Corporates have publicly accused banks of selling them toxic derivatives that they didn’t understand. Bankers have retaliated with cynical observations that the companies were happy to benefit from the products until the tide turned in the world’s financial markets.
Particularly at fault in the companies’ eyes are knock-in knock-out structures, commonly known as kikos. Small and medium enterprises bought these products to hedge themselves against appreciations in the value of the won. The structure allows them to sell a certain amount of foreign currency to the structurer at higher than market rates.
When times were good and the Korean won was rising, the structure worked well. But the currency has depreciated sharply in recent months, exposing the companies who bought them to large losses.
The merits of both arguments will be put to the test in the middle of the year, when Korean courts rule on approximately 330 law suits brought forward by corporates suffering from losses arising from kikos.
Amid all the mudslinging, a critical issue has only just come to international attention by way of the International Swaps and Derivatives Association (ISDA).
While pursuing law suits, a number of corporates asked several local courts to grant preliminary injunctions to stop payments to the banks for these kiko structures. And in some landmark decisions handed down in January, the Seoul Central District Court found in favour of the corporates.
The judges ruled that the sudden depreciation of the won was unanticipated by companies when they signed the contract, and to force them to continue owning up to their obligations would violate an obscure principle of changed circumstances and be seen as inequitable.
The courts are essentially saying that these corporates bought the products with the expectation of stable exchange rates, and because of unexpected movements in the won the trades should be voided.
It’s a spurious argument. The companies bought these contracts for the very purpose of protect themselves against potential movements of the won – they just hedged the wrong way.
In other cases the courts ruled in favour of the banks, but these were hollow victories at best. The judges reasoned that the banks were in the clear because they had offered stop loss trade ideas to their clients, or structures that would limit the potential losses from the kiko products. Because of this, the judges concluded the banks had fulfilled their fiduciary responsibility to customers.
But this ruling assumes that the banks had a responsibility to help their clients invested in the kiko structures. That severely undermines the principle of non-reliance, or the concept that each party is accountable for its own decisions in the signing of a contract. It is a widely accepted notion in over-the-counter derivatives markets.
“Once you make one counterparty responsible for looking after the other's interest, everything changes in an unhealthy fashion,” said Keith Noyes, ISDA’s regional director for Asia Pacific.
Doing companies a disservice
The courts may think that they are helping companies that have been taken advantage of by ruthless bankers.
But by creating such legal precedents they risk doing companies a grave disservice. If the courts uphold these earlier judgments in the summer, it would be very bad news for the ability of companies to hedge in the future.
Confirmation of the earlier rulings would leave the door open for any company that had taken out a derivatives contract to go to court and get it voided if the market moves unexpectedly and the company loses money.
That would call into question the sanctity of any derivatives contract made in Korea. Banks would have little choice but to cut back on selling structured products to corporates and raise the risk premiums of all products they do sell.
Rising hedging costs would leave many Korean businesses with no option but to leave their foreign exchange, interest rate and commodity risks unmanaged. That would be disastrous if they run headlong into further market volatility.
The ruling could even cause foreign banks and companies to query the sanctity of any financial contract signed in Korea that is exposed to market movements, from the simplest commercial loan to complex business partnerships.
Some of the potential harm has been averted since January as the panel that made that ruling was recently replaced in the scheduled rotation of judges. Observers also cheered when a district court in Incheon rejected a similar suit to suspend the contract in March, ruling that the depreciation of the won wasn’t a good enough reason to grant an injunction.
But observer worries still remain the earlier rulings may influence the judgments to come.
“If this doctrine of changed circumstances is confirmed in the final rulings…that would have disastrous consequences for doing derivatives in Korea,” said a senior foreign banker based in Seoul.
Korea’s judges have important decisions to make on whether investors were mis-sold kikos. They should not be tempted to uphold previous rulings that effectively void the derivatives contracts themselves.
To do so would have massive ramifications for confidence in Korea’s financial system. If international banks start getting jittery about the sanctity of financial contracts, the country’s long-stated ambition to become an international financial hub will never amount to more than a pipe dream.