South Korea: Supreme Court decides on KIKO cases

Soonghee Lee

The Supreme Court of Korea rendered an en banc decision on four knock-in/knock-out currency option cases (the KIKO cases) last September. In the KIKO cases, the Korean exporters argued that the KIKO currency option contracts (the KIKO contracts) were void, and should either be rescinded or terminated. They argued that the banks had waived the exercise of their call options, and sought the return of monies paid to the banks as unjust gains; they also argued that the banks had committed tort by violating their obligation to explain and violating the suitability principle during the process of entering into the KIKO contracts, and claimed compensation for damages.

A summary of the major legal principles determined by the Supreme Court last September is as follows.

Currency hedging

The mere fact that the exporters were given an advantageous exercise exchange rate only within a limited range and not the entire range of exchange rate hedge, does not necessarily mean that the exchange rate hedging under the KIKO contracts was structurally unsuitable. Nor does it mean that the suitability obligation would have been satisfied only if exchange rate hedging were possible for the entire foreign currency held by the exporters. If a customer which held or expected to hold foreign currency entered into a KIKO contract for the purpose of exchange rate hedging, even if a loss occurred under the KIKO contract due to a rise in the exchange rate, there was no change in terms of the overall profit and loss under the KIKO contract, since differences in the exchange rate occurred as a result of holding foreign currency. Therefore, the Korean exporters cannot be viewed as having faced greater exchange rate risk by entering into the KIKO contracts.

Standardised contracts

Given the structure of the KIKO contracts, including its knock-in and knock-out provision, leverage structure, and the fact that the banks set the theoretical value of the call options acquired by them higher than the theoretical value of the put options acquired by the exporters (and the difference between such theoretical values were collected by the banks as fees and the exporters did not pay separate fees), the KIKO contracts do not constitute standardised contracts.

Notification of theoretical value of options

Absent special circumstances, the banks cannot be viewed as having had the obligation to notify of the theoretical value of the options and related fees included in the structure of the KIKO products, and the negative market value which potentially results. The mere fact that such information was not notified to the exporters cannot be viewed as fraudulent conduct or the cause of the customer's misunderstanding.

Suitability principle

The banks should have ascertained the customer's business circumstances (including expected inflow amount of foreign currency, status of assets, necessity of currency hedging, purpose of transactions, experience in transactions, knowledge or degree of understanding of the KIKO contract, and whether the customer has entered into other currency hedging contracts), and the bank should not have recommended the execution of the KIKO contract, which was unsuitable for the customer given such circumstances. When banks recommend the trading of over-the-counter (OTC) derivative products of great risk, their duty to protect customers is higher than those of other financial institutions.

Obligation to explain

The banks were obliged to explain material transaction information at the time of entering into the KIKO contracts, including structure and major terms of the contract, specific details on the potential benefits and losses from the transactions, and in particular, the risk factors which may lead to losses. Further, the banks should have explained it in such way that the customer could properly understand the material transaction information.

Reduction of damages for contributory negligence

The banks' violation of the suitability principle and obligation to explain at the time of entering into the KIKO contracts cannot serve as a basis for preventing the reduction of damages for contributory negligence by the plaintiffs.

Through the above en banc decision on the KIKO cases, the Supreme Court presented an outline on the suitability principle and obligation to explain to be observed by banks, and the criteria for determining whether such suitability principle and obligation to explain have been violated. Following the above en banc decision on the KIKO cases, it is expected that several other disputes regarding the validity of KIKO contracts now pending before lower courts will be resolved, and deliberations and determinations by such courts on whether the suitability principle and obligation to explain have been violated will be made consistently with the en banc Supreme Court decision.

Soonghee Lee

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