20-F 1 h05180e20vf.htm 20-F e20vf
Table of Contents

As filed with the Securities and Exchange Commission on June 29, 2011
 
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, 2010
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 o
 
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
 
                 
    6  
    6  
    6  
    6  
      Selected Financial Data     6  
      Capitalization and Indebtedness     8  
      Reasons for the Offer and Use of Proceeds     8  
      Risk Factors     8  
    27  
      History and Development of the Company     27  
      Business Overview     27  
      Organizational Structure     68  
      Property, Plants and Equipment     68  
    69  
    69  
      Operating Results     69  
      Liquidity and Capital Resources     85  
      Research and Development, Patents and Licenses, Etc.      87  
      Trend Information     87  
      Off-Balance Sheet Arrangements     87  
      Contractual Obligations     88  
      Safe Harbor     89  
    89  
      Directors and Senior Management     89  
      Compensation     91  
      Board Practices     91  
      Employees     94  
      Share Ownership     95  
    96  
      Major Shareholders     96  
      Related Party Transactions     98  
      Interests of Experts and Counsel     102  
    102  
      Consolidated Statements and Other Financial Information     102  
      Significant Changes     104  
    104  
      Offer and Listing Details     104  
      Plan of Distribution     105  
      Markets     105  
      Selling Shareholders     105  
      Dilution     105  
      Expenses of the Issue     105  


2


Table of Contents

                 
    105  
      Share Capital     105  
      Articles of Incorporation     106  
      Material Contracts     111  
      Exchange Controls     112  
      Taxation     114  
      Dividents and Paying Agents     124  
      Statement by Experts     124  
      Documents on Display     124  
      Subsidiary Information     125  
    125  
    126  
    127  
    127  
    127  
    127  
    128  
    128  
    129  
    129  
    129  
    129  
    129  
    129  
    130  
    130  
    130  
    130  
 EX-4.89
 EX-4.90
 EX-4.91
 EX-4.92
 EX-4.93
 EX-4.94
 EX-8.1
 EX-12.1
 EX-12.2
 EX-13.1
 EX-13.2


3


Table of Contents

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, 2011, which was Won 1,097.25 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, 2010 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;


4


Table of Contents

 
  •  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.


5


Table of Contents

 
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 December 31, 2009 and 2010 and for the years ended December 31, 2008, 2009 and 2010 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,  
    2006     2007     2008     2009     2010     2010(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 8,420     W 9,405     W 12,576     W 12,674     W 9,908     US$ 9,030  
Online games — royalties and license fees
    26,123       24,698       30,110       34,037       32,132       29,284  
Mobile games
    3,840       4,063       6,882       7,882       9,188       8,374  
Character merchandising, animation and other revenue
    2,580       2,063       3,602       2,810       1,134       1,034  
                                                 
Total revenues
    40,963       40,229       53,170       57,403       52,362       47,722  
Cost of revenues
    17,746       19,479       27,772       21,170       20,873       19,023  
                                                 
Gross profit
    23,217       20,750       25,398       36,233       31,489       28,699  
Operating expenses:
                                               
Selling, general and administrative
    27,555       28,159       23,489       21,651       20,422       18,612  
Research and development
    9,239       5,761       2,145       1,799       4,652       4,240  
Impairment losses on investments
          8,619                          
Impairment losses on intangible assets
          871             280       475       433  
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              
                                                 
Operating income (loss)
    (12,197 )     (22,660 )     (236 )     10,854       5,940       5,414  
Other income, net
    2,265       3,441       6,030       2,108       2,322       2,115  
                                                 
Income (loss) before income tax expenses and equity income (loss) on investments
    (9,932 )     (19,219 )     5,794       12,962       8,262       7,529  
Income tax expenses
    12,069       2,916       3,379       4,544       4,207       3,835  
                                                 
Income (loss) before equity income (loss) on investments
    (22,001 )     (22,135 )     2,415       8,418       4,055       3,694  
Equity loss on investments, net
    (1,106 )     (1,026 )     (5,119 )     (1,424 )     (345 )     (314 )
Income (loss) before cumulative effect of change in accounting principle
    (23,107 )     (23,161 )     (2,704 )     6,994       3,710       3,380  


6


Table of Contents

                                                 
    As of and for the Years Ended December 31,  
    2006     2007     2008     2009     2010     2010(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data,
 
    operating data and percentage)  
 
Cumulative effect of change in accounting principle, net of tax
    849                                
Net income (loss)
    (22,258 )     (23,161 )     (2,704 )     6,994       3,710       3,380  
LESS: Net income (loss) attributable to the non-controlling interest
    7       40       69       77       (20 )     (18 )
                                                 
Net income (loss) attributable to Parent Company
  W (22,265 )   W (23,201 )   W (2,773 )   W 6,917     W 3,730     US$ 3,398  
                                                 
Earnings (loss) per share:
                                               
Before cumulative effect of change in accounting principle
  W (3,326 )   W (3,339 )   W (399 )   W 995     W 537     US$ 0.49  
Cumulative effect of change in accounting principle(2)
    122                                
Basic and diluted per share
  W (3,204 )   W (3,339 )   W (399 )   W 995     W 537     US$ 0.49  
Basic and diluted per ADS(3)
    (801 )     (835 )     (100 )     249       134       0.12  
Weighted average number of shares outstanding (basic and diluted)
    6,948,900       6,948,900       6,948,900       6,948,900       6,948,900       6,948,900  
Balance sheet data:
                                               
Cash and cash equivalents
  W 35,314     W 53,588     W 53,168     W 51,333     W 44,122     US$ 40,211  
Total current assets
    88,203       72,667       72,550       82,899       76,343       69,577  
Property and equipment, net
    8,472       7,195       5,226       2,837       2,672       2,435  
Total assets
    122,561       96,921       95,935       102,438       125,490       114,368  
Total current liabilities
    16,192       10,106       8,397       8,248       14,065       12,818  
Total liabilities
    24,419       21,377       19,327       18,828       27,078       24,678  
Total parent company shareholders’ equity
    98,113       75,476       76,471       83,396       87,416       79,668  
Non-controlling interest
    29       68       137       214       10,996       10,022  
Total equity
    98,142       75,544       76,608       83,610       98,412       89,690  
Selected operating data and financial ratios (unaudited):
                                               
Gross profit margin(4)
    56.7 %     51.6 %     47.8 %     63.1 %     60.1 %     60.1 %
Operating profit margin(5)
    (29.8 )     (56.3 )     (0.4 )     18.9       11.3       11.3  
Net profit margin(6)
    (54.4 )     (57.7 )     (5.2 )     12.0       7.1       7.1  
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(2) The Financial Accounting Standards Board, or FASB Accounting Standard Codification, or ASC 718, Compensation — Stock Compensation 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 by total net revenues for each period.
 
(6) Net profit margin for each period is calculated by dividing net income by total net revenues for each period.

7


Table of Contents

 
Exchange Rate Information
 
The following table sets forth information concerning the noon buying rate for the years 2006 through 2010 and for each month during the previous six months through June 17, 2011, expressed in Won per US dollar.
 
                                 
    At End of
  Average
       
Period
  Period   Rate(1)   High   Low
 
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  
2010
    1,130.6       1,158.7       1,253.2       1,104.0  
December
    1,130.6       1,145.5       1,155.2       1,130.6  
2011
                               
January
    1,119.1       1,118.9       1,128.1       1,111.0  
February
    1,123.7       1,117.4       1,130.6       1,100.9  
March
    1,097.3       1,119.3       1,135.6       1,097.3  
April
    1,068.4       1,083.0       1,091.8       1,068.4  
May
    1,078.0       1,084.4       1,101.6       1,065.5  
June (through June 17, 2011)
    1,085.8       1,082.3       1,091.2       1,076.2  
 
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 is currently commercially offered in 80 countries and markets. We derived Won 37,573 million (US$34,243 thousand) in revenues from Ragnarok Online in 2010 and Won 42,290 million in revenues from Ragnarok Online in 2009, representing approximately 71.8% and 73.7% of our total revenues in 2010 and 2009, respectively.
 
Ragnarok Online has been in the market for nine 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.


8


Table of Contents

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 in order to retain our existing users and attract new users. In addition to Ragnarok Online, we currently offer five other massively multiplayer online role playing games, or MMORPGs, Requiem, Emil Chronicle Online, R.O.S.E. Online, Canaan and Dragonica, which is also known as Dragon Saga in the United States and Canada, a casual third person shooter, H.A.V.E. Online, which is also known as Toy Wars in Japan, and two social network games, Fashion Star and Jeweled Planet. We conducted closed beta testing of an MMORPG sequel to Ragnarok Online, Ragnarok Online II, and open beta testing of a Web browser-based casual MMORPG, Eternal Destiny, which was developed by Xpec Entertainment Inc., a Taiwanese company. We are currently developing a new MMORPG with a tentative title of East Road. We have entered into license agreements to publish Weapons of the Gods, an MMORPG, with Shanghai Nineyou Interactive Community and Media Co., Ltd. and its two affiliated Chinese game developers and publishers, Shanghai Nineshine Information Technology Co., Ltd. and HitNorth International Limited. We have entered into license agreements to publish Da Ming Long Quan, an MMORPG developed by Shanghai Jiayou Network Technology, a Chinese company, with SL Media & Games Co., Ltd., and Finding Neverland Online, an MMORPG developed by X-Legend Entertainment Co., Ltd., a Taiwanese company, all of which are 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 Pucca Racing, a casual online game, in June 2010 as the game did not gain popularity in the market. 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 conducted open beta testing of Ragnarok Online II from May 2007 to August 2010, followed by closed beta testing on the upgraded version of the game from August 2010 to September 2010 and a customer satisfaction test called R Care Test in January 2011, 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 2011. We entered into license and distribution agreements for Ragnarok Online II with six licensees in ten countries in 2006, 2007 and 2008, including Thailand, Japan, Taiwan, the Philippines, Singapore, Malaysia, Vietnam, China, Indonesia and Brazil. Our agreement with the licensee for licensing and distribution of Ragnarok Online II in the Taiwan, Hong Kong and Macau markets was terminated in December 2010. Licensing and distribution agreements with licensees in the Philippines and Brazil were amended in June 2010, and those in Thailand, Singapore and Malaysia were amended in November 2010 with less favorable terms than the original agreements, such as reduced license fees or guaranteed minimum royalty. As a result of such termination and amendments, the total value of our license and distribution agreements for Ragnarok Online II in nine countries is US$43,390 thousand as of December 31, 2010. Any continued delay in the launch schedule of Ragnarok Online II could result in financial losses, including termination or amendments of more 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.”


9


Table of Contents

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.
 
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 and certain European countries for Ragnarok Online; Korea, the United States, Canada, certain European countries, certain Central and South American countries, Thailand, Vietnam, Singapore, Malaysia, Indonesia and the Philippines for Requiem; the United States, Canada, Mexico and certain European countries for R.O.S.E. Online; the United States and Canada for Dragonica, which is also known as Dragon Saga; and Korea for Fashion Star and Jeweled Planet 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 61.4% of our total revenues in 2010 and 59.3% of our total revenue in 2009. In particular, we are heavily dependent on one licensee for a significant portion of our revenues. In 2010, 55.5% 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 renewing 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


10


Table of Contents

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.
 
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. Hyun Chul Park, Mr. Yoshinori Kitamura, Mr. Kazuki Morishita and Mr. Kazuya Sakai currently serve as General Manager, Director and Executive General Manager, President and Chief Executive Officer, and 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 Tencent of China. We also compete with online casual game and game portal companies such as NHN Corporation, Nexon Corporation, CJ E&M and Neowiz Games Corporation, 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 the game is currently serviced in Korea and some 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


11


Table of Contents

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 with larger, better 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, or acquisitions of other companies related to development or service of 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. We account for our partnership interest under equity method of accounting and recorded our partnership interest as an equity loss equal to Won 5,119 million, Won 1,424 million and Won 358 million in 2008, 2009 and 2010, respectively. On December 31, 2010, the term of the partnership expired and it is currently undergoing liquidation process. In June 2010, we acquired from Terabit Telecom Ltd., a Russia-based online game company, a 25% of equity interest in Ingamba LLC, or Ingamba, a joint venture company established in April 2010 for online game service in Russia. In October 2010, we acquired an aggregate of 50.83% of the total shares of Barunson Interactive Corporation, subsequently named Gravity Games Corporation, an online game developer in Korea.
 
If our partners or our investments in such joint ventures and partnerships or companies acquired by us are unable to manage their investments, develop promising online games, or market or operate commercially successful online games such joint ventures and partnerships or acquired companies 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 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 recruitment and retention of qualified senior management. Our inability to successfully address these risks and difficulties could materially harm our business prospects, financial condition and results of operations.


12


Table of Contents

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.
 
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 use 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


13


Table of Contents

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.
 
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. Although we have internal security procedures in place designed to prevent electronic embezzlement and have not had any incident of electronic embezzlement since early 2006, 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 accumulate 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


14


Table of Contents

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 preliminary written accusation to the Tokyo Metropolitan Police Department in October 2009 and filed criminal charges against an illegal server operator of Ragnarok Online in April 2011 in cooperation with GungHo, our licensee in Japan, and the matter is currently under investigation by the Tokyo Metropolitan Police Department. In December 2007 and June 2008, Gravity Interactive, Inc., our wholly owned subsidiary in the United States which manages Ragnarok Online game operations in the United States, petitioned the Federal Bureau of Investigation for remission or mitigation of forfeiture of the property of two illegal server operators of Ragnarok Online, which property was deemed proceeds of copyright infringement violations by the illegal server operators, and US$154,674.73 was returned to Gravity Interactive, Inc. in April 2011. 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. For example, in November 2010, Gravity Interactive, Inc., our wholly owned subsidiary in the United States, which manages Dragonica game operations under the name Dragon Saga in the United States and Canada, THQ*ICE LLC, the former game distributor of Dragonica in the United States and Canada, and THQ Inc., the former joint venture partner of THQ*ICE LLC, were accused of trademark infringement. The owner of the registered trademark of Dragonica in the United States filed a lawsuit with the United States District Court for the Southern District of California seeking damages and any profits and gains to the defendants through the alleged trademark infringement. In February 2011, Gravity Interactive, Inc. responded to the United States District Court for the Southern District of California, stating that there was no infringement on the registered trademark of Dragonica. 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.


15


Table of Contents

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 and service 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.
 
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 2010, 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 are 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.


16


Table of Contents

The high cost to access the Internet 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 South America, 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.
 
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.
 
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.
 
Section 3(b)(1) of the Investment Company Act of 1940, or the ’40 Act, provides that a company is not an investment company and, therefore, 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 (a “Non-Investment Business”). There are several bases on which a company can rely in determining that it is a Non-Investment Business.
 
Under one set of criteria, the factors to be considered in determining that a company is a Non-Investment Business are: (i) the history of the company; (ii) the manner in which the company represents itself to the investing public; (iii) the activities of its officers and directors; (iv) the nature of its current assets; and (v) the sources of its current income. Based on those factors, we believe that we are engaged primarily and directly in the business of providing online game services, and consequently, that we are a Non-Investment Business, and not an investment company as that term is defined under the ’40 Act.
 
However, the determination as to whether a company satisfies the foregoing criteria is fact sensitive and subjective. Accordingly, it is possible that our determination could be challenged by the U.S. Securities and Exchange Commission (“SEC”), particularly if at any time we own “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. Nonetheless, if this were to become the case, we could be required to take actions to reduce our ownership of investment securities to comply with this standard, such as shifting a portion of our short-term investment portfolio into low-yielding bank deposits. If necessary, such actions would likely reduce the amount of interest or other income that we could otherwise generate from our investments. In addition, we might need to acquire additional income or loss generating assets


17


Table of Contents

that we might not otherwise have acquired or forego opportunities to acquire minority interests in companies that could be important to our business strategy.
 
Alternatively, we could consider other actions, including applying to the SEC for an exemptive order pursuant to Section 3(b)(2) of the ’40 Act, declaring that we are a company that is primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities, without regard to the composition of our assets at any particular time. However, there can be no assurance that we would receive an exemptive order and the process to obtain such an exemptive order could be long and expensive.
 
The ’40 Act contains numerous, complex requirements with respect to the organization and operations of investment companies, including restrictions on their capital structure, operations, and transactions with affiliates, as well as restrictions on the composition of the board of directors and other matters which would be incompatible with our business. Also, 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 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 2010 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 a PFIC for U.S. federal income tax purposes since our initial public offering. In particular, due to the deterioration of the trading price of our ADSs, we believe that we were a PFIC in 2008 through 2010, and there is a significant risk that we will continue to be a PFIC in 2011. 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.
 
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 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, our management identified a material weakness in our internal control over financial reporting related to lack of monitoring controls over significant transactions at the subsidiary level. Based upon the remediation actions taken by us, our management has concluded that this control deficiency no longer exists as of December 31, 2010.
 
We cannot assure you that we will not discover additional material weaknesses in our internal control over financial reporting in the future. If we fail to design and maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results in a timely manner or prevent errors or fraud. Any of these possible outcomes could result in an adverse reaction in the financial marketplace due to loss of investor confidence in the reliability of our consolidated financial statements and could result in investigations or sanctions by the SEC, the NASDAQ, or other regulatory authorities or in stockholder litigation. Any of these factors could ultimately harm our business and could adversely impact the market price of our ADSs.
 
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. See ITEM 15. “CONTROLS AND PROCEDURES” for additional discussion concerning our material weakness of prior year and changes in internal control.


18


Table of Contents

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.
 
We could suffer losses due to asset impairment charges.
 
We held a total of Won 19,964 million in acquired intangible assets and Won 7,991 million in goodwill at December 31, 2010. See Note 12 to our consolidated financial statements included in this annual report. We test goodwill and indefinite-lived intangible assets 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. If such an adverse event occurred and had the effect of changing one of the critical assumptions or estimates related to the fair value of our intangible assets or goodwill, an impairment charge could result. For example, during 2009, as a result of an overall decline in the fair value of the business reporting units in our business in Russia, we recorded a goodwill impairment charge of Won 241 million to write off the entire outstanding balance of goodwill in such reporting units. There can be no assurance that future reviews of our goodwill and other intangible assets will not result in impairment charges. Although it does not affect cash flow, an impairment charge does have the effect of decreasing our earnings, assets and shareholders’ equity.
 
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


19


Table of Contents

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 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, New Taipei City, Taoyuan County, Tainan City, Nantou County, Lienchiang 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. According to the Ministerial Regulation of Ministry of Culture Re: Permission and Operation of Video Shops B.E. 2552 (September 24, 2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 p.m. and 8:00 p.m. on Monday to Friday; and between 10:00 a.m. and 8:00 p.m. 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 p.m. and 10:00 p.m. on Monday to Friday; and between 10:00 a.m. and 10:00 p.m. 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.


20


Table of Contents

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 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 tax 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 taxes 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. 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.


21


Table of Contents

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 and Hong Kong/ Macau, and Brazil, representing 55.7%, 18.6%, 9.1%, 5.6% and 2.1%, respectively, of our total revenues in 2010. 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 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 overseas subsidiaries or licensees are denominated in local currencies, which include the U.S. dollar, the Japanese Yen, the Euro, the NT dollar, the Thai Baht and the Chinese Yuan. In 2010, approximately 81.4% of our revenues were denominated in foreign currencies, primarily in the U.S. dollar and the Japanese Yen. As the revenues denominated in local currencies, other than the U.S. dollar, the Japanese Yen and the 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. 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, 2010, 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 throughout Korea’s modern history. The level of tension between the two Koreas has fluctuated and may increase abruptly as a result of current and future events. In recent years, there have been heightened security concerns stemming from North Korea’s nuclear weapons and long-range missile programs and increased uncertainty regarding North Korea’s actions and possible responses from the international community. There can be no assurance that the level of tension on the Korean peninsula will not escalate in the future. Any further increase in tension, which may occur, for example, if North Korea experiences a leadership or economic crisis, high-level contacts break down, or military hostilities occur, 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.


22


Table of Contents

Disruptions in Taiwan’s political environment could seriously harm our business and operations in Taiwan.
 
In 2010 and 2009, we derived 5.2% and 2.8%, respectively, of our total revenues from our licensees in Taiwan. 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 June 17, 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, the Taiwanese people elected President Ma Ying-jeou, who has supported the cultivation of better relations with mainland China. For instance, in July 2008, Taiwan lifted the ban on Chinese person’s visiting 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, the 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 of furthering financial cooperation, Taiwan has entered into a memorandum of understanding regarding cross-strait financial supervision with mainland China on November 16, 2009, which became effective on January 16, 2010. Also, after several months of negotiation, the Taiwanese and Chinese governments entered into the Economic Cooperation Framework Agreement for enjoying custom benefits on June 29, 2010, which became effective on September 12, 2010. 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. President Ma Ying-jeou’s term will expire in 2012 and a new president will be elected early in that year. There can be no assurance that the political environment between Taiwan and China will remain unchanged after this election.
 
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.


23


Table of Contents

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 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.”


24


Table of Contents

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.
 
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


25


Table of Contents

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 in 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 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.


26


Table of Contents

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 R.O.S.E. Online. 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 United States which is a wholly-owned subsidiary of Gravity Interactive. L5 Games went into liquidation proceedings in the United States in August 2008 and the liquidation was completed in May 2010. 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 subsequently purchased our ADSs and beneficially owns approximately 59.3% of our common shares as of March 31, 2011. In June 2010, we acquired from Terabit Telecom Ltd., a Russia-based online game company, a 25% of equity interest in Ingamba LLC, or Ingamba, a joint venture company established in April 2010 for online game service in Russia, and Terabit Telecom sold its 75% of equity interest in Ingamba to Stylonos Technologies Ltd., a Russia-based online game company, in December 2010. In October 2010, we acquired an aggregate of 50.83% of the total shares of Barunson Interactive Corporation, or Barunson Interactive, an online game developer in Korea. Barunson Interactive changed its corporate name to Gravity Games Corporation, or Gravity Games, on March 28, 2011.
 
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, Taiwan, Brazil, the Philippines, Indonesia, Singapore, Malaysia, Thailand and Russia 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 nine online games worldwide and have two online games in development and four 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 79 other countries and markets. Requiem is commercially offered in


27


Table of Contents

Korea, the United States, Canada and 87 other countries and markets. Emil Chronicle Online is commercially offered in Thailand, Hong Kong, Taiwan and Indonesia. R.O.S.E. Online is commercially offered in the United States, Canada, Mexico and 40 other countries. Dragonica is commercially offered in the United States, Canada and 55 other countries and markets. H.A.V.E. Online is commercially offered only in Japan under the name Toy Wars. Canaan, Fashion Star and Jeweled Planet are 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 in-house 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, Xbox Live Arcade and PlayStation Portable (PSP).
 
In Korea, we directly manage all aspects of operations of our games except Dragonica, 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, 39 European countries and 24 Central and South American countries, for all aspects of R.O.S.E. Online game operations in the United States, Canada, Mexico and 40 European countries, and for all aspects of Dragonica, which is also known as Dragon Saga, in the United States and Canada. Gravity EU, our wholly-owned subsidiary in France is responsible for Ragnarok Online game operations in France and 26 European countries. In the countries where we and our wholly-owned subsidiaries, Gravity Interactive and Gravity EU, manage game operations, our game revenues are recorded as subscription revenues. In addition, our revenues from global services of Requiem, for which we offer the game directly and local consignees are responsible for services related to marketing and billing, among others, such as Thailand, Vietnam, Singapore, Malaysia, Indonesia and the Philippines, are also recorded as subscription venues.
 
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.


28


Table of Contents

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,  
    2008     2009     2010     2010(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Online game revenues(2):
                                                       
Subscriptions:
                                                       
Korea
  W 7,463       14.0 %   W 4,951       8.6 %   W 3,829       7.3 %   US$ 3,490  
United States/Canada(3)
    3,607       6.8       5,785       10.1       4,664       8.9       4,251  
Others(4)
    1,506       2.9       1,938       3.4       1,415       2.7       1,289  
Royalties and license fees:
                                                       
Japan
    23,353       43.9       28,089       48.9       24,761       47.3       22,567  
Taiwan/Hong Kong/Macau
    2,210       4.1       1,827       3.2       2,864       5.5       2,610  
Brazil
    971       1.8       1,057       1.8       1,079       2.1       983  
Others(3)(4)
    3,576       6.7       3,064       5.4       3,428       6.5       3,124  
                                                         
Subtotal
    30,110       56.5       34,037       59.3       32,132       61.4       29,284  
                                                         
Mobile game revenues
    6,882       12.9       7,882       13.7       9,188       17.5       8,374  
Character merchandising and other revenues
    3,602       6.9       2,810       4.9       1,134       2.2       1,034  
                                                         
Total revenues
  W 53,170       100.0 %   W 57,403       100.0 %   W 52,362       100.0 %   US$ 47,722  
                                                         
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(2) Online game revenues include revenues from Ragnarok Online, R.O.S.E. Online, Requiem, Emil Chronicle Online, Canaan, Dragonica, Pucca Racing, Time N Tales and from two games offered through STYLIA, our casual online game portal site. Canaan was commercially launched in October 2010. The revenues from Dragonica in 2010 only include revenues arising after October 21, 2010 when we acquired Barunson Interactive, currently Gravity Games, the developer of Dragonica. We discontinued offering games through STYLIA, Time N Tales and Pucca Racing in September 2008, March 2009 and June 2010, respectively.
 
(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. Revenues generated in India prior to the respective amendment to the license agreement were shown as Online game revenues-Royalties and license fees-Others. 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) Gravity CIS, our wholly-owned subsidiary in Russia was responsible for all aspects of Ragnarok Online and Requiem game operations in Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan only until June 15, 2010. After we entered into license agreements with Ingamba on June 16, 2010 to distribute Ragnarok Online and Requiem, the two games are serviced in the 15 countries by Ingamba. The revenues generated in the 15 countries until June 15, 2010 were shown as Online game revenues-subscription-Others and those after June 16, 2010 were shown as Online game revenues-royalties and license fees-Others.


29


Table of Contents

 
OUR PRODUCTS
 
We currently have five product lines: MMORPGs, casual online games, social network games, mobile games, and game-related products and services, including animation and character-based merchandise. Revenues from our principal product, Ragnarok Online, accounted for 71.8% of our total revenues in 2010, compared with 73.7% of our total revenues in 2009. We are seeking to diversify our revenue sources by offering additional MMORPGs, casual online games, social network games and other products and services, including mobile games.
 
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
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
Dragonica (Dragon Saga)(3)
  Three-dimensional action adventure   Originally licensed from third party developer and currently owned by us(4)   Launched in October 2010(5)
R.O.S.E. Online
  Three-dimensional action adventure with seven independent storylines   Originally licensed from third party developer; currently owned by us(6)   Launched in January 2005
Canaan
  Web browser-based casual   Licensed from third party developer   Launched in October 2010
Eternal Destiny
  Web browser-based casual   Licensed from third party developer   Currently expected to launch in the third quarter of 2011
Ragnarok Online II
  Three-dimensional sequel to Ragnarok Online   Being developed in-house by the Company   Open beta testing from May 2007 to August 2010, closed beta testing on the upgraded version from August 2010 to September 2010 and a customer satisfaction test called R Care Test in January 2011. Currently expected to launch in the fourth quarter of 2011
Da Ming Long Quan (Kun Woong Online)(7)
  Two-dimensional action adventure   Licensed from third party developer   Currently expected to launch in the third quarter of 2011


30


Table of Contents

             
            Date of Commercial
Title
 
Description
 
Game Source
 
Launch/Testing(2)
 
Weapons of the Gods
  Three-dimensional action adventure   Licensed from third party developer   Currently expected to launch in the first quarter of 2012
Finding Neverland Online
  Three-dimensional casual action adventure   Licensed from third party developer   Not determined
East Road (tentative title)
  Three-dimensional action adventure   Being developed in-house(8)   Not determined
 
 
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) Dragonica is commercially offered in the United States and Canada under the name Dragon Saga.
 
(4) We acquired an aggregate of 50.83% equity interest in Gravity Games, formerly known as Barunson Interactive, which developed Dragonica, on October 21, 2010.
 
(5) Dragonica was initially launched in China in February 2009 followed by 54 other countries and markets under license agreements between Gravity Games and local publishers before our acquisition of Gravity Games. We launched Dragonica in the United States and Canada on October 28, 2010.
 
(6) 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.
 
(7) We intend to offer Da Ming Long Quan in Korea under the name Kun Woong Online.
 
(8) East Road is being developed by Gravity Games.
 
Ragnarok Online
 
Ragnarok Online is commercially offered in Korea and 79 other countries and markets since its commercial launch in August 2002. We began to commercially offer Ragnarok Online in 22 new countries in 2010. Ragnarok Online represented 71.8% of our total revenues or Won 37,574 million (US$34,244 thousand) in 2010, compared with 73.7% of our total revenues or Won 42,290 million in 2009. See ITEM 4.B. “BUSINESS OVERVIEW— OUR MARKETS — Overseas markets.”

31


Table of Contents

The following are revenues generated by Ragnarok Online for the periods indicated:
 
                                     
        Year Ended December 31,  
Revenue Type
 
Country
  2008     2009     2010     2010(1)  
        (In millions of Won and thousands of US$)  
 
Online game-subscription revenue
  Korea   W 5,971     W 4,156     W 3,412     US$ 3,110  
    United States/Canada(2)     2,693       3,794       3,003       2,737  
    Others(3)     1,198       1,046       944       861  
                                     
      Subtotal     9,862       8,996       7,359       6,708  
                                     
Online game-royalties and license fees
  Japan     23,326       28,089       24,637       22,453  
    Taiwan/Hong Kong/Macau     1,706       1,452       2,167       1,975  
    Brazil     971       1,057       1,079       983  
    Thailand     679       819       719       656  
    Philippines     699       707       689       628  
    China     472       336       373       340  
    Indonesia     322       362       214       195  
    Europe     446       408       152       138  
    Middle East/Africa           7       123       112  
    Singapore/Malaysia     63       57       40       36  
    Russia/CIS countries(3)                 22       20  
    India(2)     26                    
    Chile     186                    
    Vietnam     191                    
                                     
      Subtotal     29,087       33,294       30,215       27,536  
                                     
         Total   W 38,949     W 42,290     W 37,574     US$ 34,244  
                                     
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(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 India prior to the respective amendment to the license agreement were shown as Online game royalties and license fees.
 
(3) Gravity CIS, our wholly-owned subsidiary in Russia, was responsible for all aspects of Ragnarok Online and Requiem game operations in Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan only until June 15, 2010. After we entered into a license agreement with Ingamba on June 16, 2010 to distribute Ragnarok Online, Ragnarok Online is serviced in the 15 countries by Ingamba. The revenues generated in the 15 countries until June 15, 2010 were shown as Online game revenues-subscription-Others and those after June 16, 2010 were shown as Online game revenues-royalties and license fees-Russia/CIS countries.


32


Table of Contents

 
The table below provides for the periods indicated, the peak concurrent users and average concurrent users of Ragnarok Online since the first quarter of 2008, 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 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  
2Q 2010
    30,542       25,087       30,760       23,643       48,113       18,547       4,933       2,478       4,427       2,367       5,476       4,124  
3Q 2010
    32,409       25,522       35,426       28,630       61,322       22,631       7,158       3,599       5,001       1,939       5,307       3,681  
4Q 2010
    120,781       71,580       34,910       15,508       55,089       20,905       5,853       2,861       15,232       4,487       5,502       3,338  
1Q 2011
    119,473       90,670       25,073       17,569       43,869       17,983       5,221       2,699       16,064       6,403       4,692       3,176  
 
 
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 non-financial variables and the data presented has not been audited or reviewed. 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;
 
  •  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;


33


Table of Contents

 
  •  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.
 
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, in the United States, Canada, Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan in June 2008, 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, Monaco, Montenegro, San Marino, Serbia, Vatican City State, Croatia, Former Yugoslav Republic of Macedonia and Turkey in December 2009, and in Taiwan, Hong Kong and Macau in May 2010. We entered into global service agreements with AsiaSoft Corporation Public Co., Ltd. in December 2009 for markets in Thailand, Vietnam, Singapore and Malaysia, with PT. Lyto Datarindo Fortuna in February 2010 for Indonesian market and with Digital Media International Inc. in June 2010 for the Philippine 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., PT. Lyto Datarindo Fortuna and Digital Media International Inc. for services related to marketing and billing, among others. We commercially offered Requiem in Thailand, Vietnam, Singapore and Malaysia in March 2010, Indonesia in April 2010 and the Philippines in August 2010. We entered into a license agreement with Ingamba in June 2010 to distribute Requiem in Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan, and Requiem is serviced in these 15 countries by Ingamba since then. Prior to the date of the license agreement with Ingamba, the game had been serviced in those countries by Gravity CIS, our wholly-owned subsidiary. In June 2011, we entered into an amendment to the license and distribution agreement with Gravity Interactive to include Mexico, Guatemala, El Salvador, Nicaragua, Panama, Honduras, Belize, Cuba, Jamaica, Haiti, Dominica, Costa Rica, Puerto Rico, Ecuador, Colombia, Peru, Venezuela, Guyana, Suriname, French Guiana, Chile, Bolivia, Paraguay and Argentina as countries serviced by Gravity Interactive and Requiem has been commercially offered in these countries since June 2011.
 
Requiem represented 4.2% of our total revenues or Won 2,182 million (US$1,987 thousand) in 2010, compared with 4.9% of our total revenues or Won 2,838 million in 2009.


34


Table of Contents

The following are revenues generated by Requiem for the periods indicated:
 
                                     
        Year Ended December 31,  
Revenue Type
 
Country
  2008     2009     2010     2010(1)  
        (In millions of Won and thousands of US$)  
 
Online game-subscription revenue
  Korea   W 964     W 559     W 303     US$ 276  
    United States/Canada(2)     470       1,387       981       894  
    Russia/CIS countries(3)     309       892       368       335  
    Others                 103       94  
                                     
      Subtotal     1,743       2,838       1,755       1,599  
                                     
Online game-royalties and license fees
  Russia/CIS countries(3)                 72       65  
    Taiwan/Hong Kong/Macau                 355       323  
                                     
      Subtotal                 427       388  
                                     
         Total   W 1,743     W 2,838     W 2,182     US$ 1,987  
                                     
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(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.
 
(3) Gravity CIS, our wholly-owned subsidiary in Russia, was responsible for all aspects of Requiem game operations in Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan only until June 15, 2010. After we entered into a license agreement with Ingamba on June 16, 2010 to distribute Requiem, Requiem is serviced in the 15 countries by Ingamba. The revenues generated in the 15 countries until June 15, 2010 were shown as Online game revenues-subscription-Russia/CIS countries and those after June 16, 2010 were shown as Online game revenues-royalties and license fees-Russia/CIS countries.
 
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 and ceased offering commercial service in Singapore and Malaysia in September 2010, and in Korea in November 2010. Emil Chronicle Online is the first online game developed by GungHo, 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 in Japan, which was renewed in August 2010. 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 Thailand and eight other countries and the distribution rights of Emil Chronicle Online in Thailand was subsequently granted to Onenet Co., Ltd., or Onenet, in February 2007. In July 2008, we amended the agreement with Infocomm Asia to cancel its rights to distribute Emil Chronicle Online in the eight countries. In February 2009, we entered into a license and distribution agreement with PT. Wave Wahana Wisesa for distribution of Emil Chronicle Online in Indonesia. We entered into license and distribution agreements for Emil Chronicle Online in Taiwan and Hong Kong with GameCyber Technology Ltd. in August 2007, which was renewed in June 2011. We entered into a license and distribution agreement in Thailand with Onenet in September 2010. We entered into license and distribution


35


Table of Contents

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 a license distribution agreement with Access Bright Limited to distribute Emil Chronicle Online in China and have been conducting closed beta testing of Emil Chronicle Online in China since February 2011. The amount of revenues from Emil Chronicle Online in 2010 represented 1.3% of our total revenues and that in 2009 represented 1.4% of our total revenues.
 
Dragonica (Dragon Saga)
 
Dragonica is a three-dimensional side-scrolling MMORPG. In August 2010, we entered into a publishing agreement with Barunson Interactive, currently Gravity Games, to publish Dragonica in the United States and Canada. We entered into a license and distribution agreement with Gravity Interactive in September 2010 to distribute Dragonica in the United States and Canada and commercially launched Dragonica in the United States and Canada under the name Dragon Saga in October 2010. Dragonica is currently commercially offered in China, Taiwan, Hong Kong, Macau, Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Romania, Slovakia, Slovenia, Sweden, Switzerland, Norway, the United Kingdom, Singapore, Malaysia, the Philippines, Australia, New Zealand, Thailand, Indonesia, Vietnam, Laos, Cambodia, Russia, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, Ukraine, Uzbekistan, Japan, Korea, the United States and Canada. The amount of revenues from Dragonica in 2010 representing revenues arising after our acquisition of Gravity Games on October 21, 2010 represented 1.6% of our total revenues in 2010.
 
R.O.S.E. Online
 
R.O.S.E. Online, which was commercially launched in January 2005, represented 1.2% of our total revenues or Won 604 million (US$550 thousand) in 2010, compared with 1.1% of our total revenues or Won 604 million in 2009.
 
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 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.
 
Canaan
 
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. In January 2010, we entered into a license agreement with Xpec Entertainment Inc., a Taiwanese game developer, to publish Canaan in Korea. We commercially launched Canaan in Korea in October 2010. The amount of revenues from Canaan in 2010 represented less than 1% of our total revenues in 2010.
 
Eternal Destiny
 
Eternal Destiny is a Web browser-based casual MMORPG. In January 2010, we entered into a license agreement with Xpec Entertainment Inc. to publish Chaos Land, the original name of Eternal Destiny, in North America excluding the Canadian province of Quebec, which was amended in December 2010 to change the title of


36


Table of Contents

the game to Eternal Destiny for service in North America. We entered into a license and distribution agreement with Gravity Interactive in January 2011 to distribute Eternal Destiny in North America excluding the Canadian province of Quebec. We conducted open beta testing of Eternal Destiny from March 2011 to April 2011. While we currently expect to commercially launch Eternal Destiny in the third quarter of 2011, no assurance can be given that we will be able to meet our current schedule.
 
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 39 designers, 15 programmers and 10 game planners dedicated to the development of Ragnarok Online II. We conducted open beta testing of Ragnarok Online II from May 2007 to August 2010, a closed beta testing on the upgraded version of the game from August 2010 to September 2010 and a customer satisfaction test called R Care Test in January 2011, and continue to upgrade and develop Ragnarok Online II in response to market feedback received during the testing and development phase. We entered into license and distribution agreements for Ragnarok Online II with six licensees in ten countries, including Thailand, Japan, Taiwan, the Philippines, Singapore, Malaysia, Vietnam, China, Indonesia and Brazil in 2006, 2007 and 2008. We entered into a termination agreement for Ragnarok Online II in Taiwan, Hong Kong and Macau in December 2010 and the license and distribution agreements for Ragnarok Online II in the Philippines, and Brazil were amended in June 2010, and those of Thailand, Singapore and Malaysia were amended in November 2010. As a result of such termination and amendments, the total value of the license and distribution agreements for Ragnarok Online II is US$43,390 thousand as of December 31, 2010. While we currently expect to launch the game in the fourth quarter of 2011, 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 or amendment of more 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.”
 
Da Ming Long Quan (Kun Woong Online)
 
Da Ming Long Quan is a two-dimensional MMORPG. In January 2011, we entered into a license agreement with Shanghai Jiayou Network Technology Co., Ltd., a Chinese game developer, and SL Media & Games Co., Ltd. a Korean game publisher, to publish Da Ming Long Quan. We currently intend to offer the game in Korea under the name Kun Woong Online. While we currently expect to launch the game in the third quarter of 2011, no assurance can be given that we can meet this anticipated launch date.
 
Weapons of the Gods
 
Weapons of the Gods is a three-dimensional MMORPG, based on the storyline and characters from a famous Chinese martial arts comic book series. In September 2010, we entered into a license agreement with Shanghai Nineyou Interactive Community and Media Co., Ltd. and its two affiliated Chinese game developers and publishers, Shanghai Nineshine Information Technology Co., Ltd. and HitNorth International Limited, to publish Weapons of the Gods in Korea. While we currently expect to launch the game in the first quarter of 2012, no assurance can be given that we can meet this anticipated launch date.
 
Finding Neverland Online
 
Finding Neverland Online is a three-dimensional casual MMORPG. In February 2011, we entered into a license agreement with X-Legend Entertainment Co., Ltd., a Taiwanese game developer, to publish Finding Neverland Online in Korea.


37


Table of Contents

East Road (tentative title)
 
East Road is a three-dimensional MMORPG, which is being developed by Gravity Games, in which 50.83% equity interest was acquired by us in October 2010. We entered into an agreement with Gravity Games to publish East Road in Korea and Japan in June 2011.
 
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, H.A.V.E. Online.
 
H.A.V.E. Online (Toy Wars)
 
In April 2010, we entered into a publishing agreement with SK i-media Co., Ltd., an online game developer based in Korea, to publish H.A.V.E. Online, a casual third person shooter game, in Korea and Japan. We entered into a license and distribution agreement with GungHo in August 2010 to distribute H.A.V.E. Online in Japan. We commercially launched H.A.V.E. Online in Japan under the name Toy Wars in March 2011 and have been conducting open beta testing of H.A.V.E. Online in Korea since May 2011.
 
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 and in Korea in March 2010 and June 2010, respectively. Pucca Racing was co-developed by us and Vooz Co., Ltd., which originally designed the Pucca characters. The amount of revenues from Pucca Racing in 2010 and 2009 represented less than 1% of our total revenues in each of 2010 and 2009.
 
Social network games
 
Social network games are simple games that are played on social networking Web sites or on mobile phones. Players typically access social network games through their social network accounts. When players connect to a game, it allows them to invite online friends to join in or facilitate competitions with potentially millions of other players. Currently, we commercially offer two social network games, Fashion Star and Jeweled Planet. We commercially launched Fashion Star and Jeweled Planet on Cyworld, a social network site, in Korea in January 2011 and March 2011, respectively.
 
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.
 
We have released Ragnarok Mobile Story and Ragnarok Violet, both of which are based on Ragnarok Online, in the smartphone game market. Ragnarok Mobile Story, which was originally launched in Japan in March 2010, was released on Google Android in Japan in December 2010. Ragnarok Violet, which was originally launched in Korea and Japan in March 2008 and November 2009, respectively, was released in Apple’s App Store in Japan in April 2011. We have also released some mobile arcade games, such as Jaja: Cheer Dancing!, Graffiti Hero, Piyodamari: Eat Up!, Mashimaro Defence and Bubble Shot Reflect in Apple’s App Store, from the end of 2010.


38


Table of Contents

The following are revenues generated from our mobile business for the periods indicated:
 
                                         
    Year Ended December 31,  
Country
  2008     2009     2010     2010(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
  W 4,573     W 4,931     W 5,274       57.4 %   US$ 4,807  
Japan
    2,309       2,951       3,913       42.6       3,566  
Others
                1       0.0       1  
                                         
Total
  W 6,882     W 7,882     W 9,188       100.0 %   US$ 8,374  
                                         
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
Game-related products and services
 
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 game characters in Korea, Japan and Brazil. We also have an agreement with Game Flier International Corporation to publish game manuals in Taiwan, Hong Kong and Macau. 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.
 
The total amount of license fees from our contracts with Korean vendors was approximately Won 4 million (US$3,000) in 2010, compared with Won 119 million in 2009, and the total amount of license fees from our contracts with overseas vendors was approximately Won 512 million (US$467 thousand) in 2010, compared with Won 798 million in 2009. 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
  2008     2009     2010     2010(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
  W 101     W 119     W 4       0.8 %   US$ 3  
Japan
    975       798       512       97.7       467  
Taiwan/Hong Kong
    17             8       1.5       7  
                                         
Total
  W 1,093     W 917     W 524       100.0 %   US$ 477  
                                         
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
Multiplatform and Internet protocol television games
 
In December 2006, we entered into a licensing agreement with GungHo 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., or Iconix


39


Table of Contents

Entertainment, to develop and publish Pororo Game, an IPTV game based on Iconix Entertainment’s 3D TV animation series “Pororo: The Little Penguin.” We commercially launched Pororo Game in September 2009.
 
The amount of revenues from multiplatform device and IPTV in 2010 represented less than 1% of our total revenues in 2010.
 
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 and represented less than 1% of our total revenues in both 2010 and 2009.
 
OUR MARKETS
 
Japan, Korea, the United States and Canada, Taiwan and Hong Kong/Macau, and Brazil were our biggest geographic markets in 2010 in terms of revenue. Each of these markets is serviced either by us or a distribution company. We directly manage game operations in Korea, except Dragonica, which is offered by NCsoft Corporation. Gravity Interactive, our wholly-owned subsidiary, manages game operations in the United States and Canada. GungHo Online Entertainment, Inc. is our licensee for Ragnarok Online and H.A.V.E. Online in Japan. Game Flier International Corporation is our licensee for Ragnarok Online, Requiem and Dragonica in Taiwan, Hong Kong and Macau. GameCyber Technology Ltd. is our licensee for Emil Chronicle Online in Taiwan and Hong Kong. Level Up! Interactive S.A. is our licensee for Ragnarok Online in Brazil.
 
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, 2010.
 
                                         
    Year Ended December 31,  
Countries
  2008     2009     2010     2010(1)  
    (In millions of Won and thousands of US$, except percentages)  
 
Japan
  W 27,037     W 31,991     W 29,186       55.7 %   US$ 26,599  
Korea
    14,009       11,544       9,737       18.6       8,874  
United States/Canada(2)
    3,620       5,800       4,759       9.1       4,337  
Taiwan/Hong Kong/Macau
    2,301       1,887       2,926       5.6       2,667  
Brazil
    1,006       1,096       1,114       2.1       1,016  
Others
    5,197       5,085       4,640       8.9       4,229  
                                         
Total
  W 53,170     W 57,403     W 52,362       100.0 %   US$ 47,722  
                                         
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(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 includes Australia, New Zealand and India as countries serviced by Gravity Interactive. The license agreement for Requiem with Gravity Interactive includes the United Kingdom and 38 other European countries serviced by Gravity Interactive.


40


Table of Contents

 
Korea
 
In Korea, we commercially launched and began to charge subscribers for Ragnarok Online in August 2002, Emil Chronicle Online in August 2007, which service was terminated in November 2010, Pucca Racing in September 2007, which service was terminated in June 2010, Requiem in October 2007 and Canaan in October 2010. 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 7,800 and 5,600 Internet cafés offered our games in Korea according to our internal data as of December 31, 2010 and 2009, 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 10.8% and 13.4% of our subscription revenues in Korea in 2010 and 2009, respectively.
 
Overseas markets
 
Ragnarok Online is commercially offered in the following 79 overseas countries and markets: Japan, China, Taiwan, Hong Kong, Macau, the United States, Canada, Australia, New Zealand, India, Singapore, Malaysia, Thailand, the Philippines, Indonesia, Brazil, Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine, Uzbekistan, the United Arab Emirates, Saudi Arabia, Jordan, Kuwait, Syria, Bahrain, Qatar, Palestine, Oman, Lebanon, Libya, Sudan, Mauritania, Iraq, Yemen, Iran, Egypt, Algeria, Morocco, Tunisia, France, Belgium, the United Kingdom, Finland, Sweden, Norway, Ireland, Scotland, Denmark, Spain, Austria, Bulgaria, Cyprus, Czech Republic, Germany, Greece, Hungary, Italy, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Switzerland and Turkey. 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; and Gravity EU in France and 27 other European 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
Taiwan/Hong Kong/Macau
  Game Flier International Corporation(1)   May 2002   October 2002   October 2011
Thailand
  AsiaSoft Corporation Public Co., Ltd.   June 2002   March 2003   March 2012
China
  Shengqu Information Technology (Shanghai) Co., Ltd.(2)   July 2005   May 2003   August 2011
Singapore/Malaysia
  Game Flier (Malaysia) Sdn. Bhd.(3)   May 2003   April 2004   October 2011
Philippines
  Level Up! Inc.   March 2003   September 2003   August 2012
Indonesia
  PT. Lyto Datarindo Fortuna   April 2004   November 2003   February 2012
Brazil
  Level Up! Interactive S.A.   August 2004   February 2005   March 2013
Middle East and Africa(4)
  Tahadi Games Ltd.   January 2009   December 2009   December 2012
Russia and CIS countries(5)
  Ingamba LLC(6)   June 2010   March 2007   June 2013
 
 
Notes:
 
(1) Game Flier International Corporation is a subsidiary of Soft-World International Corporation, former licensee in Taiwan and Hong Kong.
 
(2) Shengqu is a wholly-owned subsidiary of Shanda Games Limited.
 
(3) Game Flier (Malaysia) Sdn. Bhd. is a wholly-owned subsidiary of Soft-World International Corporation.


41


Table of Contents

 
(4) Represents MMORPG operations in the 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 20 countries under one license agreement.
 
(5) Represents MMORPG operations in Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan. A single operator services in 15 countries under one license agreement.
 
(6) We own a 25% of equity interest in Ingamba, a joint venture company for online game service in Russia.
 
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 and Indonesia. Requiem is commercially offered in the United States, Canada and 87 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 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 apply the micro-transaction model, in all the countries and markets where Ragnarok Online is serviced except Japan 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, the United States, Canada, Australia, New Zealand, India, the United Arab Emirates, Saudi Arabia, Jordan, Kuwait, Syria, Bahrain, Qatar, Palestine, Oman, Lebanon, Libya, Sudan, Mauritania, Iraq, Yemen, Iran, Egypt, Algeria, Morocco, Tunisia, France, Belgium, the United Kingdom, Finland, Sweden, Norway, Ireland, Scotland, Denmark, Spain, Austria, Bulgaria, Cyprus, Czech Republic, Germany, Greece, Hungary, Italy, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Switzerland and Turkey, we offer Ragnarok Online services with the micro-transaction model only. The amount of revenue generated from micro-transactions as a percentage of revenue per month from each country varies monthly. For example, in 2010, the approximate percentage of revenue derived from micro-transactions accounted for 26.9% of total royalty revenues for Japan, 60.4% of total revenues for the United States and Canada, 82.9% of total royalty revenues for Taiwan, Hong Kong and Macau, 83.8% of total royalty revenues for Thailand, 61.6% of total revenues for Russia and CIS countries and 69.9% of total revenues for Korea where we ceased to apply the subscription-based fee model in November 2010.


42


Table of Contents

Since September 2007, we have been offering premium services as an additional revenue model, where players are offered certain additional features such as the faster accumulation of experience points or higher rates of item drop for additional fees, in Russia and CIS countries, Indonesia, France and 27 other European countries and markets, the Philippines, the United States, Canada, Australia, New Zealand, India. The pricing for Ragnarok Online in Korea and in Japan, the United States and Canada, Taiwan, Hong Kong and Macau, Thailand and China, our principal overseas markets, are set forth below.
 
Korea
 
Individual PC account users 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 to gain access to or purchase game items of Ragnarok Online. Internet café subscribers make payments through credit card or 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 users.
 
Subscription-based fee model
 
We ceased to apply the subscription-based fee model for individual PC users in November 2010 and the subscription-based fee model is currently applied only to Internet cafés in Korea. The following table sets forth our published pricing plans for Internet cafés in Korea for Ragnarok Online access as of December 31, 2010.
 
         
Hours(1)     
  Flat Fee per PC
 
300 hours
  W 69,300  
600 hours
    138,600  
1,000 hours
    231,000  
2,000 hours
    462,000  
 
 
Note:
 
(1) Actual hours may vary depending on additional bonus hours we offer in proportion to hours purchased by the subscriber.
 
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 250 and 20,000. There are certain game items which users can buy only at Internet cafés.
 
Japan
 
GungHo, our licensee in Japan, determines the pricing plan for Ragnarok Online in Japan. A majority of users in Japan typically pay to gain access to or purchase game items of Ragnarok Online with prepaid cards, such as the WebMoney, among others, which can be purchased at convenience stores or retail game outlets, or online. In addition, credit cards are also a popular payment method. Mobile payment, which was introduced in April 2008, is increasingly popular although it cannot be used for the payment of subscription-based fees and can be used only for payment for micro-transaction.
 
Subscription-based fee model
 
Our licensee in Japan offers only one rate for Ragnarok Online and charges JPY1,500 per 30 days of unlimited use.


43


Table of Contents

Micro-transaction model
 
We have applied a micro-transaction model in Japan since December 2006. Game users buy GungHo Shop Points which enable them to buy game items or directly buy game items from the mobile item shop. The range of the game items is between JPY50 and 1,500. The following table sets forth our licensee’s published basic pricing for GungHo Shop Points in Japan as of December 31, 2010.
 
         
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, 2011, the noon buying rate of the Japanese Yens to U.S. dollars quoted by the Federal Reserve Bank of New York was JPY82.76 to US$1.00.
 
The United States and Canada
 
Gravity Interactive, our wholly-owned subsidiary in the United States, determines the pricing plan for Ragnarok Online in the United States and Canada. Users pay through credit cards, wire and/or bank transfers, or mobile payment or online payment systems such as PayPal. Gravity Interactive ceased to apply the subscription-based fee model in April 2011.
 
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 in the price range between US$0.05 and US$20. The following table sets forth our licensee’s published basic pricing for points of Ragnarok Online in the United States and Canada as of April 7, 2011:
 
         
Points     
  Retail Price
 
1,100 points
  US$ 10.00  
1,650 points
    15.00  
2,875 points
    25.00  
4,600 points
    40.00  
6,000 points
    50.00  
9,000 points
    75.00  
12,000 points
    100.00  
 
VIP Service fee model
 
Although Ragnarok Online is offered based on micro-transaction model in the United States and Canada, the VIP Service fee model, a premium service model, was introduced in April 2011 to provide users with enhanced game play as an option. The following table sets forth Gravity Interactive’s published basic pricing for VIP Service for Ragnarok Online in the United States and Canada as of April 7, 2011:
 
         
Days     
  Retail Price
 
30 days
  US$ 7.00  
90 days
    19.00  
180 days
    33.50  


44


Table of Contents

Taiwan, Hong Kong and Macau
 
Game Flier International Corporation, our licensee in Taiwan, Hong Kong and Macau, determines the pricing plan for Ragnarok Online in Taiwan, Hong Kong and Macau. In Taiwan, Hong Kong and Macau, most users purchase prepaid debit point cards to gain access to or purchase game items of Ragnarok Online. The prepaid cards can be purchased online, by mobile or landline phones, or at convenience stores, Internet cafés and at other locations. Our licensee in Taiwan, Hong Kong and Macau, Game Flier International Corporation, offers the My Card, on which customers can charge GF Points or days which can be used for any games our licensee publishes. Users of Ragnarok Online in Taiwan, Hong Kong and Macau can convert the GF Points on the My Cards to Ragnarok Points.
 
The following table sets forth our licensee’s published basic pricing for the My Card in Taiwan as of December 31, 2010:
 
         
Points(1) or Days 
  Retail Price(2)
 
150 points
  NT$ 150  
350 points or 30 days
    350  
400 points
    400  
450 points
    450  
500 points
    500  
1,000 points
    1,000  
 
The following table sets forth our licensee’s published basic pricing for the My Card in Hong Kong as of December 31, 2010:
 
         
Points(1) or Days 
  Retail Price(3)
 
50 points
  HK$ 14  
150 points
    40  
300 points
    80  
350 points or 30 days
    93  
400 points
    106  
450 points
    120  
1,000 points
    265  
1,150 points
    305  
2,000 points
    530  
 
 
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. Users of NT$350 or HK$93 My Card may choose between 350 points and 30 days.
 
(2) For your reference only, as of March 31, 2011, the noon buying rate of NT dollars to U.S. dollars quoted by the Federal Reserve Bank of New York was NT$29.40 to US$1.00.
 
(3) For your reference only, as of March 31, 2011, the noon buying rate of Hong Kong dollars to U.S. dollars quoted by the Federal Reserve Bank of New York was HK$7.775 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 game items with Ragnarok Points. 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 items, the prices of which are based on NT dollars.


45


Table of Contents

Thailand
 
Our licensee in Thailand, AsiaSoft Corporation Public Co., Ltd., permits users to gain access to or purchase game items of 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, 2010:
 
                 
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, 2011, the noon buying rate of the Thai Bahts to U.S. dollars quoted by the Federal Reserve Bank of New York was THB30.24 to US$1.00.
 
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 900.
 
China
 
A majority of Ragnarok Online players in China purchase Shanda Points from our China licensee, Shengqu Information Technology (Shanghai) Co., Ltd., a wholly-owned subsidiary of Shanda Games Limited, to gain access to or purchase game items of Ragnarok Online. Game users can choose between buying hours or days to play with Shanda Points and changing them into Ragnarok Points to buy game items. Most users purchase and charge their Shanda Points by credit cards, prepaid debit point cards and bank transfers through the Web site of an affiliate of our licensee. Mobile phone payment is also increasingly becoming a popular payment method in China.
 
The following table sets forth our licensee’s published basic pricing for Shanda Points in China as of December 31, 2010:
 
                 
Points 
  Hours or Days   Retail Price(1)
 
500 points
    10 hours       CNY 5  
1,000 points
    25 hours       10  
1,500 points
    7 days       15  
3,000 points
    75 hours       30  
4,500 points
    30 days       45  
 
Our licensee in China also offers the Shanda Point Card, a prepaid debit point card, on which players can charge Shanda Points, hours or days which can be used for any games our licensee publishes, including Ragnarok Online, which users can purchase at Internet cafés or newsstands.


46


Table of Contents

The following table sets forth our licensee’s published basic pricing for the Shanda Point Card in China as of December 31, 2010:
 
                 
Points 
  Hours or Days   Retail Price(1)
 
3,000 points
    75 hours       CNY30  
4,500 points
    30 days       45  
 
 
Note:
 
(1) For your reference only, as of March 31, 2011, the noon buying rate of Chinese Yuan to U.S. dollars quoted by the Federal Reserve Bank of New York was CNY6.5483 to US$1.00.
 
Micro-transaction model
 
We have applied a micro-transaction model in China since January 2007. Game users buy game items with Ragnarok Points. 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 and social network games in operation or under development. As of March 31, 2011, we employed a total of 227 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 two MMORPGs, Ragnarok Online II and another MMORPG with a tentative title of East Road, under in-house development.
 
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


47


Table of Contents

  projections and formulate a preliminary game operating plan. We then begin commercial negotiations with the developer.
 
  •  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 publishing department takes lead in conducting preliminary screenings to select games for potential distribution and commercial negotiations process. The games initially screened by our publishing department are additionally evaluated or tested by other teams, such as the marketing 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, four 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 1,853 million (US$1,689 thousand) on advertising and promotions in 2010, compared with Won 1,137 million in 2009.
 
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 15 in-game events for Ragnarok Online users in 2010, compared with 17 such in-game events in 2009. In October 2010, we co-hosted in Jakarta, Indonesia, with PT. Lyto Datarindo Fortuna, our licensee in Indonesia, the Ragnarok World Championship, an offline competition event with approximately 88 active participants, comprised of our game users and representatives from 11 teams representing 17 countries and approximately 30 representatives of our 10 licensees. The event was visited by approximately 8,000 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, our licensee in Japan, hosted the GungHo Conference in 2010, where the invited users of Ragnarok Online shared 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


48


Table of Contents

been an annual event since 2005 and its 2010 event was attended by approximately 6,500 visitors. In addition, GungHo sells DVD and memorial package of Ragnarok Online software to commemorate Ragnarok Online Japan Championship every year. Level Up! Inc., our licensee in the Philippines, and PT. Lyto Datarindo Fortuna, our licensee in Indonesia, 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 events annually to celebrate anniversaries of Ragnarok Online game service in Thailand since 2004, and AsiaSoft All Star Battle, which includes Ragnarok Online Thailand Championship and other promotional events since 2009. In addition, from time to time our overseas subsidiaries and licensees also market our games through sponsoring promotional events jointly with other local game publishers or participating in expositions or other events for online games in order to reach a broader local audience. For example, in July 2010, Gravity EU, our subsidiary in France, participated in Le Mondial du Jeu Vidéo, an annual international video game event held in Paris, where our game masters showed the visitors how to play Ragnarok Online and some other promotional events such as Ragnarok Online tournaments were held.
 
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 March 31, 2011, 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, 37 employees were members of our domestic customer service team and 52 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, 2011, our server network for our game operations in Korea and global service of Requiem (in Thailand, Vietnam, Singapore, Malaysia, Indonesia and the Philippines) consisted of a total of 713 servers.


49


Table of Contents

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 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 E&M Corporation, or CJ E&M, 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, 2011, 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 E&M 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. The leading companies in the market for casual online games include Nexon, which developed Maple Story and Kart Rider. The leading providers of portal-based online games in Korea are NHN Corporation, operating under the brand portal of Hangame, CJ E&M, operating under the brand portal of NetMarble, and Neowiz Games Corporation, operating under the brand portal of Pmang.


50


Table of Contents

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 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 XIV, an online game, as part of its Final Fantasy series in September 2010 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. Recently, social network games, such as Farmville, the popular farming game on Facebook from Zynga Inc., are gaining global popularity as users play such games with other users through popular social network sites.
 
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. In November 2010, Microsoft released Kinect, a motion-sensing device, which plugs into the Xbox360 and allows people to play games without the conventional controller. 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. The latest version of DS, 3DS, which allows users to play three-dimensional games without special glasses, was released in February 2011. Sony Computer Entertainment’s PSP Go, which was released in October 2009, allows user to play games downloaded from Sony’s online marketplace.
 
In addition, games for smartphones, such as Apple’s iPhone and Android-based smartphones, and tablet computers, such as Apple’s iPad or Android-based Samsung’s Galaxy Tab, are surging in popularity and competing with portable devices made solely for playing games. The Apple and Android device users can access a number of videogames available for download at Apple’s App Store or Google’s Android Market, respectively.
 
Competition in the 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.”


51


Table of Contents

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 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, Requiem, Arcturus, Pucca Racing and W Baseball, each of which has been registered with the Korea Copyright Commission. We no longer commercially offer Arcturus, a PC-based, stand-alone game, nor Pucca Racing, and have decided to cease commercialization of W Baseball. As of March 31, 2011, we owned over 63 registered domain names, including our official Web site and domain names registered in connection with each of the games we offer. We had 880 registered discrete trademarks at patent and trademark offices in 46 countries as of March 31, 2011. We had three design patents, two analogous design patents, which are variations of the two design patents, registered with the Korea Intellectual Property Office, registered copyrights covering 11 game characters, five online game business model patents and four patents pending with the Korea Intellectual Property Office, in each case as of March 31, 2011.
 
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 is 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,


52


Table of Contents

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. Fashion Star and Jeweled Planet have been classified as “suitable for users of all ages.” Ragnarok Online, Emil Chronicle Online, Canaan and Ragnarok Online II have been classified as “suitable for users 12 years of age or older.” H.A.V.E. Online has been classified as “suitable for users 12 years of age or older” or “suitable for users 15 years of age or older” depending on the version of the game, and a suitable version is automatically chosen when a user log on to the game, according to the registered user’s age. 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 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


53


Table of Contents

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 a.m. 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.
 
Currently there are proposed amendments to the Act on Promotion of Game Industry, which (i) as part of aggressive efforts to address the issue of game addiction, call for an establishment and management of a treatment center for excessive gaming and for the imposition and collection of mandatory contributions from large game companies meeting a certain criteria to set up a fund for the treatment of excessive gaming by users, (ii) require game companies to take precautionary measures against excessive gaming, such as securing parental consent when signing up for online games. The proposed amendments also seek to grant authority to the Minister of Culture, Sports, and Tourism to impose a reporting requirement for such precautionary measures and to request cooperation from the Minister of Education, Science, and Technology to include educational materials on the proper use of games in the curricula of elementary, middle, and high schools. However, it remains to be seen whether such amendments would pass the vote in the National Assembly.
 
In addition, a system to regulate the hours of gaming by minors was newly established as part of the Juvenile Protection Act on May 19, 2011, which will go into effect on November 20, 2011. Under the new system, online game providers may not provide online games to minors under the age of 16 from midnight to 6:00 a.m., and any provider violating this regulation is subject to imprisonment for no more than 2 years or a penalty not exceeding Won 10 million. As part of the same amendment, provisions for the prevention, consultation and treatment, and rehabilitation services for online game addiction suffered by minors have also been added.
 
Recently in the global online and mobile game industry, there has been growth in the open markets in which small contents developers and individual contents producers directly supply their programs to consumers. However, under current law, games can be distributed only after being rated by the Game Rating Board, and this has impeded the development of the open market in Korea. In addition, some games, especially those that permit betting, are causing social problems as speculative operating methods illegal automatic playing programs which allow players to cheat and acquire game money or game items are being developed. However, existing laws do not provide sufficient grounds to regulate such situations.
 
In response, on April 5, 2011, the Act on Promotion of the Game Industry was amended. The amendment provides that all games that cannot receive prior rating by the Game Rating Board due to special circumstances in their production and distribution channels should be subject to the distributors’ own rating. The Act also provides grounds for sanctioning speculative operating methods and the undermining of fair gaming through illegal programs, among others. The amendment is scheduled to go into effect on July 6, 2011. In addition, consistent with a recent decision by the Constitutional Court on dual punishment, the amendment also includes a revised provision which stipulates that if an employer fulfills her duty of care as a manager and supervisor of her employees, she can be exempt from punishment.
 
The main contents of the Act on Promotion of the Game Industry as amended on April 5, 2011 and the pending amendment to the Enforcement Decree of the same Act are as follows:
 
(1) Games which are inappropriate for prior rating by the Game Rating Board due to special circumstances in their production and distribution channels, excepting games unsuitable for minors, may be rated by distributors or others involved in the distribution channel at their discretion according to the standards predetermined upon consultation with the Game Rating Board. According to Article 11-4 of the pending Amendment to the Enforcement Decree of the Act on Promotion of the Game Industry, games should fulfill the following requirements in order


54


Table of Contents

to be considered being “inappropriate for prior rating by the Game Rating Board”: (i) games provided through telecommunications technologies such as a telecommunications network, (ii) games provided through enterprises in the business of brokering easy registration and supply of games by manufacturers to the public, (iii) games provided through means of mobile terminals, etc., of which use is identifiable by each user, (iv) games supplied or distributed after self-rating according to the standards predetermined upon consultation with the Game Rating Board.
 
(2) Game-related companies are prohibited from encouraging speculation by using operating methods, devices or machines closely related to the realization of game contents, and any person violating this provision is subject to corrective recommendation or corrective order imposed by the Minister of Culture, Sports, and Tourism.
 
(3) The act of distributing or manufacturing for distribution computer programs, devices or machines not provided or approved by game-related enterprises for the purpose of interrupting the normal operation of games is prohibited, and any person violating the foregoing is subject to imprisonment for no more than one year or penalty not exceeding Won 10 million.
 
(4) In order to realize the principle of responsibility in the dual punishment provision, if an employer fulfills her duty of care as a manager and supervisor with respect to her employees, the employer may be exempt from punishment (proviso in Article 47 of the Act on Promotion of the Game).
 
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.


55


Table of Contents

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.
 
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 amendment sets forth rules for (i) designating institutions providing identity authentication services and for discontinuing and closing authentication services in order to safely and efficiently authenticate identities, (ii) suspending identity authentication services or canceling designation as an identity authentication institution in the event that an institution obtains designation through false or other deceptive methods, (iii) separating the process of obtaining consent to share personal information and the process of obtaining consent to consignment of transaction from the process of signing-up for membership, and (iv) notification requirements by telecommunications billing service providers, instead of the previous practice of referring to a Presidential Decree.
 
The Personal Information Protection Act
 
The Personal Information Protection Act was enacted on March 29, 2011 and will go into effect on September 30, 2011. The scope of the Personal Information Protection Act covers anyone dealing with personal information in the private and public sectors.
 
If a person’s personal information is collected or used, or provided to a third person, such person’s consent should be obtained, and if personal information is no longer necessary upon achievement of the purpose of the collection and use of personal information, such information should be immediately destroyed.
 
Any transaction requiring identifiers granted by law for identification purposes, such as the resident registration number, is generally prohibited, and exceptions are recognized on a restrictive basis only if consent is obtained or if required by law. In addition, any person dealing with personal information as determined pursuant to the Presidential Decree, for instance, such as signing up for a Web site, should provide methods other than using the resident registration number.
 
In the event of a personal information leak, the processor of personal information should promptly notify the affected person after discovering such incident. If the volume of the leak of personal information exceeds a certain number, the processor of personal information should report the incident to the authorities and take necessary measures to minimize damages.
 
In addition, the same amendment grants to each individual the right to request perusal, the right to request correction or deletion, and the right to request suspension of process with respect to one’s personal information, and also provides the methods to exercise such rights.


56


Table of Contents

To promote prompt and fair settlement of disputes concerning personal information, the same amendment also provides that a Personal Information Dispute Settlement Board, or PIDSB, should be established and the PIDSB’s decision, if accepted by the disputing parties, should have the same legal effect as settlement by trial. In consideration of the fact that most identity theft cases are large in scale and small in the amount of monetary damages, the amendment adopts a collective dispute settlement system. A class action system for personal information has been adopted, but in order to prevent frivolous class action suits, litigants are required to go through the collective dispute settlement system prior to bringing a class action and cases are limited to those seeking suspension or injunctive relief.
 
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, formerly known as the Ministry for Health, Welfare and Family Affairs, or the MIHWAF, 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 minors 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 or utilization, to minors. A person in violation may be punished by imprisonment for a maximum of three years or by a fine not exceeding Won 20 million.


57


Table of Contents

On March 4, 2009, the MIHWAF issued a public notice announcing that “Web sites for trading items” are considered “harmful mass media” to minors based on the findings of Juvenile Protection Commission that such Web sites for trading online game items are likely to encourage gambling and speculation and negatively influence juveniles. In the public notice, the MIHWAF prohibited any person under the age of 19 from visiting a Web site 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 minors, 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 the MIHWAF seeking cancellation of the 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 minors.”
 
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, minors account for a significant percentage of online game users. As they are now prohibited from trading items on Web sites, 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 Juvenile Protection Act was partially amended on May 19, 2011 and will go into effect on November 20, 2011. Under the amendment, online game providers may not provide online games to minors under the age of 16 late at night (specifically, from midnight until 6:00 a.m.) and any provider violating the provision is subject to imprisonment for no more than 2 years and a penalty not exceeding 10 million won.
 
Furthermore, the amendment provides that the Minister of Gender Equality and Family or the MOGEF, in consultation with the Minister of Culture, Sports, and Tourism, should revisit the guidelines every two years to evaluate the appropriateness of the scope of games subject to the late-night restriction and to take measures for improvement, and, with respect to minors suffering from online game addiction, the MOGEF may also provide services for prevention, consultation, treatment and rehabilitation.
 
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 2008, 2009 and 2010 was 27.5%, 24.2% and 24.2%, respectively. Beginning in 2012, we will be subject to a 22% tax rate due to an amendment to the Corporate Tax Law of Korea. 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 and as last amended on December 7, 2010, the ROC Ministry of Economic Affairs promulgated a model


58


Table of Contents

consumer contract that online game companies are encouraged to adopt and on December 13, 2007 and as last amended on December 2, 2010, 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, to terminate the contract without cause at anytime and claim for the unused fees after deduction of necessary costs, as well as obligation of online game company to remark the rating of games in accordance with the Regulations for the Rating of Computer Software. 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 uncertain 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, New Taipei City, Taoyuan County, Tainan City, Nantou County, Lienchiang 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


59


Table of Contents

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 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. On May 26, 2010, the amendments to the Computer-Processed Personal Data Protection Act have been passed by the Legislative Yuan; however, certain amended articles are not yet effective and the effective date of such articles will be further determined by the Executive Yuan. There can be no assurance when the Executive Yuan will determine the effective date of such provision. Once those articles become effective, an Internet content provider, or ICP, may be subject to this Act as long as it, among others, collects, processes, uses and/or transmits personal data.
 
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


60


Table of Contents

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 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 (dated September 24, 2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 p.m. and 8:00 p.m. on Monday to Friday; and between 10:00 a.m. and 8:00 p.m. 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 p.m. and 10:00 p.m. on Monday to Friday; and between 10:00 a.m. and 10:00 p.m. 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 (dated September 24, 2009), users under 15 years of age can enter game shops and Internet cafés between 2:00 p.m. and 8:00 p.m. on Monday to Friday; and between 10:00 a.m. and 8:00 p.m. 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 p.m. and 10:00 p.m. on Monday to Friday; and between 10:00 a.m. and 10:00 p.m. on public holidays or during an educational term break as prescribed by the competent registrar.


61


Table of Contents

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 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 provincial counterparts of 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


62


Table of Contents

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.
 
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.
 
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 and promotion 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.
 
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. According to the Tentative Measures Concerning Online Games Administration promulgated by the Ministry of Culture on June 3, 2010, if the operator of an imported online game changed, the new operator needs to re-apply for a new 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 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


63


Table of Contents

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 severe 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. Since March 1, 2011, the Ministry of Culture and seven other authorities jointly launched a parent guardianship project for purposes of protecting minors from addiction to online games. Under the parent guardianship project rules, online game operators shall impose restrictions on and take other various measures with respect to the online game accounts held by minors based on the requirements from and communications with the parents, including restrictions on the length or periods of time during which the minors may play online games or, in certain cases, a complete prohibition. The online game operators are required to establish responsive and effective measures and make quarterly reports to local culture administrative authorities.
 
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.


64


Table of Contents

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 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 and Dragon Saga are 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.


65


Table of Contents

For example, 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. Other States have enacted laws that require the posting of signs providing information about ESRB ratings. To date, laws that regulate the sale of video games based on content, when challenged, have been declared unconstitutional. Most prominently, a federal appellate court in 2009 upheld a lower court’s decision to declare unconstitutional a California law that imposes fines on retailers that sell or rent certain violent video games to minors. The United States Supreme Court heard California’s appeal of that ruling in November 2010 and a decision is expected in the early summer months of 2011.
 
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, then the sales, advertising and labeling practices regarding such titles could be affected as producers could be required to alter the content of such video games and local legislators could introduce or re-introduce content-based regulation of video games.
 
Irrespective of any laws or industry guidelines, U.S. retailers have become more reluctant to sell “M” rated video games to minors. The FTC issues periodic marketing reports and in its most recent report to Congress in 2009, the FTC reported that 20% of underage “undercover shoppers” were able to purchase “M” rated video games. An undercover survey in 2010-11, however, showed a statistically significant improvement with only 13% of underage shoppers being allowed to purchase “M” rated 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


66


Table of Contents

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 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.


67


Table of Contents

ITEM 4.C.   ORGANIZATIONAL STRUCTURE
 
The following is our organizational structure as of March 31, 2011:
 
(CHART)
 
 
Note:
 
(1) Gravity Middle East & Africa FZ-LLC went into liquidation proceedings in the United Arab Emirates in September 2008.
 
ITEM 4.D.   PROPERTY, PLANTS AND EQUIPMENT
 
As of December 31, 2010, our property and equipment mainly consisted of (i) game engines, (ii) network servers and (iii) personal computers and (iv) software purchased externally. As of December 31, 2010, the net book value of our property and equipment was Won 2,672 million (US$2,435 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 2,067 million (US$1,884 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$60 thousand). The offices of Gravity Games, our 50.83% owned subsidiary, are located at Nuritkum Square R&D Tower 14F, 1605 Sangam-Dong, Mapo-Gu, Seoul 121-795 Korea. Gravity Games currently occupies 6,066 square feet of office space, subleased from us. The annual lease payment amounts to Won 120 million (US$109 thousand). We believe that the existing facilities of Gravity, NeoCyon and Gravity Games 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$442 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.


68


Table of Contents

France
 
The offices of Gravity EU, our wholly-owned subsidiary in France, are located at Tour Areva 30th Floor, 1 Place Jean Millier 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 EUR53 thousand (US$75 thousand). For convenience only, the Euro amounts are expressed in U.S. dollars at the rate of EUR0.71 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, 2011. 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.
 
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 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, Taiwan, Brazil, the Philippines, Indonesia, Singapore, Malaysia, Thailand and Russia 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.
 
In 2009, our revenues increased by 8.0% to Won 57,403 from Won 53,170 million in 2008. In 2010, our revenues decreased by 8.8% to Won 52,362 million (US$47,722 thousand) from Won 57,403 million in 2009. We recorded a net income of Won 3,730 million (US$3,398 thousand) in 2010 as compared to a net income of Won 6,917 million in 2009 and a net loss of Won 2,773 million in 2008. Our gross profit margin increased from 47.8% in 2008 to 63.1% in 2009, but decreased to 60.1% in 2010. Our operating margin also increased from negative 0.4% in 2008 to 18.9% in 2009 but decreased to 11.3% in 2010. 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. The decrease in revenues in 2010 was primarily due to decreased royalties and license fees of Ragnarok Online in Japan and decreased subscription revenues of Ragnarok Online in Korea, the United States and Canada, mainly attributable to Ragnarok Online having reached maturity in such markets. The decrease in subscription revenues of Requiem in Korea, the United States and Canada also contributed to the decrease in overall revenues. Our cost of revenues for 2010 decreased as compared to 2009 primarily due to the decrease in cost of goods sold, amortization on intangible assets and rent expenses. The decrease in cost of goods sold resulted from decreased sales of goods, which consisted primarily of sales of peripheral products for mobile phones by NeoCyon in 2010. Our revenue trend will continue to be materially affected in the future by the popularity of online games introduced by our competitors.
 
Revenues were Won 604 million (US$550 thousand) for R.O.S.E. Online, Won 671 million (US$611 thousand) for Emil Chronicle Online and Won 2,182 million (US$1,987 thousand) for Requiem in 2010 and Won 604 million, Won 814 million and Won 2,838 million in 2009, respectively. We recorded no revenues for Pucca Racing and ceased offering commercial service of the game in June 2010. In October 2010, we commercially launched Canaan,


69


Table of Contents

a Web browser-based casual MMORPG. We acquired Barunson Interactive Corporation, or Barunson Interactive, currently Gravity Games Corporation, or Gravity Games, the developer of Dragonica, on October 21, 2010 and the revenues from Dragonica have been included in our revenues since such date. Revenues were Won 6 million (US$5 thousand) for Canaan, and Won 824 million (US$751 thousand) for Dragonica in 2010.
 
Our corporate income tax rate in 2010 was 24.2%. See ITEM 4.B. “BUSINESS OVERVIEW — LAWS AND REGULATIONS — Korea — The Special Tax Treatment Control Law.”
 
Acquisitions of the investment in Barunson Interactive Corporation
 
In October 2010, we acquired an aggregate of 50.83% of the voting common shares of Barunson Interactive for a purchase price of Won 11,688 million (US$10,652 thousand) in cash.
 
The acquisition was accounted for as a purchase. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. Barunson Interactive’s results of operations are included in our consolidated financial statements from the date of acquisition. The excess amount of the purchase price over the fair market value of the net assets acquired is accounted for as goodwill. We believe the resulting amount of goodwill reflects its expectations of the synergistic benefits of being able to leverage Barunson Interactive’s MMORPG service with our services to provide a wide variety of game titles to our network user base.
 
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;
 
  •  mobile games; and
 
  •  character merchandising, animation and other revenue.
 
Online games — subscription revenue
 
Subscription revenues are from micro-transaction, except in Korea where we also generate subscription fees from Internet cafés. 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 three 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 licensees’ revenues from our games. Royalty revenues are recognized on a monthly basis after the licensee confirms its revenues based on the licensee’s sales from our games during the month. Our licensees’ sales consist of revenues from subscription fees and micro-transaction, except in Russia and CIS countries, the United Arab Emirates and 19


70


Table of Contents

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 China where such payments are received up to 60 days after the end of each month.
 
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.
 
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
  2008     2009     2010  
    (In millions of Korean Won and percentages)  
 
Online games-subscription revenue
  W 12,576       23.7 %   W 12,674       22.1 %   W 9,908       18.9 %
Online games-royalties and license fees
    30,110       56.6       34,037       59.3       32,132       61.4  
Mobile games
    6,882       12.9       7,882       13.7       9,188       17.5  
Character merchandising, animation and other revenue
    3,602       6.8       2,810       4.9       1,134       2.2  
                                                 
Total
  W 53,170       100.0 %   W 57,403       100.0 %   W 52,362       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 497 million for 2009 and Won 446 million (US$406 thousand) for 2010. This agreement expires in January 2033.


71


Table of Contents

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 32 million (US$29 thousand) in 2010 as compared to Won 41 million in 2009 and Won 31 million in 2008.
 
Foreign currency effects
 
In 2010, 81.4% 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 overseas subsidiaries and 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 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 United States 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 China, where such payment could be received up to 60 days after the end of each month) 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, 2010, 2009 and 2008, 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 4,207 million (US$3,835 thousand) in 2010, as compared to Won 4,544 million in 2009 and Won 3,379 million in 2008.
 
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


72


Table of Contents

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 ASC 605, 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 the 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.
 
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 1.8% 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. 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. The Company continually evaluates the reasonableness of the economic life of the capitalized software development costs based on the average life cycle of the games whenever each new game is commercially launched or acquired. 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 operating expenses 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.


73


Table of Contents

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 a business combination. As of December 31, 2010, the carrying value of goodwill for each reporting unit, NeoCyon and Gravity Games, are Won 1,210 million (US$1,103 thousand) and Won 6,781 million (US$6,180 thousand), respectively.
 
Goodwill is accounted for under ASC 350, Intangibles — Goodwill and Other, 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 goodwill impairment test is carried out at the reporting unit, which is either an operating division or a subdivision, for which stand-alone financial information is available to the management personnel of such division or subdivision for evaluating operating results.
 
We performed our annual impairment test for goodwill at all of our reporting units using data as of December 31, 2010. 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 and Gravity Games 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.
 
Assets and liabilities that make up the reporting unit of NeoCyon has not changed significantly since the 2009 impairment test. The fair value determination completed in 2009 for the reporting unit resulted in amounts that exceeded the carrying amount by a substantial margin. The likelihood that a current fair value determination would be less than the carrying amount of the reporting unit is remote based on analysis of events that have occurred since the fair value assessment was completed in 2009.
 
In October 2010, we acquired an aggregate of 50.83% of the voting common shares of Gravity Games for a purchase price of Won 11,688 million in cash. The excess amount of the purchase price over the fair market value of the net assets acquired is accounted for as goodwill. Assets and liabilities that make up the reporting unit of Gravity Games and the fair value of the reporting unit has not changed significantly since the acquisition date. The actual business performance of the reporting unit for two months after the acquisition was in line with our expectations as compared with our forecast at the acquisition date, which indicated that the fair value of the reporting unit exceed its book value as of December 31, 2010.
 
In performing the annual impairment test in 2009 for goodwill for Gravity CIS Co., Ltd., the fair 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 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. We believe that the estimates of future cash flows and fair value used in the goodwill impairment tests are reasonable; however, in the future, changes in estimates resulting in lower than currently anticipated cash flows and fair value due to unforeseen changes in business assumptions could negatively affect the valuations, which may


74


Table of Contents

result in us recognizing impairment charges for goodwill and other intangible assets in the future. In order to evaluate the sensitivity of the fair value calculations on the impairment analysis performed for the fiscal year ended December 31, 2010, we applied a hypothetical five percent decrease to the fair value of each reporting unit. We believe that plus or minus five percentage difference in cash flow projections or discount rate used would not result in a failure of step one of the goodwill impairment test.
 
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.
 
Fair value measurement on financial instruments
 
We adopted ASC 825, Financial Instruments. 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, 2010. 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, 2010.
 
Short-term available for sale securities are the investment in Equity-Linked Securities fund which represents equity interests in a fund that is comprised of bonds and trust funds as of December 31, 2010. 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. 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, 2010, we have concluded that net deferred tax assets of Gravity and its subsidiaries except NeoCyon and Gravity Games 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, 2010 were calculated based on the rate of 24.2% for fiscal years 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 2010 through 2011 and 22% for the fiscal year 2012 and thereafter. See ITEM 5.A. “OPERATING RESULTS — OVERVIEW.”


75


Table of Contents

Recent accounting pronouncements
 
In October 2009, the FASB issued Accounting Standards Update No. 2009-13, or ASU 2009-13, Revenue Recognition (Topic 605) — Multiple-Deliverable Revenue Arrangements. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The amendments of this update will replace the term “fair value” in the revenue allocation guidance with “selling price” to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. The amendments of this update will eliminate the residual method of allocation and require that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. The amendments in this update will require that a vendor determine its best estimated selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. This standard is effective for the Company’s revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company will evaluate the impact of this standard on the Company’s financial statements when reviewing its new or materially modified revenue arrangements with multiple deliverables when it becomes applicable.
 
In January 2010, the FASB issued 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, 2009 for financial and nonfinancial assets and liabilities. 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 any impact on the Company’s financial condition or results of operations, or cash flows, at its requirements only pertain to financial statement footnote disclosure.
 
In February 2010, the FASB issued ASU 2010-09, Subsequent Events (Topic 855) — Amendments to Certain Recognition and Disclosure Requirements, which amends ASC 855, Subsequent Events, so that SEC filers, as defined in the ASU, no longer are required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. The Company adopted the amendments effective immediately, and the adoption did not impact the Company’s financial condition and results of operations.
 
In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging (Topic 815) — Scope Exception Related to Embedded Credit Derivatives, to clarify how embedded credit-derivative features should be analyzed to determine whether those features should be accounted for separately. The FASB intended that an embedded credit-derivative feature related to subordination would always meet the embedded credit-derivative scope exception, excluding circumstances where a holder of an interest in a tranche of a securitized financial instrument may be required to make additional payments to the issuing entity. The amendments in this ASU are effective for each reporting entity at the beginning of its first fiscal quarter beginning after June 15, 2010. The Company adopted the amendments effective immediately, and the adoption did not impact the Company’s financial condition and results of operations.
 
In December 2010, the FASB issued ASU 2010-28, when to perform step 2 of the goodwill impairment test for reporting units with zero or negative carrying amounts (a consensus of the FASB Emerging Issues Task Force). The ASU modifies step 1 of the goodwill impairment test under ASC 350, Intangibles — Goodwill and Other, for reporting units with zero or negative carrying amounts to require an entity to perform step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists and whether an interim goodwill impairment test between annual test dates is necessary, an entity should consider whether there are adverse qualitative factors, including the examples provided in ASC paragraph 350-20-35-30, in determining whether an interim goodwill impairment test between annual test dates is necessary. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010, for a public entity. The Company is currently assessing the potential impact of the guidance.


76


Table of Contents

In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that if a public company presents comparative financial statements, the entity should only disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period. ASU 2010-29 is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010, with early adoption permitted. The Company early adopted this amendments as of January 1, 2010, however, the adoption of ASU 2010-29 did not impact our financial position, results of operations, or cash flows, as its requirements only pertain to financial statement footnote disclosure.
 
RESULTS OF OPERATIONS: 2010 COMPARED TO 2009
 
The following table summarizes our results of operations for the periods indicated.
 
                                 
    Year Ended December 31,  
    2009     2010     2010(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$
 
    except for percentages)  
 
Revenues:
                               
Online games — subscription revenue
  W 12,674     W 9,908     US$ 9,030       (21.8 )%
Online games — royalties and license fees
    34,037       32,132       29,284       (5.6 )
Mobile games
    7,882       9,188       8,374       16.6  
Character merchandising, animation and other revenue
    2,810       1,134       1,034       (59.6 )
                                 
Total net revenue
    57,403       52,362       47,722       (8.8 )
Cost of revenue
    21,170       20,873       19,023       (1.4 )
                                 
Gross profit
    36,233       31,489       28,699       (13.1 )
Gross profit margin(2)
    63.1 %     60.1 %     60.1 %        
Operating expenses:
                               
Selling, general and administrative
    21,651       20,422       18,612       (5.7 )
Research and development
    1,799       4,652       4,240       158.6  
Impairment losses on intangible assets
    280       475       433       69.6  
Settlement cost of litigation
    1,649                   N/M  
                                 
Total operating expenses
    25,379       25,549       23,285       0.7  
Operating income
    10,854       5,940       5,414       (45.3 )
Operating profit margin(3)
    18.9 %     11.3 %     11.3 %        
Other income (expenses):
                               
Interest income
    2,395       1,946       1,774       (18.7 )
Interest expense
    (41 )     (32 )     (29 )     (22.0 )
Foreign currency income (losses), net
    (225 )     96       87       N/M  
Others, net
    (21 )     312       283       N/M  
                                 
Total net other income
    2,108       2,322       2,115       10.2  
Income before income tax expenses and equity loss on investments
    12,962       8,262       7,529       (36.3 )
Income tax expenses
    4,544       4,207       3,835       (7.4 )
                                 
Income before equity loss on investments
    8,418       4,055       3,694       (51.8 )
Equity loss on investments, net(4)
    (1,424 )     (345 )     (314 )     (75.8 )
                                 


77


Table of Contents

                                 
    Year Ended December 31,  
    2009     2010     2010(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$
 
    except for percentages)  
 
Net income
    6,994       3,710       3,380       (47.0 )
LESS: Net income (loss) attributable to the non-controlling interest(5)
    77       (20 )     (18 )     N/M  
                                 
Net income attributable to parent company
  W 6,917     W 3,730     US$ 3,398       (46.1 )%
                                 
 
N/M = not meaningful
 
 
Notes:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
(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 by total net revenues for each period.
 
(4) Represents the losses from our 16.39% equity investment in Online Game Revolution Fund No. 1 and the income from our 25% equity investment in Ingamba. These investments were 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 and Gravity Games, formerly Barunson Interactive, a 50.83% held subsidiary acquired in October 2010.
 
Revenues
 
Our total revenues decreased by 8.8% to Won 52,362 million (US$47,722 thousand) in 2010 from Won 57,403 million in 2009, primarily due to:
 
  •  a 21.8% decrease in subscription revenue to Won 9,908 million (US$9,030 thousand) in 2010 from Won 12,674 million in 2009. This 21.8% decrease resulted primarily from the 22.7% decrease in the revenues in Korea to Won 3,829 million (US$3,490 thousand) in 2010 from Won 4,951 million in 2009 resulting from decreased revenues from Ragnarok Online, Requiem and Emil Chronicle Online and the 19.4% decrease in the revenues from Ragnarok Online and Requiem in the United States and Canada to Won 4,664 million (US$4,251 thousand) in 2010 from Won 5,785 million in 2009 due mostly to the fact that Ragnarok Online has reached maturity in the markets;
 
  •  a 5.6% decrease in royalties and license fees to Won 32,132 million (US$29,284 thousand) in 2010 from Won 34,037 million in 2009, which primarily resulted from decreased revenues from Ragnarok Online in the Japanese market and the strengthening of the Korean Won by approximately 2.6% against the Japanese Yen from 2009 to 2010, though such decrease was partially offset by a 49.2% increase in the revenues from Ragnarok Online in Taiwan, Hong Kong and Macau driven by the introduction of a renewed version of the game in September 2010 in the region. Royalties and license fees from Ragnarok Online decreased to Won 30,215 million (US$27,536 thousand) in 2010 from Won 33,294 million in 2009 due mostly to the fact that Ragnarok Online has reached maturity in most of our principal markets; and
 
  •  a 59.6% decrease in character merchandising, animation and other revenue to Won 1,134 million (US$1,034 thousand) in 2010 from Won 2,810 million in 2009, which resulted primarily from a 69.2% decrease in sales of goods to Won 473 million (US$431 thousand) in 2010 from Won 1,535 million in 2009 and from a 42.9% decrease in character merchandising revenue to Won 524 million (US$477 thousand) in 2010 from Won 917 million in 2009.

78


Table of Contents

 
Such decreases in revenues were partially offset by:
 
  •  a 16.6% increase in mobile game revenue to Won 9,188 million (US$8,374 thousand) in 2010 from Won 7,882 million in 2009. This 16.6% 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.
 
Cost of revenues
 
Our cost of revenues decreased by 1.4% to Won 20,873 million (US$19,023 thousand) in 2010 from Won 21,170 million in 2009, primarily due to:
 
  •  a 22.4% decrease in amortization on intangible assets to Won 2,048 million (US$1,866 thousand) in 2010 from Won 2,639 million in 2009 primarily resulting from development costs of Emil Chronicle Online and Requiem being fully amortized in July 2010 and September 2010, respectively. Amortization expense of development costs recorded was Won 1,549 million (US$1,412 thousand) in 2010 and Won 2,595 million in 2009; and
 
  •  a 68.6% decrease in cost of goods sold by NeoCyon to Won 286 million (US$261 thousand) in 2010 from Won 912 million in 2009. NeoCyon sells goods related to cell phones and decrease in sales of goods in 2010 led to decrease in cost of goods sold.
 
Such decreases in cost of revenues were partially offset by:
 
  •  a 8.8% increase in salaries to Won 9,088 million (US$8,283 thousand) in 2010 from Won 8,353 million in 2009 primarily resulting from increase in salaries for the headquarters and NeoCyon; and
 
  •  a 70.0% increase in outsourcing fees for the headquarters and NeoCyon to Won 2,339 million (US$2,132 thousand) in 2010 from Won 1,376 million in 2009.
 
Gross profit and gross profit margin
 
As a result of the foregoing, our gross profit decreased by 13.1% to Won 31,489 million (US$28,699 thousand) in 2010 from Won 36,233 million in 2009. Our gross profit margin decreased to 60.1% in 2010 from 63.1% in 2009.
 
Operating expenses
 
Selling, general and administrative expenses.  Our selling, general and administrative expenses decreased by 5.7% to Won 20,422 million (US$18,612 thousand) in 2010 from Won 21,651 million in 2009, primarily due to:
 
  •  a 32.5% decrease in commission paid to Won 2,904 million (US$2,647 thousand) in 2010 from Won 4,300 million in 2009 primarily resulting from recognition of a loss on the guarantee payment made for the development of Ice Age Online in 2009 due to the termination of our license agreement with 20th Century Fox Licensing & Merchandising, which did not occur in 2010; and
 
  •  a 24.3% decrease in rent expenses to Won 1,522 million (US$1,387 thousand) in 2010 from Won 2,010 million in 2009, which was mainly due to lower rent expense of office of Gravity Interactive in 2010 in connection with its relocation in October 2009.
 
Such decreases in selling, general and administrative expenses were offset by:
 
  •  a 63.0% increase in advertising expenses to Won 1,853 million (US$1,689 thousand) in 2010 from Won 1,137 million in 2009, which mainly consisted of advertising expenses for Ragnarok Online in Japan, closed and open beta testing of Canaan in August 2010 and in September 2010, and closed beta testing of H.A.V.E Online and War of Gods in November 2010; and
 
  •  a 181.2% increase in taxes and dues expenses to Won 925 million (US$843 thousand) in 2010 from Won 329 million in 2009 primarily resulting from a tax examination with respect to transfer pricing adjustments between the actual transaction price and the estimated arm’s length price.


79


Table of Contents

 
Research and development expenses.  Our research and development expenses increased by 158.6% to Won 4,652 million (US$4,240 thousand) in 2010 from Won 1,799 million in 2009, due to development of a console game based on one of our online games, a game for Microsoft’s Xbox Live Arcade and social network games, such as Fashion Star. The increase also partly resulted from research and development expenses of Gravity Games, formerly Barunson Interactive, in which controlling financial interest was acquired by the Company on October 21, 2010.
 
Impairment loss on intangible assets.  We had Won 475 million (US$433 thousand) impairment loss on intangible assets in 2010 for capitalized research and development cost of Canaan.
 
Settlement cost of litigation.  Our settlement cost of litigation decreased to nil in 2010 from Won 1,649 million in 2009. See ITEM 8.A. “CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION — LEGAL PROCEEDINGS.”
 
Operating income and operating profit margin
 
As a result of the cumulative effects of the reasons stated above, we recorded an operating income of Won 5,940 million (US$5,414 thousand) in 2010 compared to an operating income of Won 10,854 million in 2009 and our operating profit margin recorded at 11.3% in 2010.
 
Net other income
 
Our net other income increased 10.2% to Won 2,322 million (US$2,115 thousand) in 2010 from Won 2,108 million in 2009 primarily due to:
 
  •  a gain of Won 335 million (US$305 thousand) in 2010 on disposition of available-for-sale securities.
 
Income tax expenses
 
We recorded an income tax expense of Won 4,207 million (US$3,835 thousand) in 2010, as compared to an income tax expense of Won 4,544 million in 2009. The decrease of income tax expense is mainly due to the decrease of foreign withholding tax for overseas royalties and license fees. 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, 2010, we recorded a full valuation allowance on net deferred tax assets of Gravity and its subsidiaries except NeoCyon and Gravity Games, 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 on investments
 
In 2009, equity loss on investments represents the 16.39% of the net loss incurred from a 16.39% partnership interest in Online Game Revolution Fund No. 1. 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, 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 1,424 million as equity loss of the partnership in 2009. In 2010, equity loss on investments represents the 16.39% of the net loss incurred from a 16.39% partnership interest in Online Games Revolution Fund No. 1 and the equity income of Ingamba LLC, in which we invested Russian Ruble 13 million, which represents 25% of Ingamba’s total capital, in June 2010 in order to distribute our games in Russia. The investment in Ingamba was accounted for as an equity method investment. The Company recorded Won 358 million (US$326 thousand) as equity loss of the partnership of Online Game Revolution Fund No. 1 and Won 13 million (US$12 thousand) as equity income of Ingamba in 2010. On December 31, 2010, the term of the partnership of Online Game Revolution No. 1 expired and it is under liquidation during 2011. The partnership had invested in eight games since its operation. The Company is expecting that the partnership will be able to sell certain games before the


80


Table of Contents

consummation of the liquidation, the remaining disposable assets including cash and receivables will be distributed to each investor of the partnership upon dissolution. The Company has estimated that the Company’s share of such liquidation proceeds will be at least equal to the Company’s carrying value of its investment in the Fund at December 31, 2010.
 
Non-controlling interest
 
Non-controlling interest represents the net income from NeoCyon, our 96.11%-held subsidiary and Gravity Games, formerly known as Barunson Interactive, our 50.83%-held subsidiary, attributable to third-party minority interest holders. We acquired 96.11% and 50.83% of the voting equity of NeoCyon and Gravity Games in 2005 and 2010, respectively.
 
Net income attributable to parent company
 
As a result of foregoing, we recorded a net income attributable to parent company of Won 3,730 million (US$3,398 thousand) in 2010 compared to a net income attributable to parent company of Won 6,917 million in 2009.
 
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       N/M  
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 )     N/M  
Others, net
    (31 )     (21 )     (19 )     (32.3 )
                                 
Total net other income
    6,030       2,108       1,863       (65.0 )


81


Table of Contents

                                 
    Year Ended December 31,  
    2008     2009     2009(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$
 
    except for percentages)  
 
Income before income tax expenses and equity loss on investments
    5,794       12,962       11,458       123.7  
Income tax expenses
    3,379       4,544       4,017       34.5  
                                 
Income before equity loss on investments
    2,415       8,418       7,441       248.6  
Equity loss on investments, net(4)
    (5,119 )     (1,424 )     (1,259 )     (72.2 )
                                 
Net income (loss)
    (2,704 )     6,994       6,182       N/M  
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       N/M %
                                 
 
N/M = not meaningful
 
 
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 by total net revenues for each period.
 
(4) Represents the losses from our 16.39% equity investment in Online Game Revolution Fund No. 1. This investment in Online Game Revolution Fund No. 1 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.

82


Table of Contents

 
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;
 
  •  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 United States 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


83


Table of Contents

  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.
 
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 194 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 on investments
 
In 2008 and 2009, equity loss on investments represented 16.39% of the net loss incurred from a 16.39% partnership interest in Online Game Revolution Fund No. 1. 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, 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


84


Table of Contents

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.
 
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,  
    2008     2009     2010     2010(1)  
                      (Unaudited)  
    (In millions of Won and thousands of US$)  
 
Cash and cash equivalents at beginning of period
  W 53,588     W 53,168     W 51,333     US$ 46,783  
                                 
Net cash provided by operating activities
    6,952       15,861       8,388       7,646  
Net cash used in investing activities
    (9,028 )     (17,550 )     (15,873 )     (14,467 )
Net cash provided by (used in) financing activities
    (82 )     (55 )     275       250  
Effect of exchange rate changes on cash and cash equivalents
    1,738       (91 )     (1 )     (1 )
                                 
Net decrease in cash and cash equivalents
    (420 )     (1,835 )     (7,211 )     (6,572 )
                                 
Cash and cash equivalents at end of period
  W 53,168     W 51,333     W 44,122     US$ 40,211  
                                 
 
 
Note:
 
(1) For convenience only, the Won amounts are expressed in U.S. dollars at the rate of Won 1,097.25 to US$1.00, the noon buying rate as quoted by the Federal Reserve Bank of New York in effect on March 31, 2011.
 
Prior to the commercial launch of Ragnarok Online in August 2002, our principal s