An appeal ruling in South Korea found that the large sale of underlying assets just before maturity is not justified, even if it was done for hedging and is the proximate cause of losses suffered by investors, according to an associate US attorney at Hannuri Law Offices. On October 28, the Seoul High Court ordered Deutsche Bank to pay KRW1.8bn (US$1.6m) to 26 investors.
The ruling relates to the 514 investors who bought KRW19.89bn (US$17m) of equity-linked securities (ELS) in the form of Rich Father ELS 289, according to a press release from Hannuri, issued on May 30, 2016. The two-year capital-at-risk structured product was issued in August 2007, linked to the shares of Kookmin Bank and Samsung Electronics, and was issued by Korea Investment & Securities (KIS).
The product had a combination of knockout, protected tracker and worst-of option payoffs, where it offered initial capital plus a 28.6% payout, if the final prices of the shares did not fall below 75% of their initial prices at maturity, or if neither share fell below 60% of its initial level at any time during the investment. The product matured on August 31, 2009.
In 2010, the investors filed a case claiming they suffered losses because of Deutsche's massive sell off KB Financial Group shares on August 26, 2009, just days before the product was due to mature, 10 minutes before the market closed. The sale affected the final price of the product, avoiding additional losses, which resulted in more than 25% losses to investors and corresponding profits to Deutsche, stated the press release.
The sale could have contributed to the fall of Kookmin Bank's stock to KRW54,700 ($47.38), the court said in its judgement, just below the KRW54,740 barrier that would have triggered a knockout for an ELS, forcing the company to repay investors capital along with a coupon. The price of Kookmin Bank shares was well above the protected tracker criteria of KRW54,740 until two days before the maturity date when the price of Kookmin Bank dropped from KRW56,000 to KRW54,700.
The stock manipulation is not related to KIS, according to a spokesperson for the Korean financial institution.
The district court first sided with the investors, finding that the defendant manipulated the underlying asset of the ELS with an abrupt large sale just before the maturity, according to the attorney. On appeal, the defendant bank argued that its sale activity should not be seen as "manipulation", but rather "justified hedging activity in accordance with the related regulations", and the appellate court accepted the defendants' argument thus overturning the district court's decision, he said.
"The Supreme Court, however, again overturned the appellate court's decision and remanded the case to the appellate court, reasoning that the defendant timed its sale just before the maturity, with a large effect on the fixing of the final price of underlying asset on which the return is decided and this activity should be seen as manipulation," said the attorney.
"In the second appellate court level, the two parties sparred on the issue of the defendant's liability," he said. "The plaintiffs argued that the activity was done with intent to manipulate, while the defendant's intention was not established and the activity is just a justified hedging activity.
"The appellate court, this time, sided with the investors, stating that the hedging purpose is not enough to justify manipulation activity, thus ordering the defendant to make up the losses suffered by the investors, which amounts to about US$2m, with accrued interest."
The second appellate court found the bank in violation of section 178 of the Capital Market Act (CMA) (which is similar to Rule 10b-5 of the US Securities Exchange Act), saying that the bank's large sale of underlying assets just before maturity is not justified, even if it was done for hedging and is the proximate cause of the losses suffered by the investors, according to the attorney.
"The bank argued that its activity, so called delta hedging, should be justified, but the court did not buy it," he said. "The court specifically said that delta hedging is just one of the hedging methods used by financial institutions and, on its own, is not enough to justify the fraudulent activity in violation of the CMA. Thus, while an activity was done to hedge, it still can be illegal fraudulent activity."
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