Nov-Dec 2009 > Investment > Legal & Tax Scene
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Cracking the currency contract conundrum

A recent court ruling appears to validate the controversial Kick-in, Kick-out (KIKO) currency option contracts although a final decision is pending the outcome of several related trials

A mid the recent global economic downturn caused by risky financial products, one particular product called the knock-in/knock-out, or KIKO, option agreement has instigated numerous bankruptcies in Korea.

Beginning in mid-2008, many Korean firms and companies began folding -- and suing -- due to the devastating effects of currency contracts known as KIKO option agreements. KIKO option agreements are currency contracts with banks that involve two pre-determined currency thresholds.

If the exchange rate of the Korean won rose above the predetermined first "knock-out" threshold to the U.S. dollar, the Korean firms' right to sell U.S. dollars at a favorable fixed exchange rate to the bank would be "knocked-out" and no longer exist. In such a case, the Korean firms would sell U.S. dollars at the market rate after the option has been "knocked-out." However, if the exchange rate of the Korean won fell below the second pre-determined "knock-in" threshold to the U.S. dollar, the "knock-in" option comes into existence and the Korean firms' would have to sell US dollars to the bank at an unfavorable rate, taking a loss.

In other words, under a KIKO agreement, if the Korean won-to-the U.S. dollar exchange rate remains within the two currency levels, Korean companies can sell dollars at a higher fixed won-to-dollar exchange rate than the prevailing market won-to-dollar exchange rate. However, if the won-to-dollar exchange rate surpasses the stipulated upper limit, Korean firms must sell dollars at a rate that is twice or triple the prevailing won-to-dollar exchange rate.

From 2003 to early 2007, the Korean won kept appreciating against the U.S. dollar, while exports flourished and thrived and foreign direct investment thrived. Because exports contributed to approximately 56 percent of Korea's gross domestic product in 2008, up from 32 percent in 2001, Korean manufacturers are extremely sensitive to currency fluctuations. In 2006, the Korean won appreciated 8.4 percent against the dollar, becoming the third-best-performing currency in Asia. The steady appreciation of the won aggravated the position of Korean exporters and made KIKO option agreements attractive as a means of hedging their risk against the rising national currency.

UNCONSCIONABILITY RULED OUT

In 2006 and early 2007, KIKO options awarded purchasers generously. However, in 2008 and early 2009, the won lost 33 percent of its value against the dollar, falling precipitously to wind up as the worst performer among 16 major currencies. By September 2008, the top eight Korean banks reported profits of 2.57 trillion won (approximately US$2.3 billion at that time) from the sale of hundreds of currency-option contracts.

By the fall of 2008, more than 100 Korean companies had filed lawsuits and class action suites against domestic banks over KIKO options agreements on the grounds of unconscionability. This is a defense by one party against the enforcement of a contract because the contract contains extremely unfair terms to that party, in this case, the companies claiming that the banks had failed to properly explain the risks before selling them the KIKO option agreements. Unfortunately, the courts have ruled inconsistently on the enforceability of KIKO option contracts.

On Dec. 30th 2008, the first court decision on a KIKO option case was handed down by Seoul Central District Court. In its decision, the Court rejected the plaintiff's claim that the KIKO option agreement was unconscionable and thus null and void. However, the Court also found that the KIKO option agreement was terminated by the plaintiff when the plaintiff served a notice of termination to the defendant bank, and thus the plaintiff was no longer obligated to make further payments on the Agreement.

In its decision, the court found specifically that:

  • The KIKO agreement was entered into by the parties on the premise that the won-to-dollar exchange rate would not exceed the predetermined exchange rate range
  • It is contrary to public policy to enforce KIKO option agreements where the circumstances have changed materially since the time the agreement was entered into
  • The defendant bank violated good faith principles in the KIKO option agreement because, if the won depreciates substantially against the dollar, the plaintiff companies would have virtually unlimited liability, and
  • The defendant bank failed to adequately explain the risks involved with the KIKO option agreement.

BLANKET DECISION

In the meantime, hearings were organized by members of the National Assembly, and protests were held by businesses affected by the KIKO option agreements at the National Assembly Building with demonstrators holding signs that read "KIKO OUT." In February 2009, the National Assembly passed a new capital markets law that prohibits banks from soliciting the sale of KIKO option agreements to non-sophisticated investors.

In a similar manner to the Dec. 30th 2008 court decision, on March 10th 2009, the Incheon District Court rejected the plaintiff's request to nullify a KIKO option agreement. However, the Court differed by holding that the KIKO option agreement was not terminated upon a notice of termination served on the defendant bank.

On April 24th 2009, the Seoul Central District Court issued a blanket decision for ten KIKO option agreement cases it had consolidated. To wit, the Court did not find fraud or mistake in entering the KIKO option agreements. Similarly to the Incheon District Court's ruling, the Seoul Central District Court found that the KIKO option agreements were not terminated with a notice of termination served by the plaintiffs on the defendant banks.

Rather, the Court found that the defendant banks had to comply with the "Principle of Suitability" of products for its customers and had the "Obligation to Explain" adequately about its products. However, the Court held that a violation of these obligations does not affect the validity of the KIKO option agreements, but if a plaintiff sustains injury from a violation of these obligations, a defendant bank may be liable for such injury.

On Aug. 23rd 2009, the first decision by an appellate court on the issue of KIKO option agreement was issued. The plaintiff appealed the trial court's denial of its motion for injunctive relief on the enforcement of its KIKO option agreement. The Seoul High Court affirmed the trial court's ruling and rejected the plaintiff's claim that the KIKO option agreement was

  • Unfair
  • Entered into under fraud or mistake
  • Null and void due to a substantial change in circumstances, and
  • In violation of good faith by the defendant banks.

As the deadline to appeal to the Supreme Court has lapsed, this case has become final and conclusive. However, as there are still a number of trial and appeal cases currently pending in the court system, the issue of the KIKO option agreement has not yet been fully settled.

Jae H. Cho
Lee International IP & Law Group
jhcho@leeinternational.com