded software without cause within seven days from their purchase, to rescind the contract without cause and ask for the unused fees within seven days after the start of the game, to claim for damages suffered from the game program or computer system defect, and to terminate the contract without cause at anytime and claim for the unused


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fees after deduction of necessary costs. In general, the above model contract and Mandatory Provisions impose more responsibilities and liabilities on the online game companies. Moreover, deviations from the Mandatory Provisions may cause certain clauses to be invalidated. In addition, according to the drafted amendment to Consumer Protection Law proposed by the Executive Yuan, if violating the Mandatory Provisions, except for otherwise provided in any laws or regulations, the enterprise shall correct such violation within the time limit given by the competent authority as well as may be subject to a fine. However, it is uncertainty that whether or when the above draft amendment will be passed by the Legislative Yuan.
 
Regulations of Internet content and game software
 
Pursuant to the Children and Juvenile Welfare Act, it is illegal to transmit or provide children under 18 years of age with, among other things, computer software, Internet, electronic signals, DVDs and compact discs that contain content which propagates violence, obscenity or similar material that may undermine the mental and physical health of a minor. Any person or entity violating this Act may be subject to a fine and/or the enterprise may be forced to cease to operate for up to one year. In addition, according to this Act, the Regulations for the Rating of Internet Content, and the Regulations for the Rating of Computer Software, Internet content and computer software shall not violate any mandatory law and certain internet content and computer software shall be classified as “restricted” and therefore shall not be viewed by children and juveniles under the age of 18, which may include, among others:
 
  •  Depiction of homicide or other criminal offenses;
 
  •  Plot involving terror, bloodshed, cruelty, or perversion, which is presented in an intense manner; or
 
  •  Depiction of sexual acts or sexual obscenity, through action, image, language, text, dialogue or sound, yet which does not embarrass or disgust adults in general.
 
In addition, the Regulations for the Rating of Internet Content suggest that the Internet content that is not rated as restricted is better to be viewed by children under the guidance of the parents, guardians or others taking care of them. The Regulations for the Rating of Computer Software further stipulate that certain computer software not rated as restricted may not be reviewed by children or juveniles under certain age or may only be viewed by them under the guidance or company of the parent, teacher or adult relative depending on the rating of such computer software pursuant to such regulation. The rating of internet content and computer software shall be labeled in accordance with the above regulations, respectively.
 
Requiem is rated “restricted” class and all aforementioned rules with regard to “restricted” class are applied.
 
Internet café regulation
 
Currently, there is no mandatory national legislation specifically covering the operation of Internet cafés. However, several municipalities and counties such as Taipei City, Taipei County, Taoyuan County, Tainan City, Nantou County and Kinmen County have promulgated specific ordinances imposing restrictions on Internet cafés, which relate to the location, building structure, facilities, business hours, age limit of customers and the classification of Internet content.
 
In order to have Internet cafés regulated under a national legislation rather than by different municipalities and counties ordinances the ROC Ministry of Economic Affairs several years ago proposed draft Statutes of Information-Entertainment Industry legislation that, if implemented, would regulate all Internet cafés located in the ROC. Also, according to recent news reports, some legislators proposed to have Internet cafés regulated under the now existing national legislation, Electronic Game Arcade Business Regulation Act. It is unclear, however, whether or when the above proposals will be passed by the Legislative Yuan. In addition, pursuant to the Public Order Maintenance Act, Internet cafés may be subject to a fine and/or a business suspension or shut-down if minors are found at Internet cafés during late hours.
 
Privacy protection
 
The ROC government has promulgated the Computer-Processed Personal Data Protection Act to regulate the collection processing, usage and transmission of computer-processed personal data. Generally, an Internet content


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provider, or ICP, will not be subject to this Act if it does not collect or process the personal data through the computer as its main business activity. However, an ICP may become liable for the loss of any data so collected.
 
Intellectual property
 
Under the Copyright Act, the domestic online games software is to be classified as copyrightable works in the category of computer program, and, therefore, is to be protected in Taiwan without requiring further registration with ROC governmental agency. For foreign works, including foreign computer programs, according to the Copyright Act, if the works of persons of ROC are protected by copyright law in such foreign country by treaty, agreements or others, the works of persons of such foreign country shall also be protected by the Copyright Act. The works of persons of WTO member countries can now also be protected under the Copyright Act.
 
Japan
 
Japan does not currently have any national government regulations targeted specifically at the online game industry. Some regulations that are relevant to or that may affect the online game industry are described below.
 
Protection of personal information
 
Businesses in Japan are subject to certain statutory requirements with respect to personal information acquired during the ordinary course of business. Pursuant to these statutory requirements, businesses must set up appropriate procedures to protect personal information from use for any purpose other than the intended purpose.
 
Regulations on sound upbringing of minors
 
In Japan, Internet and game software content is generally regulated at the local, rather than the national, level. Many local governments have ordinances regarding the sound upbringing of minors, which empower competent authorities to designate game software as detrimental to the sound upbringing of minors and prohibit the sale or distribution to minors of such designated game software. In addition, the Computer Entertainment Rating Organization, or CERO, a nonprofit organization, offers rating services for home-use games, including online games. Game developers may request a rating for their game software from CERO, which will then review such software and assign one of the following five ratings: “suitable for users of all ages,” “suitable for users 12 years old or older,” “suitable for users 15 years old or older,” “suitable for users 17 years old or older,” and “suitable only for users 18 years old or older.” Ratings are based on, among other factors, the degree of sex, violence and anti-social expression in the game software content. Once a rating is assigned, the relevant game software must prominently display such rating.
 
Thailand
 
There is no specific law or regulation that directly governs online games, online game companies or the online game industry in Thailand. The online game industry in Thailand operates under a legal regime that generally regulates vendors of Internet cafés and game shops (places where people go to play video games) rather than online game operators. Several of the governmental agencies in Thailand work in cooperation with one another in regulating the industry. The Thai government, principally through the Ministry of Information and Communication Technology, or ICT Ministry, with the cooperation of the Ministry of Culture, has been making efforts to regulate the fast-growing Internet business, in particular the online game industry. The Thai government has, since 2004, proposed measures that would affect the online game industry, including restrictions on the playing time of game users under 18 years of age to three hours per day, prohibition of gambling, lottery or game item trading via online games and mandatory Internet café registration. The Ministry of Commerce in Thailand is also responsible for regulating online businesses by requiring registration.
 
In June 2008, the Thai Government passed the Films and Videos Act of 2008 to replace the Control of Business Relating to Tape Cassette and Television Material Act. The new legislation imposes measures to control the operators of game shops (including Internet cafés that provide game services) and limit access to game shops by users under 18 years of age. These measures include restrictions on the business days and hours, location and building structure of game shops as well as the daily playing time of games and curfew hours for users under


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18 years of age to enter game shops and Internet cafés. According to the Ministerial Regulation of Ministry of Culture Re: Permission and Operation of Video Shops B.E. 2552(2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 pm and 8:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during an educational term break prescribed by the competent registrar. For users aged from 15 years to 18 years, the access times are limited to between 2:00 pm and 10:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during an educational term break as prescribed by the competent registrar.
 
The Films and Videos Act is applicable only to game shop operators that use “video” materials (including, but not limited to, video tapes, video compact discs or digital video discs). “Video” under this Act is defined as “materials that record pictures, or pictures and sound, that can be shown continuously as motion pictures in the forms of games, plays, karaoke with pictures, or other characteristics as prescribed in the ministerial regulations”. Currently, there is no ratings system for online games. According to publicly available information, the Ministry of Culture is considering proposing a draft amendment to the Films and Videos Act to provide a ratings system for the film and video materials under this Act, which may or may not include online games. Due to a lack of precedent and uncertainties in the interpretation of this new legislation by the Thai authorities, the online game operators may or may not be subject to this Act. Despite such uncertainties, the control of game shop operators by this Act may have an impact on the online game industry.
 
Registration of Internet cafés and online game operators
 
There is no legislation that specifically regulates online game operators, Internet cafés or online game shops. The Ministry of Commerce in Thailand, however, requires that online game operators offering online games over Web sites or Internet portals register for e-business registration and also requires Internet cafés and online game shops to register under the Commercial Registration Act. Under the Films and Videos Act, game operators are also required to obtain an operating license from the Ministry of Culture. In addition, the ICT Ministerial Notification, enacted under the new Computer Related Crime Act, obliges Internet service providers (Internet cafés and online game shops) to keep traffic data for not less than 90 days after such data is entered into a computer system. The traffic data items are: (i) the user’s identifying data, (ii) time of use and (iii) the computer IP address.
 
Regulation of business days and hours, and location and building structure of Internet cafés and game shops
 
In June 2008, the Control of Business Relating to Tape Cassette and Television Material Act was repealed and replaced by the Films and Videos Act. Under the Films and Videos Act, the business days and hours (especially service hours for users under 18 years of age), location and building structure of game shops are restricted. According to the Ministerial Regulation of Ministry of Culture Re: Permission and Operation of Video Shops B.E. 2552(2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 pm and 8:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during an educational term break prescribed by the competent registrar. For users aged from 15 years to 18 years, the access times are limited to between 2:00 pm and 10:00 pm on Monday to Friday; and between 10:00 am and 10:00 pm on public holidays or during an educational term break as prescribed by the competent registrar.
 
Restriction on access by children
 
The Child Protection Act prohibits any person from forcing, threatening, inducing, advocating, causing or permitting children to misbehave or engage in misconduct. In order to implement the protective measures under the Child Protection Act, the Ministry of Culture will also prescribe ministerial regulations under the Films and Videos Act to limit access to Internet cafés and game shops by users under 18 years of age. In addition, the ICT Minister requests online game operators to close access to its game server after curfew hours. Users over 18 years of age, however, are permitted password protected access to certain online game servers even after curfew hours by obtaining a password available at the post office. The ICT Minister has also implemented the “Goodnet” project, which recommends that members of the computer and Internet service provider community cooperate in restricting their business hours to prevent children under the age of 18 from entering their place of business after curfew hours. Similarly, the Office of the National Culture Commission, in cooperation with the Thai Health Promotion


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Foundation, has established the “White Game Shops for Juveniles” project which encourages offline and online game shop operators to operate their businesses in strict compliance with the relevant laws and regulations.
 
Intellectual property
 
Under the Copyright Act, online games are classified as copyrightable work in the category of computer program or software, and, therefore, automatically protected in Thailand without requiring further registration with or notification to any governmental agency. Despite the lack of mandatory registration or notification requirements, it is recommended that copyright owners of online games notify the Department of Intellectual Property, the Ministry of Commerce of their online games to ensure that their names officially and publicly appear in the listing of copyrighted computer software. The copyright owner has the exclusive right to copy, modify and publish its copyrighted work.
 
China
 
The online game industry in China operates under a legal regime that consists of the State Council, which is the highest authority of the executive branch of the PRC central government, and various ministries and agencies under its leadership. These ministries and agencies include, among others:
 
  •  the Ministry of Industry and Information Technology;
 
  •  the Ministry of Culture;
 
  •  the General Administration of Press and Publication;
 
  •  the National Copyright Administration;
 
  •  the Ministry of Public Security; and
 
  •  the Bureau of State Secrecy.
 
The State Council and these ministries and agencies have issued a series of rules that regulate a number of different substantive areas of our business, which are discussed below.
 
Licenses
 
Online game companies are required to obtain licenses from a variety of PRC regulatory authorities. As an ICP business, online game companies are required to hold a value-added telecommunications business operation license, or ICP license, issued by the Ministry of Industry and Information Technology or its local offices, and for ICP operators which provide ICP services in multiple provinces, autonomous regions and centrally administered municipalities, it is required that they obtain an inter-regional ICP license. Any ICP license holder that engages in the supply and servicing of Internet cultural products, which include online games, must obtain an additional Internet culture business operation license from the Ministry of Culture. The General Administration of Press and Publication and the Ministry of Industry and Information Technology jointly impose an approval requirement for any entity that intends to engage in Internet publishing, defined as any act by an Internet information service provider to select, edit and process content or programs and to make such content or programs publicly available on the Internet and, further, an online game operator is required to obtain an online game related Internet publishing permit from the General Administration of Press and Publication. Furthermore, the Ministry of Industry and Information Technology has promulgated rules requiring ICP license holders that provide online bulletin board services to register with, or obtain an approval from, the relevant telecommunications authorities.
 
In addition, under a notice published by it in September 2009, the General Administration of Press and Publication prohibits foreign investors from making investment in online game operation business through joint ventures or wholly owned subsidiaries in China, or from controlling the online game operation business through contractual arrangements. This notice may impact the landscape of the online game industry in China, because a lot of online game operators in China are controlled by non-PRC incorporated entities through contractual arrangements.


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Regulation of Internet content
 
The PRC government has promulgated measures relating to Internet content through a number of ministries and agencies, including the Ministry of Industry and Information Technology, the Ministry of Culture and the General Administration of Press and Publication. These measures specifically prohibit Internet activities, including the operation of online games, that result in the publication of any content which is found to, among other things, propagate obscenity, gambling or violence, instigate crimes, undermine public morality or the cultural traditions of the PRC, or compromise State security or secrets. If an ICP license holder violates these measures, the PRC government may revoke its ICP license and shut down its Web sites.
 
In addition, the PRC government has issued several regulations concerning the installation of filter software to filter out unhealthy content from the Internet. On April 1, 2009, the Ministry of Education, the Ministry of Industry and Information Technology and other ministries and agencies promulgated a notice requiring that by the end of May 2009, all computer terminals connected with the Internet at all elementary and secondary schools shall be able to include and operate the Green Dam-Youth Escort, a software aimed at filtering out unhealthy content in text and graphics from the Internet, which, according to the official Web site of the software, may be used to control the time on Internet, prohibit access to computer games, and filtering out unhealthy Web sites. The Ministry of Industry and Information Technology further expands the scope of usage of this filter software by issuing a notice on May 19, 2009 requiring that effective as of July 1, 2009, all computers manufactured and sold in China shall have the latest available version of Green Dam-Youth Escort preinstalled when they leave the factories and all imported computers shall have the latest available version of Green Dam-Youth Escort preinstalled before being sold in China. The Green Dam Youth Escort should be preinstalled on the hard drive of the computer or in the form of a CD accompanying the computer and should also be included in the backup partition and system restore CD. However, the implementation of this requirement of preinstallation of Green Dam-Youth Escort was postponed according to remarks at the press conference by the Ministry of Industry and Information Technology on June 30, 2009.
 
Regulation of information security
 
Internet content in China is also regulated and restricted from a State security standpoint. The National People’s Congress, China’s national legislative body, has enacted a law that may subject a person to criminal punishment in China for any effort to, among other things: (i) gain improper entry into a computer or system of strategic importance; (ii) disseminate politically disruptive information; (iii) leak State secrets; (iv) spread false commercial information or (v) infringe intellectual property rights.
 
The Ministry of Public Security has promulgated measures that prohibit use of the Internet in ways which, among other things, result in a leakage of State secrets or a spread of socially destabilizing content. The Ministry of Public Security has supervision and inspection rights in this regard. If an ICP license holder violates these measures, the PRC government may revoke its ICP license and shut down its Web sites.
 
Import regulation
 
Licensing online games from abroad and importing them into China is regulated in several ways. Any license agreement with a foreign licensor that involves import of technologies, including online game software into China, is required to be registered with the Ministry of Commerce. Without that registration, a licensee cannot remit license fees out of China to any foreign game licensor. In addition, the Ministry of Culture requires the licensee to submit for its content review and approval any online games to be imported, and after obtaining the approval from the Ministry of Culture, if there is any upgrade or any material change to the content of the imported online games during the operation, the licensee shall submit the new version of imported online games to the Ministry of Culture for content review. If a licensee imports and/or operates games without the required approval, the Ministry of Culture may impose penalties, including revoking the Internet culture business operations license required for the operation of online games in China. Furthermore, the National Copyright Administration requires the licensee to register copyright license agreements relating to imported software. Without the National Copyright Administration registration, a licensee is not allowed to publish or reproduce the imported game software in China. Several notices published by the General Administration of Press and Publication in 2009, individually or jointly with other authorities, emphasize that all imported online games licensed by offshore copyright owners may not be published


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in China without obtaining the approval of the General Administration of Press and Publication, and any new version, expansion packs or innovation of content of such approved online games shall be submitted to the General Administration of Press and Publication for re-approval. Failure to comply with such requirements may lead to certain penalties, including cease of operation by the General Administration of Press and Publication, or shutting down the Web site.
 
Intellectual property rights
 
The National People’s Congress, the State Council and the National Copyright Administration have promulgated various laws, regulations and rules relating to protection of software in China. Under these laws, regulations and rules, software owners, licensees and transferees may register their rights in software with the National Copyright Administration or its local branches and obtain software copyright registration certificates. Although such registration is not mandatory under PRC law, software owners, licensees and transferees are encouraged to go through the registration process and registered software rights may receive better protection.
 
Internet café and online game regulation
 
Internet cafés are required to obtain a license from the Ministry of Culture and the State Administration for Industry and Commerce, and are subject to requirements and regulations with respect to minimum registered capital, location, size, number of computers, age limit of customers and business hours. The PRC government has published a series of rules in recent years to intensify its regulation of Internet cafés. In February 2007, 14 PRC governmental agencies, including the Ministry of Industry and Information Technology, the General Administration of Press and Publication and Ministry of Public Security jointly promulgated a notice about strengthening regulations over Internet cafés and online games. According to the notice, no new Internet café should be approved in 2007 and the regulation of existing cafés should be strengthened. In April 2007, eight PRC governmental agencies, including the Ministry of Education, the Ministry of Industry and Information Technology, the General Administration of Press and Publication and the Ministry of Public Security jointly promulgated a notice regarding the implementation of online game anti-addiction systems to protect the physical and psychological health of minors. According to the notice, online game operators are required to develop and implement anti-addiction systems to all online games from July 16, 2007, and the corresponding identity authentication schemes of the anti-addiction systems shall be put into operation at the same time. Otherwise, the online games may not be approved by or filed with the relevant authorities or may not carry out “open beta” testing for operational purposes. In mid-2008 and March 2009, the Ministry of Culture and other ministries and agencies, individually or jointly, issued several notices which provide various ways to strengthen the regulation of Internet cafés, including investigating and punishing the Internet cafés which accept minors, cracking down on Internet cafés operating without sufficient and valid licenses, limiting the total number of Internet cafés, screening unlawful games and Web sites, and improving the coordination of regulation over Internet cafés and online games. A notice published by the Ministry of Culture in March 2010 imposes significantly severer punishment on Internet cafés admitting minors, according to which, the Internet culture business operation license of an Internet café will be revoked, if it engages in certain activities, including admitting three or more minors at one time, or admitting minors not within permitted business hours, or having incurred malignant events due to admitting minors, or admitting less than two minors for more than twice within one year.
 
Privacy protection
 
PRC law does not prohibit Internet content providers from collecting and analyzing personal information from their users. PRC law prohibits Internet content providers from disclosing to any third parties any information transmitted by users through their networks unless otherwise permitted by law. If an Internet content provider violates these regulations, the Ministry of Industry and Information Technology or its local bureaus may impose penalties and the Internet content provider may be liable for damages caused to its users.
 
Regulation on information reporting
 
On April 13, 2009, the Ministry of Industry and Information Technology promulgated the Implementation Measures for Internet Network Security Information Reporting, or the Implementation Measures, pursuant to which


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ICP operators with inter-regional operations shall set up information monitor mechanism and information report mechanism, and shall report the required event information and early warning information to the competent tele-communications authorities and/or National Computer Network Emergency Response Technical Team/Coordination Center of China in accordance with the Implementation Measures.
 
While we believe that our licensees are in compliance with the applicable laws and regulations governing the online game industry in China, we cannot assure you that operation of our games in China will not be found to be in violation of any current or future Chinese laws and regulations. Failure by our overseas licensees to comply with laws and regulations in China, including obtaining and maintaining the requisite government licenses and permits, may have a material adverse effect on our business, financial condition and results of operations. See ITEM 3.D. “RISK FACTORS — RISKS RELATING TO OUR BUSINESS — We depend on our overseas licensees for a substantial portion of our revenues and rely on them to distribute, market and operate our games, and comply with applicable laws and government regulations.”
 
United States
 
Game Ratings and Attempts to Regulate Access to Children
 
Most video game software publishers comply with the standardized rating system established by the Entertainment Software Rating Board, or ESRB, a non-profit, self-regulatory body established in 1994 by the Entertainment Software Association, or ESA. ESRB rates video games submitted by video game publishers; the ratings include both a symbol for age appropriateness (e.g., “E” for Everyone or “M” for Mature) and a content descriptor (e.g., “Blood and Gore” or “Intense Violence”). The ESRB specifically excludes any online interactions from the rating, as the ESRB is unable to review content, such as chat, text, audio and video generated by other users in an online environment.
 
ESRB has rated our games as follows: Requiem is rated “Mature,” Ragnarok Online is rated “Teen,” and R.O.S.E. Online is rated “Everyone 10+”.
 
By submitting a game to the ESRB and using an ESRB rating, a video game publisher must agree to adhere to advertising and packaging guidelines for the rated game, such as using appropriate advertising content and not targeting any advertisement for a game rated “Teen,” “Mature” or “Adults only” to consumers for whom the product is not rated as appropriate. The Advertising Review Board has been granted the oversight and enforcement authority for compliance with the advertising guidelines. The ESRB ratings must be displayed on both the front and back of game packaging in compliance with the ESRB requirements. The ESRB may sanction game producers for failing to label their product properly. Although submitting a game to the ESRB is voluntary, many retailers will not sell games without an ESRB rating.
 
The United States Federal Trade Commission, or FTC, has also taken action with respect to improper ratings pursuant to its broad authority to prohibit fraudulent, deceptive, or unfair business practices. For example, in response to allegations that two videogame publishers failed to disclose hidden nudity and sexually-themed content to the ESRB during the ratings process, the FTC issued a consent order compelling the videogame publishers not to, expressly or implicitly, misrepresent the ratings or content descriptors of their videogames and to maintain a system that ensures that all of the content in their video games is considered and reviewed in preparing submissions to the ESRB. The FTC has also posted an online form on its Web site for the public to file complaints regarding video game ratings that do not accurately reflect of the content of the game.
 
A number of bills have been introduced in Congress to specifically regulate the sale of video games with violent content to minors, but currently no such federal laws are in force. Several States, as well as several cities, have enacted or are considering laws that would regulate game industry content and marketing, including the rental or sale of games with violent content by or to minors.
 
The State of Maryland has enacted a law that regulates the sale of video games with explicit sexual content to minors. The Maryland law has not been challenged in court and remains in force. Some other States have enacted laws that require the posting of signs providing information about ESRB ratings. However, to date, such laws, when challenged, have been declared unconstitutional. A federal court recently declared unconstitutional a California law


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that imposes fines on retailers that sell or rent certain violent video games to minors, but in April 2010, the United States Supreme Court agreed to hear California’s appeal of the ruling during the Court’s Fall 2010 session.
 
If the United States Supreme Court were to overturn the decision to invalidate the California law regarding sales of “M” rated games, or if any groups (including international, national and local political and regulatory bodies) were to otherwise target “M” rated titles, sales practices regarding such titles could be affected and/or producers could be required to alter the content of such video games.
 
Irrespective of any laws or industry guidelines, retailers have become more reluctant to sell “M” rated video games to minors. The FTC issues periodic reports with respect to the marketing of “M” rated games to minors, and in its most recent report (2009) the FTC reported that only 20% of the underage “undercover shoppers” were able to purchase “M” rated video games. Consumer advocacy groups have also opposed sales of interactive entertainment software containing graphic violence, profanity or sexually explicit material by engaging in public demonstrations and media campaigns.
 
Online Collection of Information from Children
 
The Children’s Online Privacy Protection Act of 1998, or COPPA, prohibits any Web site operator from collecting, maintaining or using personal information (including first and last name, home address, email address, telephone number, Social Security number, or other information that permits the physical or online contacting of a specific individual) of children under 13 years of age, unless the Web site operator obtains verifiable parental consent.
 
A Web site that knowingly collects information from children under 13 years old, or that in whole or in part is directed to children under 13 years old, must obtain verifiable parental consent before collecting personal information from any child. The Web site operator must also post a clear online privacy policy that provides notice of what information is collected from children, how the information is used, and a list of third parties with whom the operator may share or sell the child’s information; parents must be given the choice to determine whether the child’s information can be shared with third parties, and must also be provided access to the child’s information and the opportunity to delete any such information collected. Moreover, the operator must establish and maintain reasonable procedures to protect the confidentiality, security and integrity of any personal information collected from children under 13 years of age. COPPA also prohibits conditioning a child’s participation in a game on the child disclosing more personal information than is reasonably necessary to participate in such activity.
 
COPPA authorizes the FTC and the State Attorneys General to bring actions against Web site operators to enforce the statute.
 
Protection of Personal Information
 
Most States have some form of specific legislation regarding the protection of personal information collected, processed, maintained or used in electronic form, as well as specific notification procedures in the event that such information is accessed by unauthorized individuals. Under these laws, among other things, businesses are required to implement and maintain reasonable security measures designed to protect the computerized personal information of its customers or users from unauthorized access, disclosure or use. These measures may require the encryption of sensitive data, such as credit card numbers, social security numbers, bank security access codes, etc. In the event that a business suffers a security breach, these laws generally require the business to provide notice of such breach to each individual user affected by the breach. In addition, if such personal information is accessed by unauthorized individuals as a result of the business’ failure to use reasonable measures to protect the information, the business may be liable to those customers for any misuse of such personal information and may be liable for statutory fines or penalties, as well as civil and even potential criminal prosecution by government authorities.
 
Privacy Policy Requirements
 
The FTC and many States require an operator of a Web site to develop, maintain and post on its Web site a privacy policy that informs its customers and users of the categories of personal information that are collected by the operator, how that personal information is used and shared with third parties and how users may change or update


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such information and opt-out of its collection and use. While most States have generally not imposed statutory fines or penalties on an operator for failing to comply with its privacy policy, an operator may be directly liable to its customer or users if it fails to comply with its posted privacy policy if such noncompliance harms the users. The FTC, however, has initiated numerous investigations and imposed significant civil penalties in several cases involving alleged failures by companies to comply with the representations made in their online privacy policies and/or adequately disclose the companies’ actual practices in such policies.
 
Liability Arising from User Speech and Conduct
 
Section 230 of the Communications Decency Act of 1996, or CDA, provides limited protection to interactive computer services, such as an online game service, from liability for publishing information posted or provided by others, such as the users of an online game service. The CDA can, for example, help protect an online game service provider from liability as a publisher that could otherwise arise from a user making defamatory statements on the service about another user. The protections of the CDA, however, do not immunize interactive computer services from criminal liability under United States Federal law (e.g., obscenity or child pornography), for infringement of intellectual property law, or any state laws that are not inconsistent with the CDA.
 
Some commentators consider Section 230 of the CDA controversial and have called for it to be amended by Congress because a number of courts have interpreted it as granting broad tort immunity. One recent case rejected immunity by holding that claims involving a person’s personal information is a violation of such persons’ publicity rights, which the court held were intellectual property rights outside of the scope of immunity. Another court recently held that an interactive computer service was not immune from federal Fair Housing Act violations because the interactive computer service provided tools such as pull down menus that assisted the users in creating the content that violated the Fair Housing Act.
 
Congress or the courts could continue to narrow the application of Section 230 of the CDA, in which case online game service operators, such as the Company, could face increased potential liability for certain speech or conduct by the users on their online game service.
 
ITEM 4.C.   ORGANIZATIONAL STRUCTURE
 
The following is our organizational structure as of March 31, 2010:
 
(CHART)
 
 
Note:
 
(1) L5 Games Inc. and Gravity Middle East & Africa FZ-LLC went into liquidation proceedings in the United States and United Arab Emirates in August 2008 and September 2008, respectively.


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ITEM 4.D.   PROPERTY, PLANTS AND EQUIPMENT
 
As of December 31, 2009, our property and equipment mainly consisted of (i) game engines, (ii) network servers and (iii) personal computers. As of December 31, 2009, the net book value of our property and equipment was Won 2,837 million (US$2,508 thousand). Because our main business is to develop and distribute online game services, we do not own any factories.
 
Korea
 
Our principal executive and administrative offices are located at Nuritkum Square Business Tower 15F, 1605 Sangam-Dong, Mapo-Gu, Seoul 121-795 Korea. We currently occupy 110,551 square feet of office space, which we lease from Korea Software Industry Promotion Agency, pursuant to a lease that will expire on December 31, 2012 and which is renewable for one additional year. The annual lease payment amounts to Won 1,969 million (US$1,740 thousand). The offices of NeoCyon, our 96.11% owned subsidiary, are located at Nuritkum Square R&D Tower 14F, 1605 Sangam-Dong, Mapo-Gu, Seoul 121-795 Korea. NeoCyon currently occupies 3,914 square feet of office space, subleased from us. The annual lease payment amounts to Won 66 million (US$58 thousand). We believe that the existing facilities of Gravity and NeoCyon are adequate for our current requirements and that additional space can be obtained on commercially reasonable terms to meet our future requirements.
 
United States
 
The offices of Gravity Interactive, our wholly-owned subsidiary in the United States, are located at 13160 Mindanao Way, Marina Del Rey, California 90292. Gravity Interactive currently occupies 7,102 square feet of office space, leased from a third party. The annual lease payment amounts to US$429 thousand. We believe that the existing facilities of Gravity Interactive are adequate for their current requirements and that additional space can be obtained on commercially reasonable terms to meet their future requirements.
 
France
 
The offices of Gravity EU, our wholly-owned subsidiary in France, are located at Tour Areva 30th Floor, 1 Place Jean Miller 92084 Paris La Defense Cedex. Gravity EU currently occupies 312 square feet of office space, leased from a third party. The annual lease payment amounts to EUR44 thousand (US$59 thousand). For convenience only, the Euro amounts are expressed in U.S. dollars at the rate of EUR0.74 to US$1.00, the noon buying rate of EMU (European Monetary Union) Euros to U.S. dollars as quoted by the Federal Reserve Bank of New York as of March 31, 2010. We believe that the existing facilities of Gravity EU are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
Russia
 
The offices of Gravity CIS, our wholly-owned subsidiary in Russia, are located at 125040, Str. Nizhnyaya build. 14, str.1, Moscow. Gravity CIS currently occupies 1,812 square feet of office space, leased from a third party. The annual lease payment amounts to Russian Ruble 4,615 thousand (US$157 thousand). For convenience only, the Russian Rubles amounts are expressed in U.S. dollars at the rate of Russian Ruble 29.36 to US$1.00, the rate of Russian Rubles to U.S. dollars as quoted by the Russian Central Bank as of March 31, 2010. We believe that the existing facilities of Gravity CIS are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
ITEM 4A.   UNRESOLVED STAFF COMMENTS
 
Not applicable.
 
ITEM 5.   OPERATING AND FINANCIAL REVIEW AND PROSPECTS
 
You should read the following discussion together with our consolidated financial statements and the related notes which appear elsewhere in this report. The following discussion is based on our consolidated financial


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statements, which have been prepared in accordance with U.S. GAAP. Our historic performance may not be indicative of our future results of operations and capital requirements and resources.
 
ITEM 5.A.   OPERATING RESULTS
 
OVERVIEW
 
We are a leading developer and distributor of online games in Japan, Brazil, the Philippines, Indonesia, Singapore, Malaysia, Thailand, Russia and Taiwan based on the number of peak concurrent users. Our headquarter is in Korea and we are incorporated under the laws of Korea. From our inception in April 2000 to the commercialization of our first online game, Ragnarok Online, in August 2002, our operating activities were limited primarily to developing Ragnarok Online. Our revenues have been and continue to be driven primarily by our first game, Ragnarok Online. Our future growth and profitability will be determined by our ability to enhance the features on our existing games and introduce new games with characters, features and functions that gain market acceptance and following.
 
Since Ragnarok Online’s initial commercial launch in August 2002, we have experienced significant growth in revenues and net income until 2004, followed by a substantial decrease in revenues and net income in 2005 and 2006. In 2008, our revenues increased by 32.2% to Won 53,170 compared to 2007 and net loss decreased to Won 2,773 million from net loss of Won 23,201 million in 2007. In 2009, our revenues increased by 8.0% to Won 57,403 million (US$50,746 thousand) from Won 53,170 million in 2008. We recorded a net income of Won 6,917 million (US$6,114 thousand) in 2009 as compared to a net loss of Won 2,773 million in 2008. Our gross profit margin increased to 63.1% in 2009 from 47.8% in 2008 and 51.6% in 2007, and our operating margin increased to 18.9% in 2009 from negative 0.4% in 2008 and negative 56.3% in 2007. We attribute our revenue growth until 2004 largely to our early entry into additional markets since Ragnarok Online’s commercial launch and the continuing popularity of Ragnarok Online among users in the existing markets. Once a game is launched and the initial development and marketing costs have been expensed, relatively low marginal costs are incurred to expand into additional markets directly or through licensing arrangements. The decrease in revenues between 2005 and 2008 was primarily due to the continuing decline in royalties from Ragnarok Online because we believe that it had begun to reach relative maturity in our principal markets. The increase in revenues in 2009 was mainly due to the currency gains from the depreciation of the Won against foreign currencies, mainly the Japanese Yen, and the increase in revenues from Ragnarok Online and Requiem in the United States and Canada. Our cost of revenues for 2009 decreased as compared to 2008 primarily due to the decrease in salaries, amortization on intangible assets, commission paid and cost of good sold. Our revenue trend will be materially affected in the future by the popularity of online games introduced by our competitors.
 
In January 2005, we commercially launched R.O.S.E. Online, an MMORPG. In August 2007, we commercially launched Emil Chronicle Online, an MMORPG, followed by Pucca Racing, a casual online role playing game, in September 2007 and Requiem, an MMORPG, in October 2007. Revenues were Won 604 million (US$534 thousand) for R.O.S.E. Online, Won 814 million (US$719 thousand) for Emil Chronicle Online, Won 120 million (US$106 thousand) for Pucca Racing and Won 2,838 million (US$2,509 thousand) for Requiem in 2009 and Won 766 million, Won 957 million, Won 106 million and Won 1,743 million in 2008, respectively.
 
Our corporate income tax rate in 2009 was 24.2%. From 2002 to 2007, our corporate income tax was 13.75% as we were entitled to a 50% reduction in our corporate income tax rate as we were designated as a small-and medium-sized venture company. We lost such designation in 2008. See ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS — Korea — The Special Tax Treatment Control Law.”
 
Revenues
 
We derive, and expect to continue to generate, most of our revenues from online game subscription revenue generated in the countries where our games are offered by us and royalties and license fees paid by our licensees in our overseas markets. Our revenues can be classified into the following four categories:
 
  •  online games — subscription revenue;
 
  •  online games — royalties and license fees;


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  •  mobile games; and
 
  •  character merchandising, animation and other revenue.
 
Online games — subscription revenue
 
Subscription revenues include revenues from subscription fees and micro-transaction, except in Russia and CIS countries where our game services are only offered with the micro-transaction model. All subscription fees are prepaid. Prepaid online game subscription fees are deferred and recognized as revenue on a monthly basis in proportion to the number of days lapsed or based on actual hours used. Micro-transaction fees are deferred when in-game items are purchased by users and recognized as revenue when the purchased in-game items are used in the games.
 
Online games — royalties and license fees
 
We license the right to market and distribute our games in various countries for a license fee and receive monthly royalties based on an agreed percentage of the licensees’ revenues from our games.
 
The initial license fees are deferred and recognized ratably as revenue over the license period, which generally does not exceed two years. If license agreements are renewed upon expiration of their terms, renewal license fees are deferred and recognized ratably over the new license period. The guaranteed minimum royalty payments are deferred and recognized as the relevant royalty is earned. For a table setting forth details of each license agreement, See ITEM 4.B. “BUSINESS OVERVIEW — OUR MARKETS — Overseas markets.” In addition, if the license agreements are renewed upon the expiration of their terms, we generally receive renewal license fees, which are deferred and recognized ratably over the new license period.
 
We also receive royalty revenues from our licensees based on an agreed percentage of each of the licensee’s revenues from our games. Royalty revenues are recognized on a monthly basis after the licensee confirms its revenues based on the licensees’ sales from our games during the month. Our licensees’ sales also consist of revenues from subscription fees and micro-transaction, except in Vietnam, United Arab Emirates and 18 other countries in the Middle East and Northern Africa where our game services are only offered with the micro-transaction model. We generally are advised by each of our licensees as to the amount of royalties earned by us from such licensee within 15 to 25 days following the end of each month. We generally receive payments of the royalties within 20 to 30 days following the end of each month, except in Europe and China where such payments are received up to 45 days and 60 days after the end of each month, respectively.
 
Mobile games revenue
 
Mobile games are played using mobile phones and other mobile devices. Mobile game revenues are derived from contract prices and a proportion of the per-download fees that users pay. Contract prices are recognized when the products or services have been delivered or rendered and the customers can begin use in accordance with the contractual terms, and per-download fees are recognized on a monthly basis as they are earned.
 
Character merchandising, animation and other revenue
 
We license the right to commercialize or distribute our game characters or animation to third-party licensees in exchange for contract prices. These contract prices are recognized when the products or services have been delivered or rendered and the customers can begin their use in accordance with the contractual terms. In addition, we receive royalty payment based on a specified percentage of the licensees’ sales.
 
We also generate revenues from multiplatform game business and sell goods related to mobile phones, such as ornamental accessories and USB data cable.


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The following table sets forth a breakdown of revenues by type of revenue and the percentage of total revenue for the periods indicated.
 
                                                 
    Year Ended December 31,  
Revenue Type
  2007     2008     2009  
    (In millions of Korean Won and percentages)  
 
Online games-subscription revenue
  W 9,405       23.4 %   W 12,576       23.7 %   W 12,674       22.1 %
Online games-royalties and license fees
    24,698       61.4       30,110       56.6       34,037       59.3  
Mobile games
    4,063       10.1       6,882       12.9       7,882       13.7  
Character merchandising, animation and other revenue
    2,063       5.1       3,602       6.8       2,810       4.9  
                                                 
Total
  W 40,229       100.0 %   W 53,170       100.0 %   W 57,403       100.0 %
                                                 
 
Cost of revenues
 
Our cost of revenues consists principally of the following:
 
  •  operational expenses, server depreciation expenses, server maintenance costs and related personnel costs and amortization of development-related costs as described in ITEM 5.A. ‘‘OPERATING RESULTS — CRITICAL ACCOUNTING POLICIES — Capitalized software development costs”; and
 
  •  royalty payments to Mr. Myoung-Jin Lee, for the right to use the storyline and characters from his “Ragnarok” cartoon series used in our game Ragnarok Online. We paid Mr. Lee an initial license fee of Won 40 million and are required to pay royalties based on 1.0% or 1.5% of adjusted revenues (net of value-added taxes and certain other expenses) or 2.5%, 5% or 10% of net income generated from the use of the Ragnarok brand, depending on the type of revenues received from the operation or licensing of Ragnarok Online
 
The cost of revenues from the payments to Mr. Myoung-Jin Lee was Won 520 million for 2008 and Won 497 million (US$439 thousand) for 2009. This agreement expires in January 2033.
 
Selling, general and administrative expenses
 
Selling, general and administrative expenses consist of sales commissions paid to independent promotional agents that distribute our online games to our Internet café subscribers in Korea, commissions paid to payment settlement providers, administrative expenses and related personnel expenses of executive and administrative staff, and marketing and promotional expenses and related personnel expenses.
 
Research and development expenses
 
Research and development expenses consist primarily of payroll and other overhead expenses which are all expensed as incurred until technological feasibility of a game is reached. Once technological feasibility of a game is reached, these costs are capitalized and, once commercial operation commences, amortized as cost of revenues. See ITEM 5.A. “OPERATING RESULTS — CRITICAL ACCOUNTING POLICIES — Capitalized software development costs.”
 
Interest expense
 
We recorded interest expense of Won 41 million (US$36 thousand) in 2009 as compared to Won 31 million in 2008 and Won 92 million in 2007.
 
Foreign currency effects
 
In 2009, 79.9% of our revenues were denominated in foreign currencies, primarily in the U.S. dollar and the Japanese Yen. In most of the countries in which our games are distributed, the revenues generated by our licensees are denominated in local currencies, which include the Japanese Yen, the Euro, the NT dollar, the Thai Baht and the Chinese Yuan. The revenues from those countries, other than the United States, Japan and European countries, are


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converted into the U.S. dollar for remittance of monthly royalty payments to us. Depreciation of these local currencies against the U.S. dollar will result in reduced monthly royalty payments in the U.S. dollar terms, thereby having a negative impact on our net income.
 
Although we receive our monthly royalty revenues from our overseas licensees in foreign currencies, primarily in the U.S. dollar and the Japanese Yen, in the case of the U.S. and Japan, and other local currencies, such as the Euro, the NT dollar, the Thai Baht and the Chinese Yuan in our other principal markets, substantially all of our costs are denominated in Won. We receive monthly royalty payments from our overseas licensees based on an agreed percentage of revenues confirmed and recorded at the end of each month applying the foreign exchange rate applicable on such date. We generally receive these royalty payments 20 to 30 days after the end of each month (except in Europe and China, where such payment could be received up to 45 days and 60 days after the end of each month, respectively) unless delayed due to extraordinary circumstances. Appreciation or depreciation of the Won against these foreign currencies during this period will result in foreign currency losses or gains and affect our net income.
 
As of December 31, 2009, 2008 and 2007, we had no foreign currency forward contracts outstanding. See ITEM 11. “QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.”
 
Income tax expenses
 
Income tax expenses were Won 4,544 million (US$4,017 thousand) in 2009, as compared to Won 3,379 million in 2008 and Won 2,916 million in 2007.
 
CRITICAL ACCOUNTING POLICIES
 
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, contingent liabilities, and revenue and expenses during the reporting period. We evaluate our estimates on an ongoing basis based on historical experience and other assumptions we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The policies discussed below are considered by our management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies require both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.
 
Revenue recognition
 
We derive, and expect to continue to generate, most of our revenues from online game subscription revenue generated in the countries where our games are offered by us and royalties and license fees paid by our licensees in overseas markets. Our revenues can be classified into the following four categories: (i) online games — subscription revenue; (ii) online games — royalties and license fees; (iii) mobile games; and (iv) character merchandising, animation and other revenue. For details, See ITEM 5.A. “OPERATING RESULTS — OVERVIEW — Revenues.”
 
We recognize revenue in accordance with U.S. GAAP, as set forth in Accounting Standard Codification (ASC) 605, Revenue Recognition (formerly referenced as SEC Staff Accounting Bulletin No. 104, Revenue Recognition, Statement of Position 97-2, Software Revenue Recognition) and other related pronouncements.
 
Allowances for doubtful accounts
 
We maintain allowances for doubtful accounts receivable for estimated losses that result from the inability of our customers to make required payments. We base our allowances on the likelihood of recoverability of accounts receivable based on past experience and current collection trends. We record allowances for doubtful accounts based on historical payment patterns of our customers and increase our allowances as the length of time such receivables become past due increases.


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Subsequent to June 2003, pursuant to agreements with various payment processing service providers, the providers are responsible for remitting to us the full subscription revenues generated in Korea after deducting their fixed service fees and charges of approximately 8% to 15%. In addition, we do not assume any collection risk since payment processing service providers now bear the risk of loss and delinquencies.
 
Capitalized software development costs
 
We account for capitalized software development costs in accordance with ASC 985, Costs of Software to be Sold, Leased, or Marketed (formerly referenced as the FASB’s SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed). Software development costs incurred prior to the establishment of technological feasibility are expensed when incurred and treated as research and development expenses. Once the game has reached technological feasibility, all subsequent software development costs for that product are capitalized until it is available for general release to customers. Technological feasibility is evaluated on a product-by-product basis, but generally occurs once the online game has a proven ability to operate on a multi-player level for a large number of users. After the game is available for general release to customers, the capitalized product development costs are amortized and expensed over the game’s estimated useful life, which is deemed to be three years. This expense is recorded as a component of cost of revenues.
 
We evaluate the recoverability of capitalized software development costs on a product-by-product basis. Capitalized costs for those products whose further development or sale is terminated are expensed in the period at which cancellation of the development or sale of such products occurs. In addition, a charge to cost of revenues is recorded when management’s forecast for a particular game indicates that unamortized capitalized costs exceed the net realizable value of that asset.
 
Significant management judgment is required to assess the timing of technological feasibility as well as the ongoing recoverability of capitalized costs.
 
Impairment of goodwill and other intangible assets
 
Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in our acquisition of NeoCyon. As of December 31, 2009, goodwill reflected on our balance sheet was Won 1,210 million (US$1,070 thousand).
 
Goodwill is accounted for under ASC 350, Goodwill and Other (formerly referenced as the FASB’s SFAS No. 142, Goodwill and Other Intangible Assets), which requires that goodwill and indefinite-lived intangible assets no longer be amortized, but instead be tested at least annually for impairment, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of these assets below their carrying amount.
 
Such an event would include unfavorable variances from established business plans, significant changes in forecasted results or volatility inherent to external markets and industries, which are periodically reviewed by management. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized immediately in an amount equal to that excess. The reporting unit for goodwill impairment test is determined based on each legal entity, which is the component level.
 
We performed our annual impairment test for goodwill at all of our reporting units using data as of December 31, 2009. In performing the valuations, we used cash flows, which reflected management’s forecasts and discount rates which reflect the risks associated with the current market. Based on the results of our testing, the fair value of the business reporting unit for NeoCyon, Inc. exceeded its book value, and therefore, the second step of the impairment test (in which fair value of the reporting unit’s assets and liabilities are measured) was not required to be performed. However, in performing the annual impairment test for goodwill for Gravity CIS Co., Ltd., the fair


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value of the business reporting unit for the Russian subsidiary was determined to be lower than the book value of the business reporting unit. Therefore, during the fiscal year ended December 31, 2009, the Company recorded impairment losses of Won 241 million (US$231 thousand) in reporting units in the Russian business due to the overall decline in the fair value of the reporting units and uncertainty in the future. The fair values of the reporting units were estimated principally using the expected present value of future cash flows.
 
The assessment of impairments under ASC 350 requires significant judgment and requires estimates to assess fair values. A percentage difference in cash flow projections or discount rate used would not likely result in an impairment write-down. We believe that plus or minus five percentage difference in cash flow projections or discount rate used would not result in additional significant impairment loss.
 
Impairment of Investments
 
Our investments are comprised of equity securities accounted for under both the cost and equity methods of accounting. If it has been determined that an investment has sustained an other-than-temporary decline in its value, the investment is written down to its fair value by taking a charge to earnings. We regularly evaluate our investments to identify other-than-temporary impairments of individual securities. We consider the following factors in determining whether an other-than-temporary decline in value has occurred: the length of time and extent to which the market value of the security has been less than its original cost, the financial condition, operating results, business plans, milestones and estimated future cash flows of the investee, and other specific factors affecting the market value. We have evaluated our investment in Online Game Revolution Fund No. 1, a limited liability partnership, or the Revolution Fund, and Perpetual Entertainment Inc. The Company’s investment in Perpetual Entertainment was recorded as an impairment loss due to the liquidation of Perpetual Entertainment on October 10, 2007. The impairment loss reflected in our statements of operations was Won 8,619 million. Significant management judgment is involved in evaluating whether there is an impairment. Any changes in assumptions could significantly affect the valuation and timing of recognition of impairment losses.
 
Fair value measurement on financial instruments
 
We adopted ASC 825, Financial Instruments (formerly referenced as the FASB’s SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities). We have elected the fair value option for two of our investments in short-term available-for-sale securities that were acquired during the year ended December 31, 2009. Under the fair value option, unrealized gains and losses related to this investment are reflected in the consolidated statements of operations for the year ended December 31, 2009.
 
Short-term available for sale securities are the investment in Equity-Linked Securities fund (“ELS fund”) which represents equity interests in a fund that is comprised of bonds and trust funds as of December 31, 2009. The fair value of bonds is derived based on quoted prices in active markets, and the fair value of trust funds is derived based on quoted prices in markets that are not active or other inputs that are observable. The trust fund portion of this investment contains an embedded derivative. We have determined that it is not practical to bifurcate the embedded derivative and account for separately as the host contract and embedded derivative are closely related. Pursuant to ASC 825, we have elected the fair value option to account for this investment. Accordingly, the entire change in estimated fair value in the beneficiary certificates is included in the consolidated statement of operations.
 
Income taxes
 
We account for income taxes under the provisions of ASC 740, Income Taxes (formerly referenced as the FASB’s SFAS No. 109, Accounting for Income Taxes). Under ASC 740, income taxes are accounted for under the asset and liability method.
 
Management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the extent to which deferred tax assets can be realized. A valuation allowance is provided for deferred tax assets to the extent that it is more likely than not that such deferred tax assets will not be realized. Realization of future tax benefits related to the deferred tax assets is dependent on many factors, including our ability to generate taxable income within the period during which the temporary differences reverse, the outlook for the economic environment in which the business operates, and the overall future industry outlook. As of December 31, 2009, we


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have concluded that net deferred tax assets of Gravity and its subsidiaries except NeoCyon will not be realized in the near future based on our historical and projected net and taxable income.
 
We enjoyed in 2007 a reduced tax rate of 13.75%, which is 50% of the statutory tax rate and applied to certain designated venture companies. However, the Company is no longer entitled to such tax benefits since 2008. Accordingly, deferred income taxes as of December 31, 2009 were calculated based on the rate of 24.2% for fiscal years 2010 and 2011 and 22% thereafter for the amounts expected to be realized during the relevant fiscal year. Due to the amendment to the corporate income tax law, the rate of 24.2% will be applied for the fiscal years from 2009 through 2011 and 22% for the fiscal year 2012 and thereafter. See ITEM 5.A. “OPERATING RESULTS — OVERVIEW”
 
Recent accounting pronouncements
 
In January 2010, the FASB issued Accounting Standards Update 2010-06 (ASU 2010-06), which amends the disclosure requirements of ASC 820, Fair Value Measurements and Disclosures, as of January 1, 2010. ASU 2010-06 requires new disclosures for any transfers of fair value into and out of Level 1 and 2 fair value measurements and separate presentation of purchases, sales, issuances and settlements within the reconciliation of Level 3 unobservable inputs. The Company previously adopted ASC 820 on January 1, 2008 and January 1, 2009 for financial assets and liabilities and for nonfinancial assets and liabilities, respectively. ASU 2010-06 is effective for annual and interim periods beginning after December 15, 2009, except for the Level 3 reconciliation which is effective for annual and interim periods beginning after December 15, 2010. The adoption of ASU 2010-06 as of January 1, 2010 did not have a material effect on the Company’s financial condition or results of operations. The Company does not expect the adoption of ASU 2010-06 in relation to the Level 3 reconciliation to have a material impact on the Company’s financial condition or results of operations.
 
In September 2009, the Emerging Issues Task Force (the “EITF”) reached final consensus under ASU No. 2009-13 on the issue related to revenue arrangements with multiple deliverables. This issue addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting and how arrangement consideration should be measured and allocated to the separate units of accounting. This issue is effective for the Company’s revenue arrangements entered into or materially modified on or after January 1, 2011. The Company will evaluate the impact of this issue on the Company’s financial statements when reviewing its new or materially modified revenue arrangements with multiple deliverables when it becomes applicable.
 
In June 2009, the FASB issued a statement which improves financial reporting by enterprises involved with variable interest entities. This statement requires companies to perform an analysis to determine whether the company’s variable interest or interests give it a controlling financial interest in a variable interest entity. This statement will be effective as of the beginning of the annual reporting period that begins after November 15, 2009. The Company will evaluate the impact of this statement on the Company’s financial statements when reviewing any new variable interest entities or transactions when it becomes applicable.
 
In June 2009, the FASB issued a statement which improves the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets as well as the effects of a transfer on its financial position, financial performance, and cash flows and a transferor’s continuing involvement, if any, in transferred financial assets. The statement requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. The statement will be effective as of the beginning of annual reporting period that begins after November 15, 2009. The Company believes the adoption of this pronouncement will not have a material impact on the Company’s financial statements as the Company does not currently transfer its financial assets.


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RESULTS OF OPERATIONS: 2009 COMPARED TO 2008
 
The following table summarizes our results of operations for the periods indicated.
 
                                 
    Year Ended December 31,  
    2008     2009     2009(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$
 
    except for percentages)  
 
Revenues:
                               
Online games — subscription revenue
  W 12,576     W 12,674     US$ 11,204       0.8 %
Online games — royalties and license fees
    30,110       34,037       30,090       13.0  
Mobile games
    6,882       7,882       6,968       14.5  
Character merchandising, animation and other revenue
    3,602       2,810       2,484       (22.0 )
                                 
Total net revenue
    53,170       57,403       50,746       8.0  
Cost of revenue
    27,772       21,170       18,715       (23.8 )
                                 
Gross profit
    25,398       36,233       32,031       42.7  
Gross profit margin(2)
    47.8 %     63.1 %     63.1 %        
Operating expenses:
                               
Selling, general and administrative
    23,489       21,651       19,140       (7.8 )
Research and development
    2,145       1,799       1,590       (16.1 )
Impairment losses on intangible assets
          280       248       N/M  
Settlement cost of litigation
          1,649       1,458       N/M  
                                 
Total operating expenses
    25,634       25,379       22,436       (1.0 )
Operating income (loss)
    (236 )     10,854       9,595       4,699.2  
Operating profit margin(3)
    (0.4 )%     18.9 %     18.9 %        
Other income (expenses):
                               
Interest income
    2,857       2,395       2,117       (16.2 )
Interest expense
    (31 )     (41 )     (36 )     32.3  
Foreign currency income (losses), net
    3,235       (225 )     (199 )     (107.0 )
Others, net
    (31 )     (21 )     (19 )     (32.3 )
                                 
Total net other income
    6,030       2,108       1,863       (65.0 )
Income before income tax expenses and equity loss of joint venture and partnership
    5,794       12,962       11,458       123.7  
Income tax expenses
    3,379       4,544       4,017       34.5  
                                 
Income before equity in loss of related joint venture and partnership
    2,415       8,418       7,441       248.6  
Equity loss of joint venture and partnership(4)
    5,119       1,424       1,259       (72.2 )
                                 
Net income (loss)
    (2,704 )     6,994       6,182       (358.7 )
LESS: Net income attributable to the non-controlling interest(5)
    69       77       68       11.6  
                                 
Net income (loss) attributable to parent company
  W (2,773 )   W 6,917     US$ 6,114       (349.4 )%
                                 
 
N/M = not meaningful


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Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
(2) Gross profit margin for each period is calculated by dividing gross profit by total net revenues for each period.
 
(3) Operating profit margin for each period is calculated by dividing operating income (loss) by total net revenues for each period.
 
(4) Represents the losses from our 16.39% equity investment in the Revolution Fund. This investment in the Revolution Fund was accounted for using the equity method of accounting.
 
(5) Represents the non-controlling interest in NeoCyon, a 96.11% held subsidiary acquired in December 2005.
 
Revenues
 
Our total revenues increased by 8.0% to Won 57,403 million (US$50,746 thousand) in 2009 from Won 53,170 million in 2008, primarily due to:
 
  •  a 0.8% increase in subscription revenue to Won 12,674 million (US$11,204 thousand) in 2009 from Won 12,576 million in 2008. This 0.8% increase resulted primarily from the 60.4% increase in the revenues in the United States and Canada to Won 5,785 million (US$5,114 thousand) in 2009 from Won 3,607 million in 2008 resulting from the commercial launch of Requiem in June 2008 and the increased revenues from micro-transactions mainly due to sales of certain game items of Ragnarok Online in 2009. Such increase in subscription revenues was partially offset by the 33.7% decrease in the revenues from Ragnarok Online, Requiem, Pucca Racing, Time N Tales and Emil Chronicle Online in Korea to Won 4,951 million (US$4,377 thousand) in 2009 from Won 7,463 million in 2008;
 
  •  a 13.0% increase in royalties and license fees to Won 34,037 million (US$30,090 thousand) in 2009 from Won 30,110 million in 2008, which primarily resulted from the weakening of the Korean Won by approximately 26.4% against the Japanese Yen from 2008 to 2009. Royalties and license fees from Ragnarok Online increased to Won 33,294 million (US$29,432 thousand) in 2009 from Won 29,087 million in 2008; and
 
  •  a 14.5% increase in mobile games revenue to Won 7,882 million (US$6,968 thousand) in 2009 from Won 6,882 million in 2008. This 14.5% increase resulted primarily from revenues of NeoCyon, mainly due to the increase in sales of games embedded in mobile phones and royalty revenues from mobile games based on Ragnarok Online in the Japanese market.
 
Such increases in revenues were partially offset by:
 
  •  a 22.0% decrease in character merchandising, animation and other revenue to Won 2,810 million (US$2,484 thousand) in 2009 from Won 3,602 million in 2008, which resulted primarily from a 16.1% decrease in character merchandising revenue to Won 917 million (US$811 thousand) in 2009 from Won 1,093 million in 2008 and from a 19.4% decrease in sales of goods to Won 1,535 million (US$1,357 thousand) in 2009 from Won 1,905 million in 2008.
 
Cost of revenues
 
Our cost of revenues decreased by 23.8% to Won 21,170 million (US$18,715 thousand) in 2009 from Won 27,772 million in 2008, primarily due to:
 
  •  a 42.1% decrease in amortization on intangible assets to Won 2,639 million (US$2,333 thousand) in 2009 from Won 4,561 million in 2008 primarily resulting from fully completed amortization of intangible assets in December 2008, related to acquisition of NeoCyon in December 2005. Amortization expense of development costs recorded was Won 2,595 million (US$2,294 thousand) in 2009 and Won 2,595 million in 2008;


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  •  a 19.7% decrease in salaries to Won 8,353 million (US$7,384 thousand) in 2009 from Won 10,403 million in 2008 primarily resulting from decrease in salaries for the headquarters and decrease in salaries for the subsidiaries in the U.S. mainly due to the liquidation proceedings of L5 Games Inc. taking place since August 2008;
 
  •  a 28.9% decrease in service fees and license fees paid to Won 2,468 million (US$2,182 thousand) in 2009 from Won 3,469 million in 2008 resulting from (i) a switch to an Internet Data Center charging lower service fee rate, (ii) lower royalty payments to GungHo, the licensor of Emil Chronicle Online as a result of the amendment of the license agreement in January 2009 and (iii) decrease in service fees paid to the provider of content delivery network service as a result of a decrease in the number of downloads by our users of the client-side software of our games; and
 
  •  a 44.3% decrease in cost of goods sold by NeoCyon to Won 912 million (US$806 thousand) in 2009 from Won 1,637 million in 2008. NeoCyon sells goods related to cell phones and decrease in sales of goods in 2009 led to decrease in cost of goods sold.
 
Gross profit and gross profit margin
 
As a result of the foregoing, our gross profit increased by 42.7% to Won 36,233 million (US$32,031 thousand) in 2009 from Won 25,398 million in 2008. Our gross profit margin increased to 63.1% in 2009 from 47.8% in 2008.
 
Operating expenses
 
Selling, general and administrative expenses.  Our selling, general and administrative expenses decreased by 7.8% to Won 21,651 million (US$19,140 thousand) in 2009 from Won 23,489 million in 2008, primarily due to:
 
  •  a 29.3% decrease in rent expenses to Won 2,010 million (US$1,777 thousand) in 2009 from Won 2,845 million in 2008, which was mainly due to (i) higher rent expense in 2008 as rent expenses were incurred in both the old and new office buildings for the period between February 1, 2008 and March 16, 2008 in connection with the relocation of the headquarter office and (ii) rent expenses of Gravity Middle East & Africa FZ-LLC which ceased to exist in 2009 due to liquidation proceedings taking place since September 2008; and
 
  •  a 32.1% decrease in severance benefit to Won 743 million (US$657 thousand) in 2009 from Won 1,094 million in 2008, due to changes in benefit policies for the directors of a certain subsidiary in February 2008.
 
Such decreases in selling, general and administrative expenses were offset by:
 
  •  a loss of Won 975 million (US$862 thousand) on guarantee payment made for development of Ice Age Online, due to the low likelihood of recovery as we received a written notice of termination of the license agreement with 20th Century FOX Licensing & Merchandising, the trademark licensor of Ice Age, in November 2009.
 
Research and development expenses.  Our research and development expenses decreased by 16.1% to Won 1,799 million (US$1,590 thousand) in 2009 from Won 2,145 million in 2008, as certain research and development expenses were capitalized into intangible assets after open beta testing of some of our games and charged into cost of revenues after such games are available for general release to customers.
 
Impairment loss on intangible assets.  We had Won 280 million (US$248 thousand) impairment loss on intangible assets in 2009, for (i) capitalized research and development cost of Pucca Racing; and (ii) goodwill of Gravity CIS Co., Ltd., which was acquired in our acquisition of NeoCyon in 2005.
 
Settlement cost of litigation.  We paid US$2,000 thousand to Softstar Entertainment, Inc. for the settlement of litigation filed in October 2006 related to R.O.S.E. Online service in Taiwan, Hong Kong and Macau, and recognized the loss of Won 1,649 million, which is the difference between the settlement and the existing deferral revenue balance.


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Operating income (loss) and operating profit margin
 
As a result of the cumulative effects of the reasons stated above, we recorded an operating income of Won 10,854 million (US$9,595 thousand) in 2009 compared to an operating loss of Won 236 million in 2008 and our operating profit margin recorded at 18.9% in 2009.
 
Net other income
 
Our net other income decreased 65.0% to Won 2,108 million (US$1,863 thousand) in 2009 from Won 6,030 million in 2008 primarily due to:
 
  •  a 107.0% decrease in foreign currency income to a loss of Won 225 million (US$199 thousand) in 2009 from a gain of Won 3,235 million in 2008 mainly resulting from the lower rate of depreciation of the Won against the Japanese Yen in 2009 compared to 2008.
 
Income tax expenses (benefit)
 
We recorded an income tax expense of Won 4,544 million (US$4,017 thousand) in 2009, as compared to an income tax expense of Won 3,379 million in 2008. The increase of income tax expense is mainly due to the increase of foreign withholding tax for overseas license and royalty revenue and to the decrease in income tax benefit in the amount of Won 530 million which was no longer available to the Company after 2008, due to the amortization of intangible assets incurred from acquisition of NeoCyon in December 2005 being fully completed in December 2008. In 2009, overseas license and royalty revenue of Gravity headquarters increased by Won 5 billion and accordingly the foreign tax increased by Won 514 million. This increase was also partially due to the loss carry back of Won 195 million from Gravity Interactive in 2008. In assessing the realizability of deferred tax assets, we considered whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. However, it is possible that these income tax expenses could be treated as income tax benefit if any taxable income becomes realizable in the future. For the year ended December 31, 2009, we recorded a full valuation allowance on net deferred tax assets of Gravity and its subsidiaries except NeoCyon, as we determined that it was more likely than not that such net deferred tax assets would not be realizable in the near future.
 
Equity loss of joint venture and partnership
 
In 2008 and 2009, equity loss of joint venture and partnership represents the 16.39% of the net loss incurred from a 16.39% partnership interest in the Revolution Fund. The Company cannot significantly influence the partnership’s operation and financial policies under the partnership agreement, however, the Company accounts for the investment under the equity method of accounting in accordance with ASC 323, Investment-Equity Method and Joint Ventures (formerly referenced as EITF D-46, Accounting for Limited Partnership Investments), which requires the use of the equity method unless the investors’ interest “is so minor that the limited partner may have virtually no influence over partnership operating and financial policies”. The Company recorded Won 5,119 million and Won 1,424 million (US$1,259 thousand) in 2008 and 2009, respectively, as equity loss of the partnership. During 2008, the partnership purchased an online game under development of which technological feasibility had not been established, therefore, the partnership charged the purchase price of the game to expense, which resulted in a significant loss in 2008.
 
Non-controlling interest
 
Non-controlling interest represents the net income from NeoCyon, our 96.11%-held subsidiary acquired in December 2005, attributable to third-party minority interest holders. We acquired 96.11% of the voting equity of NeoCyon in 2005.
 
Net income (loss) attributable to parent company
 
As a result of foregoing, we recorded a net income attributable to parent company of Won 6,917 million (US$6,114 thousand) in 2009 compared to a net loss attributable to parent company of Won 2,773 million in 2008.


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RESULTS OF OPERATIONS: 2008 COMPARED TO 2007
 
The following table summarizes our results of operations for the periods indicated.
 
                                 
    Year Ended December 31,  
    2007     2008     2008(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$
 
    except for percentages)  
 
Revenues:
                               
Online games — subscription revenue
  W 9,405     W 12,576     US$ 9,848       33.7 %
Online games — royalties and license fees
    24,698       30,110       23,579       21.9  
Mobile games
    4,063       6,882       5,389       69.4  
Character merchandising, animation and other revenue
    2,063       3,602       2,821       74.6  
                                 
Total net revenue
    40,229       53,170       41,637       32.2  
Cost of revenue
    19,479       27,772       21,748       42.6  
                                 
Gross profit
    20,750       25,398       19,889       22.4  
Gross profit margin(2)
    51.6 %     47.8 %     47.8 %        
Operating expenses:
                               
Selling, general and administrative
    28,159       23,489       18,394       (16.6 )
Research and development
    5,761       2,145       1,680       (62.8 )
Impairment losses on investments
    8,619                   N/M  
Impairment losses on intangible assets
    871                   N/M  
                                 
Total operating expenses
    43,410       25,634       20,074       (40.9 )
Operating income (loss)
    (22,660 )     (236 )     (185 )     (99.0 )
Operating profit margin(3)
    (56.3 )%     (0.4 )%     (0.4 )%        
Other income (expenses):
                               
Interest income
    3,041       2,857       2,237       (6.1 )
Interest expense
    (92 )     (31 )     (24 )     (66.3 )
Foreign currency income, net
    388       3,235       2,533       733.8  
Others, net
    104       (31 )     (24 )     (129.8 )
                                 
Total net other income
    3,441       6,030       4,722       75.2  
Income tax expenses
    2,916       3,379       2,646       15.9  
                                 
Income (loss) before equity in loss of related joint venture and partnership
    (22,135 )     2,415       1,891       (110.9 )
Equity loss of joint venture and partnership(4)
    1,026       5,119       4,009       398.9  
                                 
Net income (loss)
    (23,161 )     (2,704 )     (2,117 )     (88.3 )
LESS: Net income attributable to the non-controlling interest(5)
    40       69       54       72.5  
                                 
Net income (loss) attributable to parent company
  W (23,201 )   W (2,773 )   US$ (2,172 )     (88.0 )%
                                 
 
N/M = not meaningful
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,277.0 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on April 30, 2009.


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(2) Gross profit margin for each period is calculated by dividing gross profit by total net revenues for each period.
 
(3) Operating profit margin for each period is calculated by dividing operating income (loss) by total net revenues for each period.
 
(4) Represents the losses from our 15.15% and 16.39% equity investment in the Revolution Fund in 2007 and 2008, respectively. This investment in the Revolution Fund was accounted for using the equity method of accounting.
 
(5) Represents the non-controlling interest in NeoCyon, a 96.11% held subsidiary acquired in December 2005.
 
Revenues
 
Our total revenues increased by 32.2% to Won 53,170 million (US$41,637 thousand) in 2008 from Won 40,229 million in 2007, primarily due to:
 
  •  a 33.7% increase in subscription revenue to Won 12,576 million (US$9,848 thousand) in 2008 from Won 9,405 million in 2007. This 33.7% increase resulted primarily from the 26.4% increase in the revenues from Ragnarok Online to Won 9,862 million (US$7,723 thousand) in 2008 from Won 7,804 million in 2007 due to (i) the increased revenues from micro-transactions resulting from opening free-to-play servers in Korea in May 2008 and in United States and Canada in September 2008; and (ii) commercialization of Ragnarok Online in Russia in March 2007 and in France and Belgium in June 2007. This increase also partially came from the initial commercial launch of Requiem in the United States, Canada, Russia and CIS countries in June 2008. Subscription revenues of Requiem increased to Won 1,743 million (US$1,365 thousand) in 2008 from Won 644 million in 2007;
 
  •  a 21.9% increase in royalties and license fees to Won 30,110 million (US$23,579 thousand) in 2008 from Won 24,698 million in 2007, which primarily resulted from the weakening of the Korean Won by approximately 36% against the Japanese Yen from 2007 to 2008 and increased revenues in Japan. Royalties and license fees from Ragnarok Online increased to Won 29,087 million (US$22,778 thousand) in 2008 from Won 23,310 million in 2007;
 
  •  a 69.4% increase in mobile games revenue to Won 6,882 million (US$5,389 thousand) in 2008 from Won 4,063 million in 2007. This 69.4% increase resulted primarily from revenues of NeoCyon, primarily due to the commercial launch of new mobile games based on Ragnarok Online in 2008. Mobile revenues of NeoCyon recorded Won 8,258 million (US$6,466 thousand) in 2008 and Won 4,794 million in 2007; and
 
  •  a 74.6% increase in character merchandising, animation and other revenue to Won 3,602 million (US$2,821 thousand) in 2008 from Won 2,063 million in 2007, which resulted primarily from a 29% increase in character revenue to Won 1,093 million (US$856 thousand) in 2008 from Won 847 million in 2007 and from a 119% increase in sales of goods to Won 1,905 million (US$1,492 thousand) in 2008 from Won 870 million in 2007.
 
Cost of revenues
 
Our cost of revenues increased by 42.6% to Won 27,772 million (US$21,748 thousand) in 2008 from Won 19,479 million in 2007, primarily due to:
 
  •  a 43.3% increase in amortization on intangible assets to Won 4,561 million (US$3,572 thousand) in 2008 from Won 3,182 million in 2007 primarily resulting from the commercial launch of Emil Chronicle Online, Pucca Racing and Requiem in August, September and October 2007, respectively. Amortization expense of development costs recorded was Won 2,595 million (US$2,032 thousand) in 2008 and Won 1,007 million in 2007; and
 
  •  a 45.5% increase in salaries to Won 10,403 million (US$8,147 thousand) in 2008 from Won 7,149 million in 2007 mainly resulting from the commercial launch of Emil Chronicle Online, Pucca Racing and Requiem in August, September and October 2007, respectively and increase in salaries of L5 Games Inc., which was established in October 2007 as such expenses are, subsequent to the commercial launch, incurred as an item in cost of revenues; and


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  •  a 210.6% increase in cost of goods sold by NeoCyon to Won 1,637 million (US$1,282 thousand) from Won 527 million. NeoCyon sells goods related to cell phones and increase in sales of goods in 2008 led to increase in cost of goods sold.
 
Gross profit and gross profit margin
 
As a result of the foregoing, our gross profit increased by 22.4% to Won 25,398 million (US$19,889 thousand) in 2008 from Won 20,750 million in 2007. Our gross profit margin decreased to 47.8% in 2008 from 51.6% in 2007.
 
Operating expenses
 
Selling, general and administrative expenses.  Our selling, general and administrative expenses decreased by 16.6% to Won 23,489 million (US$18,394 thousand) in 2008 from Won 28,159 million in 2007, primarily due to:
 
  •  a 77.6% decrease in advertising expenses to Won 1,483 million (US$1,161 thousand) in 2008 from Won 6,623 million in 2007, which mainly consisted of advertising expenses for closed and open beta testing of Ragnarok Online II, Requiem and Pucca Racing, which were Won 1,747 million, Won 504 million and Won 389 million respectively, and commercialization expenses of Requiem, which was Won 645 million, and Won 1,496 million of expenses related to the Gravity Festival held in July 2007, which did not recur in 2008; and
 
  •  a 15.0% decrease in professional service fees paid to Won 3,934 million (US$3,081 thousand) in 2008 from Won 4,628 million in 2007, for fees and expenses incurred in connection with legal consulting service and advisory service for accounting and Sarbanes-Oxley compliance.
 
Such decreases in selling, general and administrative expenses were partially offset by:
 
  •  a 88.6% increase in severance benefits to Won 1,094 million (US$857 thousand) in 2008 from Won 580 million in 2007, due to changes in benefit policies for the directors of a certain subsidiary in February 2008.
 
  •  a 5.8% increase in salaries to Won 8,234 million (US$6,448 thousand) in 2008 from Won 7,782 million in 2007, primarily resulting from the payment of retirement bonus by the Company during its restructuring process, and by NeoCyon and Gravity RUS.
 
Research and development expenses.  Our research and development expenses decreased by 62.8% to Won 2,145 million (US$1,680 thousand) in 2008 from Won 5,761 million in 2007, as the research and development expenses were capitalized into intangible assets after open beta testing of some of our games and charged into cost of revenues after such games are available for general release to customers.
 
Impairment loss on investments.  In 2007, we had Won 8,619 million impairment loss on available-for-sale securities of Perpetual Entertainment, Inc., or Perpetual Entertainment, in which the Company invested in May 2006. Perpetual Entertainment was liquidated in October 2007. There were no such impairment charges recorded in 2008.
 
Operating income (loss) and operating profit margin
 
As a result of the cumulative effects of the reasons stated above, we recorded an operating loss of Won 236 million (US$185 thousand) in 2008 compared to an operating loss of Won 22,660 million in 2007.
 
Net other income
 
Our net other income increased 75.2% to Won 6,030 million (US$4,722 thousand) in 2008 from Won 3,441 million in 2007 primarily due to:
 
  •  a 733.8% increase in foreign currency income to a gain of Won 3,235 million (US$2,533 thousand) in 2008 from a gain of Won 388 million in 2007 as a result of favorable exchange rates in 2008, mainly from the depreciation of the Won against the Japanese Yen.


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Income tax expenses (benefit)
 
We recorded an income tax expense of Won 3,379 million (US$2,646 thousand) in 2008, as compared to an income tax expense of Won 2,916 million in 2007. The increase of income tax expense is mainly due to the increase of foreign withholding tax for overseas license and royalty revenue. In 2008, overseas license and royalty revenue of Gravity headquarters increased by Won 7 billion and accordingly the foreign tax increased by Won 618 million. This increase was partially offset by the loss carry back of Won 194 million from Gravity Interactive. In assessing the realizability of deferred tax assets, we considered whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. However, it is possible that these income tax expenses could be treated as income tax benefit if any taxable income becomes realizable in the future. For the year ended December 31, 2008, we recorded a full valuation allowance on net deferred tax assets of Gravity and its subsidiaries except NeoCyon, as we determined that it was more likely than not that such net deferred tax assets would not be realizable in the near future.
 
Equity loss of joint venture and partnership
 
In 2007, equity loss of joint venture and partnership represents the 15.15% of the net loss incurred from a 15.15% partnership interest in the Revolution Fund. In 2008, equity loss of joint venture and partnership represents the 16.39% of the net loss incurred from a 16.39% partnership interest. As of December 31, 2008, the Company held 16.39% partnership interest in the Revolution Fund due to the withdrawal of a participant. The Company cannot significantly influence the partnership’s operation and financial policies under the partnership agreement, however, the Company accounts for the investment under the equity method of accounting in accordance with ASC 323, Investment-Equity Method and Joint Ventures (formerly referenced as EITF D-46, Accounting for Limited Partnership Investments), which requires the use of the equity method unless the investors’ interest “is so minor that the limited partner may have virtually no influence over partnership operating and financial policies”. The Company recorded Won 1,026 million and Won 5,119 million (US$4,009 thousand) in 2007 and 2008, respectively, as equity loss of the partnership. During 2008, the partnership purchased an on-line game under development of which technological feasibility had not been established, therefore, the partnership charged the purchase price of the game to expense, which resulted in a significant loss in 2008.
 
Non-controlling interest
 
Non-controlling interest represents the net income from NeoCyon, our 96.11%-held subsidiary acquired in December 2005, attributable to third-party minority interest holders. We acquired 96.11% of the voting equity of NeoCyon in 2005.
 
Net loss attributable to parent company
 
As a result of foregoing, we recorded a net loss attributable to parent company of Won 2,773 million (US$2,172 thousand) in 2008 compared to a net loss attributable to parent company of Won 23,201 million in 2007.


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ITEM 5.B.   LIQUIDITY AND CAPITAL RESOURCES
 
Liquidity
 
The following table sets forth the summary of our cash flows for the periods indicated:
 
                                 
    Year Ended December 31,  
    2007     2008     2009     2009(1)  
                      (Unaudited)  
    (In millions of Won and thousands of US$)  
 
Cash and cash equivalents at beginning of period
  W 35,314     W 53,588     W 53,168     US$ 47,002  
                                 
Net cash provided by (used in) operating activities
    (10,626 )     6,952       15,861       14,021  
Net cash provided by (used in) investing activities
    29,338       (9,028 )     (17,550 )     (15,514 )
Net cash provided by (used in) financing activities
    (438 )     (82 )     (55 )     (49 )
Effect of exchange rate changes on cash and cash equivalents
          1,738       (91 )     (81 )
                                 
Net increase in cash and cash equivalents
    18,274       (420 )     (1,835 )     (1,623 )
                                 
Cash and cash equivalents at end of period
  W 53,588     W 53,168     W 51,333     US$ 45,379  
                                 
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,131.2 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2010.
 
Prior to the commercial launch of Ragnarok Online in August 2002, our principal sources of liquidity were cash from equity financing and incurrence of debt, including the debt we incurred from YNK Korea. Following the commercial launch of Ragnarok Online, our principal sources of liquidity have been cash flows from our operating activities and equity financing and, to a lesser extent, short-term borrowings. Net cash used in investing activities has consisted primarily of investments in acquisition of interests in companies which develop online games or which provide related products and services. See Note 6 to the notes to our consolidated financial statements included in this annual report. However, our net property and equipment decreased from Won 5,226 million as of December 31, 2008 to Won 2,837 million (US$2,508 thousand) as of December 31, 2009 mainly due to the depreciation of property and equipment totaling Won 2,924 million (US$2,585 thousand). This decrease is partially offset by purchase of property and equipment amounting to Won 627 million (US$554 thousand).
 
Our cash investment policy emphasizes liquidity and preservation of principal over other portfolio considerations. We deposit our cash in demand deposits, short-term financial instruments, which primarily consist of time deposits with maturity of one year or less, and money market funds with a rolling maturity of 90 days or less. Our short-term financial instruments decreased from Won 8,715 million as of December 31, 2007, to Won 7,278 million as of December 31, 2008 and increased to Won 16,000 million (US$14,144 thousand) as of December 31, 2009. The decrease in our short-term financial instruments in 2008 was primarily as a result of use of proceeds from such financial instruments in connection with working capital requirements and other expenses and the increase in our short-term financial instruments in 2009 primarily resulted from increase in income from our business.
 
The Company generates cash primarily through royalties and license fees, and subscription fees from our online games in various countries as described in ITEM 5.A. “OPERATING RESULTS — OVERVIEW — Revenues”. The level of popularity of our games in the market place is a key factor in how much cash we can generate. Most of our cash disbursements relate to internal costs such as salaries and other overhead costs for game servicing, other selling, general and administrative activities, and R&D activities.
 
Cash flows from operating activities.  The increase in net cash provided by our operating activities from 2007 to 2008 was primarily the result of decrease in net loss from 2007 to 2008. Our increase in net cash provided by our


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operating activities in 2008 as compared to 2007 reflected an adjustment of (i) Won 8,501 million for depreciation and amortization and (ii) Won 5,119 million in equity loss of related joint venture and partnership. This increase was partially offset by change in account receivable of Won 1,393 million and also change in account payable of Won 2,035 million. The increase in net cash provided by our operating activities from 2008 to 2009 was primarily the result of net income in 2009. Our increase in net cash provided by our operating activities in 2009 as compared to 2008 reflected an adjustment of (i) Won 5,627 million (US$4,974 thousand) for depreciation and amortization and (ii) Won 1,424 million (US$1,259 thousand) in equity loss of related joint venture and partnership. This increase was partially offset by payment of severance benefits of Won 832 million (US$736 thousand) and also change in account payable of Won 602 million (US$531 thousand).
 
Cash flows from investing activities.  Our decrease in net cash by investing activities in 2008 as compared to 2007 reflected (i) Won 6,054 million for purchase of equity investments and (ii) Won 3,645 million for purchase of intangible assets. This decrease was partially offset by (i) Won 1,769 million for proceeds from leasehold deposits and (ii) Won 1,585 million from maturity of short-term financial instruments. Our decrease in net cash by investing activities in 2009 as compared to 2008 reflected (i) Won 8,743 million (US$7,729 thousand) for increase in short-term financial instruments, (ii) Won 2,746 million (US$2,428 thousand) for purchase of intangible assets and (iii) Won 5,000 million (US$4,420 thousand) for increase in short-term available for sale investments.
 
Cash flows from financing activities.  Our increase in net cash used by financing activities in 2008 as compared to 2007 reflected proceeds from borrowings of Won 212 million. This increase was offset by repayments of borrowings of 294 million. Our increase in net cash used by financing activities in 2009 as compared to 2008 reflected proceeds from borrowings of Won 140 million (US$124 thousand). This increase was offset by repayments of borrowings of Won 195 million (US$173 thousand).
 
Capital resources
 
As our overseas operations are conducted primarily through our subsidiaries and our overseas licensees, our ability to finance our operations and any debt that we or our subsidiaries may incur depends, in part, on the payment of royalties and other fees by our overseas licensees and, to a lesser extent, the flow of dividends from our subsidiaries.
 
As of December 31, 2009, our primary source of liquidity was Won 51,333 million (US$45,379 thousand) of cash and cash equivalents. We believe that our available cash and cash equivalents and net cash provided by operating activities will be sufficient to meet our capital needs through at least the first quarter of 2011. However, we cannot assure you that our business or operations will not change in a manner that would consume available capital resources more rapidly than anticipated. We may require additional cash resources due to changed business conditions or other future developments, including any significant investments or acquisitions. If these sources are insufficient to satisfy our cash requirements, we may seek to sell additional securities either in the form of equity or debt. In the past, we raised cash resources through the issuance of common shares. The sale of additional equity securities or convertible debt securities could result in additional dilution to our shareholders. In the past, we also raised cash by entering into indebtedness arrangements such as the transaction entered into with YNK Korea. In addition, we may seek to incur indebtedness through the issuance of debt securities or by obtaining a credit facility. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financial covenants that would restrict operations.
 
As of December 31, 2009, Gravity Interactive, our subsidiary in the U.S., has issued an irrevocable letter of credit in the amount of US$500,000 to its landlord in relation to its lease agreement, with no amount drawn. A short-term investment valued at US$500,000 was provided to a bank as collateral for this letter of credit.
 
We expect to have capital expenditure requirements for the ongoing expansion into other markets, including expenditures for expanding and upgrading our existing server equipment continuously, for developing new games internally, for acquiring and publishing third party games, or for investing in enhancing our technological, marketing, distributing and servicing capabilities. We believe that our internal cash flow from operations, together with our proceeds from our initial public offering in February 2005 will be sufficient to satisfy our working capital requirements through at least the first quarter of 2011, including our new game development expenditures for Ragnarok Online II.


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ITEM 5.C.   RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.
 
To remain competitive, we have continued to focus on our research and development efforts. For the past three years, our research and development efforts and plans have consisted of the following:
 
  •  Strategy and planning — overall game design and review of technical feasibility, market feasibility and the game development process;
 
  •  Graphics — designing game characters and game environments, with the objective of optimizing the overall gaming experience;
 
  •  Server programming — server design and development, handling interconnections, validation, security, character data and game process coordination and facilitating online communication among players; and
 
  •  Client programming — enhancing the visual and sound experience and movement simulation of game characters.
 
Our research and development expenditures were Won 5,761 million, Won 2,145 million and Won 1,799 million (US$1,590 thousand) in 2007, 2008 and 2009, respectively. Our research and development expenses decreased significantly as (i) investments in new games have decreased since 2007: and (ii) certain research and development expenses were capitalized into intangible assets after open beta testing of some of our games and charged into cost of revenues after commercialization.
 
See ITEM 4.B. “BUSINESS OVERVIEW — GAME DEVELOPMENT AND PUBLISHING” for our research and development and ITEM 4.B. “BUSINESS OVERVIEW — INTELLECTUAL PROPERTY” for our intellectual property.
 
ITEM 5.D.   TREND INFORMATION
 
Trends, uncertainties and events which could have a material impact on our sales, operating revenues and liquidity and capital resources are discussed above in ITEM 5.A. “OPERATING RESULTS” and ITEM 5.B. “LIQUIDITY AND CAPITAL RESOURCES.”
 
ITEM 5.E.   OFF-BALANCE SHEET ARRANGEMENTS
 
There are no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditure or capital resources that are material to investors.
 
ITEM 5.F.   CONTRACTUAL OBLIGATIONS
 
The following table sets forth a summary of our contractual cash obligations due by period as of December 31, 2009.
 
                                         
    Payments Due by Period
        Less than
          More than
    Total   1 Year   1-3 Years   3-5 Years   5 Years
    (In millions of Won)