In this administrative case, the Governor of the Financial Supervisory Service (the “FSS”) imposed heavy penalties on the executives of a bank, including the president of the bank, for misselling derivatives-linked funds whose value is linked to overseas interest rates (“DLFs”) and violating obligations to implement internal control standards under the Corporate Governance Act.
Following a judgment from the first instance court (Seoul Administrative Court), the Seoul High Court ruled that the heavy disciplinary action imposed by the FSS was unlawful. The Supreme Court also recently rendered a decision dismissing the appeal of the Defendant. This decision is the first Supreme Court decision that explains the specific legal principles on the violation of obligations to implement internal control standards. Kim & Chang successfully represented the plaintiffs in this case.
In this instance, the misselling of DLFs to general investors caused huge losses for the investors and became a social issue. In addition to raising issues regarding the misselling of DLFs by a person responsible for sales, the FSS also argued for the first time that the fundamental cause of the misselling was that financial companies failed to establish adequate internal control standards, and imposed administrative sanctions on the officers of financial companies (including, as in this case, the president of the bank).
At the time of the initial disposition, the FSS was criticized for claiming that the misselling of DLFs violated the obligation to establish internal control standards in order to sanction the executives of financial companies. This case has drawn attention as it marks the first time a claim was filed against the FSS regarding financial companies’ obligations to establish internal control standards. The following paragraphs will elaborate on the details related to this case.
Contents, Requirements and Criteria Regarding Obligations to Establish Internal Control Standards
The FSS argued that even if formal internal control standards have been established, in the event that they are not effective, and result in large-scale misselling as in this case, based on the purpose of the Enforcement Decree of the Corporate Governance Act “to ensure that internal control is effectively carried out,” the obligation to establish internal control standards was violated.
As counsel for the plaintiffs, we argued that the obligation to establish internal control standards under the Corporate Governance Act should be strictly interpreted in light of its wording, as it serves as the basis for administrative sanctions, and that it is unreasonable to excessively expand the scope of such obligation by interpreting “effectiveness,” which is merely the stated purpose of the Enforcement Decree, as a requirement to satisfy the obligation to establish internal control standards, as argued by the Governor of the FSS. In particular, we pointed out that the FSS’s logic would result in holding the bank’s management, which is obligated to establish 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 detailed internal control standards in advance to entirely prevent misselling and that it was not predictable by the bank, which is subject to internal control standards, and argued that governance laws and regulations should 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 the duty to prepare internal control standards was violated. Considering the foreseeability of financial companies and the 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. The Court applied the principles of strict interpretation, foreseeability, non-punishment of a violation of the duty to comply with internal control standards, which were argued by the plaintiffs, to determine whether to accept the violation of the duty to prepare, as acknowledging the principle of administration under the rule of law.
Citing the Seoul High Court’s decision, the Supreme Court unprecedentedly declared a legal principle providing that as long as the statutory matters set forth in the internal control standards-related laws and regulations are all included in the internal control standards, and such statutory matters cannot be deemed ineffective, a violation of the duty to establish internal control standards cannot be recognized.
This is the first Supreme Court decision that provided clear legal principles and judgments on the specific scope of the obligations to establish internal control standards and the standards for interpretation that are imposed on the officers of financial companies under the Corporate Governance Act.
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), this would have had a significant impact on the financial market as a whole, as the financial market would have been subject to administrative sanctions for violations of internal control standards that had not been anticipated by executives of financial companies, including, in particular the CEO of the financial company concerned.
However, even considering the implications of the Supreme Court’s decision, whether the obligation to establish internal control standards has been violated may be judged differently depending on the circumstances of each individual case. Therefore, in practice, it is expected that there will still be controversy over whether the FSS may impose sanctions for violating obligations to establish internal control standards.