1.1 The Purpose of the Book
Financial mis-selling began occurring in advanced financial markets such as the US and the UK from the early 1990s. During the 1990s in the US, āmis-sellingā disputes about over-the-counter derivatives started to become a matter of public concern, which involved the California District Government of Orange County, Procter & Gamble, and many other private and public entities.1 In the UK, from the 1990s, disputes concerning āmis-sellingā of over-the-counter derivatives reached courts despite not attracting public attention as in the US.2
Since then, with the progress of financialization and the rise of the level of income, financial mis-selling has become a common problem shared by many jurisdictions. The global financial crisis showed this global trend of āmis-sellingā vividly. Macro-economic indicators such as currency exchange rates and interest rates showed great volatility during the crisis and in its aftermath, which resulted in unexpected, significant losses for end-users of investment instruments. The International Monetary Fund reported that 50,000 non-financial firms in many developing and developed countries suffered significant losses from over-the-counter derivatives contracts during the crisis.3
Because mis-selling of investment instruments can shake lives of ordinary households and destroy financial stability of small and medium sized enterprises (hereafter āSMEsā), it can turn into a social and political issue and become one of the major regulatory targets. As such, financial regulators of developed capital markets have crafted conduct of business regulation (hereafter āCOBā) such as information disclosure, suitability duty, and product intervention to prevent mis-selling of financial services and the COB has spread to other jurisdictions.
However, there are two major challenges to adopting and implementing the COB. The first challenge comes from the fact that COBās rules are not specific and clear rules but general standard rules. General standard rules describe the regulatory objective and do not specify detailed procedures or measures, and so discretionary judgement is required to determine whether compliance has been achieved depending on the circumstances. For example, suitability duty requires financial institutions to recommend only suitable products to investors, and suitability can be determined based on each investorās capability and wealth; information disclosure duty requires financial institutions to provide all information that is important for the investment decision and so discretionary judgement is needed about what is important information for each investor. As such, jurisdictions that do not have prior experience of operating general standard rules in their regulatory system are highly likely to fail in achieving the intended goal of the COB.
The second challenge to implementing the COB is that it is likely to conflict with principles of private law which has governed contracting in commerce for centuries. For example, private law holds caveat emptor as one of its basic principles in commercial transactions while the COB demands fiduciary duty, or at least equivalent duty, on sellers, i.e. financial institutions. The basic assumption of the COB is that transactions between financial institutions and unsophisticated investors cannot be armās length contracts. Because the COBās requirements conflict with the traditional order set by private law, they are difficult to enforce.
The book explores such challenges that deter achievement of the objectives of the COB and discusses ways to overcome them. For this purpose, the book is based on case studies of COB regimes of the UK and South Korea, in particular mis-selling cases of over-the-counter derivatives. Albeit that there is a large spectrum of financial instruments, such as investment, insurance, and deposit and lending products, with the potential of incurring financial mis-selling, this bookās focus on over-the-counter derivatives comes from that over-the-counter derivatives show the causes and devasting consequences of mis-selling with the most clarity. First, over-the-counter derivatives are more vulnerable to mis-selling than other financial instruments because of the significant informational asymmetry between consumers and sellers. While the financial services industry is notorious for information asymmetry,4 the over-the-counter derivatives market is one of the worst areas even in the industry. Derivatives are unfamiliar products compared to other commonly transacted financial products like loans and insurance.5 Consumers have limited knowledge of derivatives markets. Even large corporationsā financial comptrollers who have substantial knowledge and experience in financial markets cannot understand the structure and risks of complex over-the-counter derivatives by themselves. It is practically impossible for consumers, even corporate clients, to compare the price and other terms of non-standardized over-the-counter derivatives offered by different financial institutions.6 Therefore, consumers with insufficient information and knowledge have to rely on salespersonsā explanations of over-the-counter derivatives.
Second, on the supply side, over-the-counter derivatives transactions are more lucrative for financial institutions compared to other generic financial products.7 The attractive margins lead to pressure on salespersons to achieve high sales volume. This pressure isnāt only business-driven, but also self-inflicted due to the personal sales-based compensation system. The lucrative profit and generous personal compensation can create blindness8 to the interest of consumers, if not opportunism.9 The combination of the reliance and sales performance pressure makes over-the-counter derivatives more vulnerable to mis-selling.
Third, the size of losses from over-the-counter derivatives tends to be extensive. The leverage used by over-the-counter derivatives can cause losses significantly exceeding the investment principal and can even drive the investor into bankruptcy. In fact, many companies that incurred losses in derivatives transactions ended up in bankruptcy. Thus, a mis-selling scandal involving over-the-counter derivatives can create a huge economic, social, and political disturbance and so the failure to prevent or adequately manage such a scandal can greatly damage the publicās confidence in the financial market. So, it is critical for the vitality and sustainability of the financial market to prevent extensive āmis-sellingā scandals of over-the-counter derivatives.
This book seeks to provide practical guidance to the policymakers and the financial regulators for redesigning COB. Thus it is an important goal of the book to derive normative and practical conclusions. To achieve this goal, the thesis adopts the comparative methodology in analysing the COB regimes of the UK and South Korea. The comparative study of the two countriesā COB regimes offers understanding of the nature of different regulatory strategies and finally identification of the resulting difference. Comparative study provides the insight which cannot be obtained by just analysing one regime on its own. Without a comparator, it is almost impossible to identify the causal relationship for certain aspects of regulation and their results.10 Section 1.2 discusses more about why the comparative approach is valuable for this book.
The reason for selecting the UK and South Korea as comparator jurisdictions...