Will the KIKOs Kill Further OTC Derivatives in Korea? Business Law Asia & In-House Summit June 2009...

Will the KIKOs Kill Further OTC Derivatives in Korea?

Business Law Asia & In-House Summit

June 2009Kwon Hoe Kim

Yoon Yang Kim Shin & Yu

Capital Markets and Financial Investment Services Act

Effective Feb. 4., 2009

Consolidated financial law replacing the Securities and Exchanges Act, Trust Business Act, Futures Trading Act and Indirect Asset Management Act, etc.

Modeled after the Financial Services and Markets Act 2000 (England) Financial Services Reform Act 2001 (Australia)

Any and all financial services are covered except for banking and insurance services.

Three-prong approach: Financial Investment Corporations (“FICs”), Investors and Financial Products

Different level of protection between professional investors and ordinary investors.

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Professional Investors (Art. 9)

With professional knowledge in financial products or risk undertaking ability considering amount of assets, etc.

Financial institutions, listed corporations, governmental agencies and international organizations

Corporations with financial investment amount of KRW10 billion or more

Individuals with transactional experience (one year) and financial investment amount (KRW5 billion)

Non-professional or Ordinary Investors Other individuals and corporations which do not belong to

the category of professional investors

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Non-professional Investor Treatment for Professional Investors If certain professional investor (excluding governmental agencies, financial institutions etc.) expresses in writing its intention to the FICs to be treated as non-professional investor, upon the FICs’ consent which shall not be withheld unreasonably, shall be deemed as non-professional investor.

Listed corporations transacting with FICs in derivative products shall be treated as professional investors only when they notify in writing to the FICs that they will be treated as professional investors.

Universal regulations on all financial business activities

Duty of good faith

Prohibition of loss compensation

Know-your-customer rule

Prohibition of unwanted solicitation

Suitability principle

Duty of lawful product guidance

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■ Universal regulations on financial business activities shall be differentiated in application according to the type of investor

Individual regulations on each financial investment service

(examples) Dealing

Prohibition of self-contracting

Arranging Arbitrary dealing prohibited

Asset management

CIS asset management restricted

Discretionary investment

advisory service

provider

Loans prohibited

Asset custodian management

FICs’ own asset & clients’ asset in custodian clearly separated

Non-professional investor

Professional investor

Duty of good faith applied applied

Prohibition of loss compensation applied applied

Know-your-customer rule applied appliedProhibition of unwanted solicitation applied applied

Suitability principle applied ×Duty of lawful product guidance applied ×

Regulation of business activities (quoted from MOSF presentation)

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Regulation of Investor Solicitation under CMFISA

• Suitability Rule

• Know-Your-Customer Rule

• Duty of Product Guidance

• Prohibition on Unwanted Solicitation


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Investor Protection Scheme under CMFISA

1. Suitability Rule

A. Introduction of Suitability Rule (Arts. 46 and 46-2)

• Rule which requires FICs to recommend investments that are

appropriate for the particular non-professional investor;

• Suitability rule is a general principle that applies to

transactions regarding all financial investment products.• Before the introduction of the suitability rule under the

CMFISA, the Supreme Court of Korea had already recognized the duty on FICs for investor protection, which is to avoid actively recommending transactions that carry excessive risks considering the investment circumstances of investor (93Da26205, 1994.1.11)

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B. Obligations under the Suitability Rule1) Duty to confirm type of investor• Duty to confirm type of investor: professional or ordinary

investor (Article 46(1))

2) Duty to confirm investor information • Duty to confirm investor information (Article 46(2))• Prior to investment recommendation, must ascertain and

confirm in writing the investment purpose, condition of assets, investment experience, etc. of investor through interview, etc.

3) Duty to determine suitability • Prohibition on investment recommendation which is deemed

inappropriate for relevant investor (Article 46(3))

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C. Important Issues under the Suitability Rule

• Information which forms basis for determination of suitability is limited to information provided by investor: No need to conduct independent DD.

• Suitability is determined not by how the investment has turned out, but in terms of what was known or reasonably should have been known at the time recommendation was made.

• Suitability Rule is limited in that, if investment is found to be unsuitable after initial determination of suitable, the only requirement is a warning.

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C. Important Issues under the Suitability Rule (2)

• Determination of suitability is made according to the investor’s knowledge and experience, etc. If investor has sufficient expertise to be able to ascertain risks and structure of financial investment products on his/her own, determination of suitability by financial investment company may not be necessary.

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D. Appropriateness Rule

• Introduction of “appropriateness rule,” a sister rule to the Suitability Rule.

• According to which, even in cases where no investment recommendation is made by FIC to a non-professional investor, FIC bears duty to confirm investor information (as in suitability rule) and if conclude that the intended investment is not appropriate for the investor, FIC shall notify the investor of such fact before the investment is made (Article 46-2)

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2. Duty of Product Guidance

A. Introduction of Express Provision (Article 47).

– In cases where an FIC makes an “investment recommendation” to an “ordinary investor”, the company has duty to explain details and risks of products, and other matters provided by relevant law, such that the investor is able to understand.

• Previously, courts recognized duty of product guidance owed by FICs which made investment recommendations to investors, on the grounds of the general duty of investor protection (Supreme Court case no. 2003Da51057, 2006.5.11.).

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B. Scope of Items to be ExplainedStructure and nature of financial investment product,

matters relating to fees/charges, risks from investment, conditions to early redemption, if any, and matters relating to termination or cancellation of contract (Article 53(1) of Enforcement Decree)

Provision prohibiting FICs from falsely stating or distorting, or omitting to provide, any material information, in providing product guidance (Article 47(3))

• ‘Distorting’ refers to any act of providing a definite conclusion or conveying information which could be misconstrued as certainty regarding an uncertain matter.


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C. Presumption of liability for damages from breach of duty of product guidance

Existence of breach of duty of product guidance (to be proved by the investor)

Occurrence of loss and loss amount (presumed)

Causal relationship between breach of duty and loss (presumed)

* Loss amount = [amount paid or payable by the investor for the investment] – [amount recovered or recoverable from disposition, etc. of the investment products]


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D. How to Explain

CMFISA requires explanation such that “an ordinary investor can understand” (Article 47(1))

CMFISA requires “confirmation that the investor understands through one or more means, including by signature (including electronic signature), affixing of seal, voice recording, or other means designated by Presidential Decree (Article 47(2)).


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Previous LawPrevious Law

Applicable products

Certain products only (indirect investment securities, futures)

Means of explanation

Provision of investment memorandum or

explanation

Special rules on

compensation of loss

Exist only with respect to indirect investment

securities

Presumption of amount of


×

Current LawCurrent Law

Applicable products

All financial investment products

(financial products with investment

characteristics)

Means of explanation

Explanation and confirmation of understanding

Special rules on


Applies to all financial investment products

Presumption of amount of


Applies to all financial investment products

Improvement of System of Duty of Product Guidance

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1. What is KIKO? USD and KRW currency option contracts between banks in

Korea and Korean export companies with two barriers called Knock-in and Knock-out

From around early 2007, many (appx. 570) Korean export companies entered into KIKO transactions in response to continuing appreciation of KRW which threatened their profit from exports.

To reduce upfront hedging costs, Korean corporations purchased USD put options from, and sold USD call options to banks, normally with knock-out condition to further reduce hedging costs or higher exercise price.

KIKO Litigation in Korea and its Key Issues

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2. KIKO Litigation KRW depreciated very substantially from March 2008

against USD and the KRW/USD exchange rate soared from a level of 900 to 1,500 in Nov. 2008.

Which “knock-in”ed the call options of the banks and the KIKO buyers faced huge losses on the call options they sold to the banks.

KIKO buyers sued banks in courts to invalidate or terminate their KIKO contracts and sought damages on various legal grounds.

KIKO buyers also filed for preliminary injunctions to suspend the KIKO contracts until the court decides on the merits.


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2. KIKO Litigation (2)

The first decision was issued by the 50th Civil Division of the Seoul Central District Court on December 30, 2008 (the “First Case”)

The First Case shocked the financial community of Korea those outside Korea

Continued criticism and worries covered news media More corporations started litigations and there have been

more than three hundred cases filed and decisions on preliminary injuction cases have been issued regarding few of the pending cases.


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3. Doctrine of Changed Circumstances (“DCC”) A doctrine of equity derived from the “principle of good

faith” which is one of the basic rules of the Civil Code of Korea.

Civil Code is based on the principle of freedom of contract and self-liability which take you to the maxim of “Pacta sunt servanda”

DCC is a very special exception to principle of “Pacta sunt servanda”, which has been adopted by the Supreme Court of Korea in a limited number of cases involving “term contracts or the like” such as guarantees.


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3. Doctrine of Changed Circumstances (“DCC”)

DCC is recognized when Especially when the contract is of a continuing nature; There is substantial change in objective circumstances after

the agreement has been entered; Such change was not foreseeable by either party; Neither party is responsible for such changes; and, Enforcing the contract will result in violation of the

principle of good faith and fairness.


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3. Doctrine of Changed Circumstances

If DCC is recognized, either of the parties may terminate the contract in the future.


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4. The Court in the First Case

KIKO contract is of a continuing nature in that the term is normally 1 to 3 years and settlement is made in each tranche;

The implied volatility of USD-KRW rate constitutes an objective circumstance that forms the basis of the KIKO contract;

The steep change in the USD-KRW (from 3-5 to 15-20) rate was far beyond anticipation of the parties;

There is no scheme through which the terms and conditions are adjusted or terminated prior to expiry to stop losses;


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4. The Court in the First Case

The banks breached their duty under the Suitability Rule for the following reasons:

KIKO is not adequate for buyers in that it is open to unlimited loss; and

The banks should not have recommended KIKO or should have tried to revise the terms thereof to limit potential losses before recommending, both of which the banks failed to do.


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4. The Court in the First CaseThe banks breached their duty under the Rule of Product Guidance for the following reasons: Must clearly and sufficiently explain risks implied in contract – insufficient to explain in general, abstract terms;

In other words, must clearly and in detail explain what could happen in worst-case scenario;

In providing outlook on foreign exchange rate, must not interfere with proper awareness of risk by disclosing content which may be misconstrued as being certain; and

The banks failed in all of the above duties.


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5. New Court and its new ReasoningNew chief judge was assigned to the 50th Division and rendered new judgment on April 24, 2009. The court held that DCC shall not apply in the KIKO case before it for the following reasons:

Even if implied volatility of foreign exchange rate increased after execution of the KIKO contract, it could not have been anticipated by the parties at the time of contract execution, and such increase is a result of causes for which the parties are not responsible.

The view that the KIKO buyer will incur substantial losses during the remaining contractual period is true, however, when it is assumed that the foreign exchange rate does not subsequently decline.


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5. New Court and its new Reasoning

If the KIKO contract is terminated during the contractual period with a view to the future, the parity that each party has toward the other in terms of the option will be break.

In the future as well, cannot be certain that the foreign exchange rate will continue to remain high.

Increase in losses resulting from over-hedging or reduced exports is the buyer’s responsibility.

If the KIKO contract is deemed terminated, only the bank, the party at the other end of the transaction, will see losses.


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The new decision, however, continued to say that under the suitability rule,

- the bank should have offered the option amount which did not exceed the scope which the company could handle,

- with elements of foreign exchange speculation removed from the contract structure itself,

- and the offer should have fit the purpose of avoidance of foreign exchange risk.


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As to the rule of product guidance, the new court points out in detail the items and content which must be explained, as follows.

Basic structure of the option agreement The scope of risk that is hedged by the option agreement The possibility of risk and its level that the buyer will undertake by or through the option agreement Means to unwind or stop the loss Price information on the options.


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The new court also found that the bank breached its duties under the rule of suitability and product guidance.

In this regard, the issue of whether or not such breach will entitle the buyer to terminate the KIKO contract, the new court found that the breach of the above duty will make the bank subject to liability for damages but would not give the buyer the right of

termination.


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6. Remaining Issues

A. Can banks wear two hats under the Suitability Rule?

- Do banks bear the duty to structure and recommend a derivative contract that will not put the buyer at risk of loss?

B. How detailed must be the product guidance?

- Do banks have to point out every possible scenario?

C. Preliminary injunction increases uncertainty to the bank in regard to its hedging scheme


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7. Remaining Issues D. How to calculate the damages, if any, in case of

breach of duties?- The introduction of marginal rate, 130% of the

market rate at the time of KIKO contract, calculated based on the average fx rate volatility for the last 10 years from now?

- 50th Division says if the settlement fx rate exceeds the marginal rate, such amount shall be the damage amount to be compensated by the bank


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8. Outlook

Uncertain, but not too pessimistic.

Decisions with different view started to be released.

CMFISA will have to be shaped to provide clear picture on how far should the FICs go under the suitability rule and rule of product guidance.


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Thank you

Yoon Yang Kim Shin & Yu

Will the KIKOs Kill Further OTC Derivatives in Korea? Business Law Asia & In-House Summit June 2009...

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