In this administrative case, the Governor of the Financial Supervisory Service (the “FSS”) imposed heavy penalties on executives of a bank (including the president of the bank) for misselling overseas interest rate-linked derivatives-linked funds (“DLFs”), violating obligations to implement internal control standards under the Corporate Governance Act.

In addition to the district court (Seoul Administrative Court), the Seoul High Court recently rendered an appellate decision ruling that the heavy disciplinary action imposed by the FSS was unlawful.  Kim & Chang successfully represented the plaintiffs in this case.

In this case, the misselling of DLFs to general investors caused a huge loss to investors and became a social issue.  The FSS raised issues with the misselling of DLFs by the person responsible for the sales.  It also argued for the first time, that the fundamental cause of the misselling was the failure to establish internal control standards for financial companies to prevent misselling, and imposed administrative sanctions on the officers of financial companies (including the president of the bank, as in this case).

At the time of the initial disposition, the FSS was criticized for unreasonably arguing that misselling violated obligations to establish internal control standards in order to sanction the executives of financial companies.  This case has drawn much attention as it marks the first time a claim has been filed against the FSS based on obligations to establish internal control standards by financial companies.

1.   Contents, Requirements and Criteria for Obligation to Establish Internal Control Standards

• The FSS argued that even if formal internal control standards have been established, in the event they are not effective, and result in large-scale misselling as in this case, based on the purpose of the Enforcement Decree of the Governance Act “to ensure that internal control is effectively carried out,” the obligation to establish internal control standards has been violated.

• As counsel for the plaintiffs, we argued that the language of the obligation to establish internal control standards under the Governance Act should be interpreted strictly as it serves as the basis for administrative sanctions.  We also contended that it would be unreasonable to excessively expand the scope of the obligation to establish internal control standards by interpreting the “effectiveness” referenced in the purpose of the Enforcement Decree as a requirement to satisfy the obligation to establish internal control standards, as argued by the FSS.  In particular, our team pointed out that the FSS’s logic would result in holding the bank’s management, which is obligated to establish the internal control standards, accountable for consequences ex post facto, when the actual violation was simply a violation of the “obligation to comply” with the internal control standards.  We explained in detail that it was not possible to prepare all detailed internal control standards in advance to prevent misselling entirely and it was not predictable by the bank, which is subject to the internal control standards, and argued for  the governance laws and regulations to be interpreted systematically.

• The Seoul High Court noted that it is necessary to take into account the meaning of effectiveness, which is explicitly included in the Enforcement Decree, to determine whether there is a violation of the duty to prepare internal control standards.  Considering the foreseeability of financial companies and principle of strict interpretation of intrusive administrative dispositions, the Seoul High Court presented a compromised legal principle that the duty to prepare internal control standards can be deemed to exist only in cases where the statutory matters have been substantively flawed.  In its determination of the case, the Court applied the principles of strict interpretation, foreseeability, non-punishment of a violation of the duty to comply with internal control standards, etc., as argued by the plaintiffs to determine whether to accept the violation of duty to prepare, as acknowledging the principle of administration under the rule of law.

2.   Application of Obligation to Establish Internal Control Standards 

• The Seoul High Court applied the above criteria to determine the obligation to prepare internal control standards and held that none of the five points raised by the FSS were in violation of the obligation to prepare the internal control standards to the extent that the internal control standards were practically defective.  The Seoul High Court found that the internal control standards were only insufficient in part or due to errors in the operation process.  Thus, it found that all of the dispositions issued by the FSS were unlawful (for reference, the district court had ruled that one of the five points raised by the FSS was a violation of the obligation to prepare the internal control standards, but the appellate court applied the relevant legal principles more strictly and denied there was any violation of the obligation to prepare, including even the single point which had been recognized by the district court).

This judgment is the first court decision to clarify the legal principles and judgments on the specific scope of the obligation to establish internal control standards and the standards for interpretation imposed on officers of financial companies under the Corporate Governance Act.

In particular, if the arguments made by the FSS had been accepted, i.e., that this type of event was to be deemed an ex post facto violation of the obligation to prepare internal control standards, there would have been a significant impact on the financial market as a whole, as the financial market would be subject to administrative sanctions for violations of internal control standards, that have not been anticipated by executives of financial companies, especially the CEO of the financial company concerned.  This is a case of significant interest in the financial industry.

However, even considering the purport of the Seoul High Court’s decision, whether the obligation to establish internal control standards has been violated may be judged differently depending on each individual case.  Therefore, in practice, the controversy regarding whether the FSS may impose sanctions for violating an obligation to establish internal control standards will persist in other cases.