Since equity-linked securities (ELS) were first introduced to the Korean capital market in 2003, the market has grown to over W20 trillion ($17.8 billion) in annual issuance. Among the ELS products are principal-protected products and non-principal protected products, internal hedge structures and back-to-back hedge structures. In general, although it depends on the products, the principal and a fixed rate of return are paid to investors if the stock prices of the underlying assets of ELS maintain a certain level on the early redemption date or at maturity.
Complaints were made from 2009 regarding some ELS that the redemption condition failed to be met on account of a sudden drop in stock prices around the early redemption date or maturity. When it was found out that a large number of stocks were suddenly put to sale immediately before the stock market closing, the Korea Exchange (the KRX) began to investigate ELS.
As a result of this investigation, the KRX issued sanctions against some brokerages which dealt with ELS for violation of the provisions under its own regulations. After the investigation, the public prosecutors' office began investigating some brokerage firms that dealt with ELS and civil proceedings were instituted by investors.
In the civil proceedings, the trial courts recently made two inconsistent decisions. First, in a case where a brokerage firm won, the court held that "as fulfilment of the early redemption condition and the redemption at maturity are deemed to be compatible with each other in legal effects, the legal relationship between the plaintiffs (investors) and the defendant (brokerage) had already ended as the defendant completed its performance through redemption at maturity."
On the contrary, in the case where investors partially won, the court ruled that "the brokerage would have been disadvantaged by the fulfilment of the early redemption condition in relation to investors and that such brokerage firm's sale of the underlying assets of ELS at issue in a large amount immediately before the stock market closed on the early redemption date violated the good faith principle to not conduct trades which would have unjust influence on formation of the fair prices of the underlying assets."
Both cases are now pending before the same appeal court in Seoul High Court. The brokerage industry is watching the progress of the cases with great interest because the court's decision regarding ELS could determine the legality of delta hedging by brokerages, the basis of ELS.
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