[Law Talk] Importance of internal controls for financial institutions

For the past year, the financial crisis caused by the unsound business practices of certain financial companies such as Lime, Optimus and companies that sold derivative-linked funds, has been the hottest topic within the financial industry. Following the eruption of these well-publicized scandals, financial supervisory authorities began sanctioning financial companies for unsound business practices, fraud perpetrated by fund managers, and misleading sales practices known as “incomplete sales.”

Even after two years of issuing such sanctions, it remains an ongoing process because investors suffered losses in excess of hundreds of billions of Korean won as a result of these scandals. Accordingly, the Financial Supervisory Service announced severe disciplinary actions against certain representatives of large commercial banks and securities companies and required them to stand before the sanctions review committee, which had a considerable impact on the financial industry.

The FSS determined that the primary cause attributable to the recent private equity crisis was the lack of adequate internal controls within financial companies, and began to hold key executives of the financial companies responsible. Therefore, chief executive officers and key executives were under severe pressure to address the issue of whether adequate internal controls had been established. Under the existing legal framework, legal liability cannot be imposed on executives for neglecting internal controls, therefore, the FSS held executives of financial companies responsible for neglecting the codified duty to establish internal controls instead as required by the Financial Company Governance Act. Furthermore, even if a company had established such internal controls, if they were not properly implemented using an effective standard, the FSS could construe it as the equivalent of a failure to establish internal controls, and hold the CEO responsible.

Following these disciplinary actions, a sharply divided legal debate ensued. Questions arose as to whether a report of a violation of the duty to establish internal control standards could serve to impute liability for other incidents. Questions also arose as to what constitutes an appropriate legal basis for imposing such sanctions. In the wake of this uncertainty, the then CEOs of two commercial banks who had been sanctioned filed an unprecedented lawsuit against the FSS.

Recently, the Seoul Administrative Court ruled that sanctions imposed without a clear legal basis would shake the very foundation of the rule of law, and overturned the sanctions in that particular case. Although merely a judgment from a court of first instance, if comparable cases render similar judgements or such judgements are affirmed by higher courts, a fundamental limitation on regulators’ power to sanction executives for violating any obligation to establish internal control standards may take root.

Such judgements could blunt the power of the regulators to ‘sanction;’ however, would not necessarily mean that the financial authorities would change their policy direction of ‘strengthening and improving the internal controls of financial companies.’ Rather, it is expected that this policy direction will continue to trend so long as the purposes of internal controls are to protect financial consumers and ensure compliance with law and management directives.

This policy direction is accentuated in the proposal to amend the FCGA to hold executives accountable for neglecting their duties related to internal controls. Should another similar financial crisis occur or should a financial company‘s internal control system be found to have not been effectively integrated, sanctions may resurface. Therefore, financial companies remain faced with the difficult task of reorganizing internal control standards and establishing and properly operating an internal control system that can prevent scandals.

Financial scandals, whether or not subject to sanctions, is an internal controls issue. When an employee’s minor mistake, such as a fat-finger, overlaps with inadequate internal controls, it can lead to a major scandal. Reputational harm that flows from a major scandal can lead to investor churn, therefore, from a business perspective, internal controls is an important area of concern.

In an environment where financial consumer protection is being emphasized with enforcement actions related to the Financial Consumer Protection Act and the reorganization of the private equity fund system, many financial companies are reorganizing, supplementing and improving their existing internal control systems. Considering the role of internal controls in the recent private equity crisis, its importance cannot be overemphasized. To that end, financial companies are encouraged to prepare and establish an internal control system tailored to the changing environment while maintaining a good working relationship with the FSS.

Je Ok-pyeong and S. Janet Lee
Je Ok-pyeong is a partner at Yoon & Yang, with expertise in general finance, financial regulations and compliance, government investigations, as well as financial and capital markets disputes. S. Janet Lee is a US-qualified attorney at Yoon & Yang, with expertise in M&A, private equity transactions, foreign investments, and general corporate law. -- Ed.

By Korea Herald (khnews@heraldcorp.com)