Kiko contracts survive initial challenges in court

Author: | Published: 24 Jun 2010
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One of the repercussions of the severe fluctuations in foreign exchange rates in Korea that followed the global financial crisis has been the controversy regarding Kiko (Knock-In-Knock-Out) transactions, the foreign currency hedging instruments that were developed and sold by banks to Korean corporations. Several hundred companies that entered into Kiko transactions stood to lose huge amounts of money as a result of the sharp increase in exchange rates, prompting calls for investigations by government regulatory agencies and action by the National Assembly. Kiko also became the first structured foreign-exchange derivative to be subject to multiple challenges in the courts, with an unprecedented number of cases being filed for a single type of instrument. Some 140 applications for preliminary injunctions were filed by customers against their banks (most of which have now been decided, with a few cases still pending appeal) and more than 300 main action cases have been filed to date, of which 279 cases are still pending.

The Kiko structure

In a basic Kiko, the customer acquires a put option from the bank with a so-called knock-out condition that allows the buyer to sell foreign currency at a higher rate than the spot rate, so long as the exchange rate stays above the predetermined knock-out rate. Instead of paying an option premium to the bank, the customer sells a call option with a so-called knock-in condition under which the customer is obliged to sell foreign currency at a lower knock-in rate than the spot rate if the spot rate trades at or beyond a specified upper limit before the expiation of the option.

If the foreign exchange rate remains relatively stable and fluctuates between the knock-in rate and the knock-out rate, the customer effectively hedges its currency risk without incurring direct costs. The option is advantageous to the buyer when the foreign currency becomes weaker, since it allows the buyer to make a profit by selling foreign currencies to the banks at a higher rate than it would be able to in the market. Such advantage disappears if the exchange rate falls below the knock-out rate, since the put option terminates automatically and the customer is exposed to currency risk. Meanwhile, if the exchange rate increases beyond the knock-in rate, the customer is obligated to bear potentially large cost since the bank has the right to purchase the notional amount of the call option and the customer is obliged to sell such amount of the relevant foreign currency to the bank at a predetermined strike rate.

Exchange rates rise

The trouble for customers began around March 2008 when the Korean won began to lose its value against other major currencies such as the US dollar, the euro and the yen. The rate of the Korean won against the US dollar (which had remained relatively stable and experienced a marginal downward trend in January 2004 to slightly below W1000:$1 at the end of December 2008) began to climb rapidly, eventually spiking at over W1500:$1 in January 2009. Similar dramatic changes affected the won exchange rate with the yen. Customers who had purchased Kiko products and enjoyed profits under their contracts in previous years now faced banks exercising their call options under the contract.

Companies that allegedly suffered as a result were quick to create an informal representative organisation and, due in part to their aggressive campaign, media coverage generally favoured the customers who had purchased the Kiko products. Of the regulatory agencies, the Korean Fair Trade Commission (KFTC) was the first to take action, initiating its investigation into Kiko products in June 2008. This was based on complaints filed by small and medium-sized corporations against several banks claiming that their Kiko trading contracts provided unfair terms and conditions under the Regulation of Standardised Contracts Act. Later, in the autumn of 2008, the Financial Supervisory Service (FSS) began a series of investigations covering various aspects of the Kiko transactions.

There were a few notable events concerning the regulatory environment of the Over-the-Counter (OTC) derivatives market as well. In early 2009, the Financial Investment Services and Capital Market Act (FSCMA) introduced an explicit requirement for distributors of OTC derivative products to assess the suitability of a purchaser, and a duty to explain these products (They were acknowledged by the courts as a part of the 'principle of trust and good faith' prior to the FSCMA era.). Also, by way of amendment to the Presidential Decree of FSCMA, a regulation that prohibits any uncovered foreign exchange derivatives has been reintroduced (after it was abolished in or around 1998). Under this regulation, a party is not allowed to enter into foreign exchange derivatives in excess of its foreign currency assets or cash flows, and the counterparty bank is obliged to review documents to conform to this requirement.

Following the initiative of the US, Korea is also contemplating the feasibility of adopting a centralised clearance system to settle OTC derivative products; however, it is difficult to predict whether this proposal will actually be adopted and, if adopted, what the extent of the adoption would be.

Battle in the courtroom

Around the time that the FSS began conducting its investigations in autumn 2008, a deluge of suits was brought by plaintiffs against the banks. Approximately 220 corporations filed main action complaints against their banks seeking nullification of their Kiko contracts and claiming damages. Approximately 110 corporations also filed preliminary injunction applications. The number of suits filed continued to climb, and eventually more than 140 preliminary injunctions were filed, in addition to some 300 main action cases. Such large number of individual cases were/are litigated separately, and not as a class action.

The first sets of challenges brought by customers were litigated in the context of preliminary injunction proceedings brought by customers seeking temporary suspension of performance pending resolution of the main actions. Some of the initial decisions of the courts in these preliminary injunction cases were unfavourable to the banks. For example, in late December 2008, the Seoul Central District Court rendered its first decision in a case seeking preliminary injunctive relief, deciding to suspend the effectiveness of the Kiko contracts based on the theory of changed circumstances, principle of suitability, and failure to make adequate disclosures. While subsequent lower courts' rulings on the key legal issues in litigation such as the principle of suitability and duty to explain were rather inconsistent, they all tended to recognise a duty owed by a bank to protect its customers.

With respect to the suitability issue, an August 2009 Seoul High Court decision provided a significant turning point for the banks. The court, deciding on an appeal against the dismissal of an application for a preliminary injunction, took a different position from many of the district courts. It construed a bank's duties narrowly regarding suitability and ruled in favour of the banks. Specifically, the court ruled that the terms and conditions of the Kiko contracts were neither unfair nor unreasonable because, among other things, the applicant would not have incurred large losses under the Kiko contracts so along as it had not over-hedged its position since the applicant had constant inflow of foreign currency from its export business. The applicant company did not further appeal this appellate decision and many appeals on preliminary injunction decisions were withdrawn after this ruling.

Key issues

As the first court dispute regarding structured foreign-exchange derivatives in Korea, the Kiko litigation raised a number of complex challenges for the courts, some of which the courts addressed for the very first time in the absence of any legal precedents or discussion by Korean legal scholars on the subject. For the banks' defence, close collaboration with expert witnesses and intense research and comparative law analysis of key issues, such as suitability, in jurisdictions such as the US, UK, Japan, and Germany was necessary. In a move that drew wide attention from the general public, both sides retained prominent world-renowned experts; the plaintiffs retained Nobel Laureate Professor Robert Engle while the defendant banks retained Professor Stephen A Ross of the Sloan Business School at MIT, a renowned scholar in corporate finance particularly in option pricing. Each side also retained prominent Korean law experts.

Because the cases involved factual issues and arguments that required the courts' in-depth knowledge of foreign-exchange option theory and market practice, including complicated theories involving the meaning of back-to-back transaction and dynamic hedging strategy, so-called zero-cost, and imbalance between call and put option values, both sides also prepared extensive presentations to explain arguments based on complex financial concepts to the courts.

Structural fairness

One of the key arguments by the customers was that the Kiko contracts should be cancelled because of a fundamental unfairness in the transaction deriving from the inequality between the value of the put option purchased by the customers and the call option purchased by the banks, resulting from hidden and/or excessive fees to the customers. Specifically, customers argued that the structure was unfair because (i) potential loss to the banks was limited whereas the potential loss to applicants due to a spike in exchange rates was unlimited; and (ii) the contract amount for the respondent bank when exercising its call option is twice the notional amount of the contract amount for the customer when exercising its put opinion.

Principle of suitability and duty to explain

With respect to suitability, customers have argued that the Kiko contracts are too complicated for small and medium-sized companies to fully understand and that they entered into the contracts without appreciating the risk profile of the product. They have also argued that, because the value of the customer's put option and the bank's call option were explained to be identical and the customer was not obligated to pay an option premium to the bank at the time of entering into the transaction, this so-called zero-cost structure lures unsophisticated corporations to enter Kiko contracts by encouraging them to disregard potential risk, when in fact the company was issuing a leveraged call option to the bank. Because the potential losses to the company are unlimited and could potentially be beyond the level that a small or medium-sized company could bear, customers have argued that banks are obliged to warn against such risks and that the banks should have recommended other hedging products more suitable to small or medium-sized companies.

Related to the arguments based on suitability, plaintiff customers have argued that the banks failed to provide adequate and sufficient warning to the companies of the possibility of rising exchange rates and the resulting losses to the company.

Change in circumstances

The doctrine of "change in circumstances" was developed under Article 2 of the Korean Civil Code to allow modification or termination of a contract if circumstances that serve as the basis for the conclusion of the contract are significantly changed, the change was not foreseeable, the change is beyond the control of the parties, and the enforcement of the contract under such changed circumstances would be grossly unfair. Plaintiffs argued that the parties expected the exchange rate to stay stable or fall and that this expectation was completely reversed, that this change of circumstances was not foreseeable, and that the losses to be suffered if the contract were enforced would be too great to be borne by the plaintiff companies.


Other significant issues that have been raised by customers include arguments that (a) Kiko contracts constituted unreasonably unfair standardised contracts that are prohibited by the Regulation of Standardised Contract Act; (b) the contracts are subject to cancellation because the customers that concluded them lacked experience in derivative transactions; and (c) the companies were induced by the banks to enter into Kiko transactions because of fraud committed by the respondent bank or a mistake on the part of the applicant companies.

The first decision

The first trial level decision in a Kiko main action case was rendered on February 8, 2010 where the Seoul Central District Court denied the plaintiff company's claim for the return of unjust enrichment as lack of grounds for legal action and accepted the defendant banks' claim for the full payment of settlement under the relevant Kiko contract.

In its decision, the court denied as completely groundless the company's claim that the Kiko contract should be cancelled or invalidated as an unfair legal act or as a legal act by fraud or mistake. Further, the court rejected the company's claim that the banks caused damages to the company by breaching the suitability principle and duty to explain on the ground that the risk disclosure by the banks was adequate.

In particular, unlike some prior preliminary injunction decisions, the court ruled that the Kiko contract was not a standard contract and rejected the company's claim of unlimited loss on the grounds that, as acknowledged by the plaintiff companies' own expert witnesses, the plaintiff company could not incur any loss as long as it had underlying assets.

It is noteworthy that despite expert witness testimony that the Kiko contract was fundamentally unfair and an unsuitable currency option contract, the court ruled that the Kiko contract had no problems either structurally or from the perspective of suitability. The court ruled that the fairness of the transaction should be judged as of the time of execution of the Kiko contract; that it is a partial hedging instrument but is more advantageous to the company than a forward contract; and that although it is true that the customer is exposed to risks when the exchange rate rises above a certain range, customers would not incur any loss as long as it had underlying assets. The court agreed with the testimony of the banks' expert witness that the Kiko is a suitable hedging instrument and that its structure is fair. With respect to the commissions, the court ruled that it was not excessive, that there was no legal obligation for banks to notify that they charge commission for the Kiko, and that, even if banks explained the Kiko as having a zero-cost structure, this was not problematic.

In the meantime, around the same time as this decision, two Seoul High Court panels rendered their appellate decisions on Kiko preliminary injunction cases overturning the lower courts' decisions to partially accept the company's application for preliminary injunction and accepting the banks' appeals. In doing so, the court rejected all preliminary injunction applications filed by the plaintiff companies.

The first main action decision marked an important step forward for the banks in the Kiko litigation, although the outcomes of individual cases are expected to hinge on the specific facts as the courts' decisions tend to be quite fact-specific.

Kim & Chang has represented banks in more than 100 of the 141 preliminary injection cases filed to date and more than two-thirds of all of the main action cases now pending, obtaining favourable outcome for the banks in several major decisions including in the main action decision discussed above.

About the author

Mr Chung leads the Cross-Border Litigation Practice Group and the Insolvency and Restructuring Practice Group at Kim & Chang.

For more than 20 years, Mr Chung has represented various foreign and domestic clients in cross-border litigation and arbitration, and domestic civil and criminal litigation. His expertise covers corporate restructuring and he has advised numerous companies, creditors and investors in relation to the restructuring of large business groups in Korea.

His advocacy of a foreign investor in ICC arbitration against the governmental deposit insurance corporation led to an award of several trillion Korean won, and he also represented a Korean company to fully prevail in an international arbitration proceeding in New York, with a projected multi-billion dollar value. He represented a Korean investment trust company in a court case against a Korean public entity, winning on all claims valued at approximately one trillion Korean won, and successfully defended a foreign private equity fund in the appellate proceedings of a high-profile white-collar criminal case in connection with acquisition of a Korean commercial bank.

Contact information

Jin Yeong Chung
Kim & Chang

223 Naeja-dong, Jongno-gu, Seoul 110-720, Korea

Tel: +82 2 3703 1108
Fax: +822 737 9091~3

About the author

Sungjean Seo is a foreign attorney in the firm's International Arbitration and Cross-Border Litigation Practice Group. Ms Seo concentrates her practice on representing Korean and international clients in international arbitration and advising clients in connection with cross-border litigation. She has advised Korean conglomerates, foreign private equity firms, and European and Japanese companies in disputes arising out of various commercial contexts, including joint ventures, share purchase agreement, distributorship relationships and sale of intellectual property rights.

Before joining Kim & Chang, Ms Seo practiced for several years in New York with Milbank Tweed Hadley & McCloy and Rogers & Wells (now Clifford Chance), concentrating in the areas of complex cross-border finance, securities offerings and asset securitisation.

Contact information

Sungjean Seo
Kim & Chang

223 Naeja-dong, Jongno-gu, Seoul 110-720, Korea

Tel: +82 2 3703 1214
Fax: +822 737 9091~3