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The notorious Kiko disputes

Soonghee Lee

When the Korean won continued to appreciate against the US dollar after 2005, Korean exporters with dollar earnings began to worry about their foreign exchange translation losses.

Under the then prevailing market conditions, even if the companies entered into foreign exchange forward contracts, foreign exchange translation losses were inevitable. Many exporters expected the won/dollar exchange rate to stabilise at the appreciated levels and started to purchase knock-in and knock-out double barrier (Kiko) currency option derivatives. These allowed them to avoid exchange rate fluctuation risks at cheaper costs, even though the Kiko products only allowed a limited range of foreign exchange hedge and would deprive the purchasers of any gain if there was more than sizeable depreciation of the Korean Won.

Unfortunately, contrary to their expectations, the won began depreciating rapidly in early 2008 and the Kiko purchasers subsequently had to sell US dollars at a below-market exchange rate to the banks pursuant to the Kiko agreements. Once these companies began to suffer substantial losses from these products, they started filing lawsuits, resulting in the now notorious and numerous Kiko disputes.

Initially, Kiko purchasers sought preliminary injunctions from the Korean courts asking for suspension of the Kiko agreements on the ground that these agreements were unfair, in order to seek relief from monthly payment obligations. The Seoul Central District Court regarded the steep depreciation of the Korean Won as a material change in circumstances and issued preliminary injunction orders to suspend Kiko agreements in December 2008.

Accordingly, Kiko disputes rapidly increased, reaching over 180 cases. However, in April 2009, the Seoul Central District Court changed its previous position and no longer regarded the sharp depreciation of the Korean Won as a change in circumstances and also did not see any problems with the Kiko agreements themselves. The court only issued preliminary injunctions for those cases where the obligation to explain and the suitability obligation were not complied with at the time of sale. And in August 2009, the Seoul High Court's decisions in appeals tended to adopt the position taken by the banks and thus even in the cases where partial preliminary injunctions were issued, such district court decisions were overturned.

Kiko purchasers also began to litigate the cases on merits in order to avoid payment obligations or to recover the payments already made, by attacking the validity of the Kiko agreements. In these cases on merits, the Kiko purchasers made the following arguments:

(i) under the Kiko structure, the purchasers would only gain limited upside potential when the Korean Won appreciated while bearing potentially unlimited loss when the Korean Won depreciated with the banks getting all the benefit, rendering such structure unfair and invalid.

(ii) the banks failed to comply with their obligation to explain and their suitability obligation when selling Kiko products and should pay damages.

But the banks argued that Kiko products are, in essence, customised products aimed at limited foreign exchange rate risk hedge. Purchasers were given an advantageous exercise exchange rate within the desired range of exchange rate hedge in return for granting the banks call options whereby the value of these call options were adjusted to be equivalent to the value given to the Kiko purchasers reflecting the banks' appropriate profit margin.

Since the purchasers typically only needed to sell the dollars they already had at a Kiko-determined exercise price, the loss alleged by the purchasers is merely the opportunity cost arising from failure to profit from exchange rate movements and therefore cannot be considered as a real loss. Furthermore, the banks had already hedged their foreign exchange positions under the Kiko agreements in compliance with relevant regulations and thus were not getting all the profits from the exercise of their call options.

The Seoul Central District Court rejected all the arguments made by the Kiko purchasers following a careful consideration during a case in February 2010. However, around 100 Kiko cases on the merits case are still ongoing.

When both preliminary injunction cases and cases on the merits were decided against the Kiko purchasers, they filed a criminal complaint against the banks' employees for alleged fraud. The criminal complaint alleges that the banks provided the Kiko purchasers with the conclusive forecast that the Korean Won would appreciate while knowing that the Korean Won could actually depreciate and that the banks induced the Kiko purchasers to enter into Kiko agreements by deceiving them that the banks' call option premium was equal to the Kiko purchasers' put option premium, when in fact the banks' call option premium was much larger because it reflected the banks' profit margin.

The banks made the following arguments in response:

(i) they had never presented a conclusive forecast regarding exchange rate movements, since uncertainties in exchange rate fluctuations are obvious.

(ii) they simply presented a forecast that the Korean Won would continue to appreciate which was then the generally accepted view in Korea and abroad when they sold the Kiko products.

(iii) the abrupt depreciation of the Korean Won in 2008 was an unforeseen development due to the financial crisis originating from the US.

(iv) it is unreasonable to ask for-profit corporations like banks to sell financial products for free.

(v) the practice of adding profit margin to the option premium is an established practice in both Korean and foreign financial markets, therefore zero-cost cannot be considered equivalent to no-margin.

(vi) the banks do not have any obligation to disclose the existence or scale of their profit margin in light of applicable laws and decrees or industry practices.

This criminal case is currently under investigation at the Seoul Central District Prosecutors' Office.

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