This is the abstract of an article on Collateralization, which is contained in the Kyung Hee Law Journal, Vol.39 No.1 published in June 2004.

When a finance company X entered into derivative deals with a Korean company Y, X collateralized the transactions using pledge upon the stocks issued by X under the Korean law. In the meantime, Y fell into default and finally applied for corporate reorganization proceedings. As a consequence, X could unilaterally dispose of Y-owned stocks and used the proceeds to satisfy its claims. But the receiver of Y tried to avoid the disposition of pledged property by X on the ground that it amounted to the extinguishment of claims after the suspension of payment subject to the Court's order to preserve Y's assets. It is true Y did not commit any act in relation to the disposition.

Nevertheless, in February 2003, the Supreme Court rendered a decision (2000 Da 50275) that denied the disposition of collateral by a secured party because a receiver's right to avoid was still applicable. The rationale was that any individual exercise of pledge rights is prohibited and stayed, and that all acts of repayment of debt or extinguishment of claims had to be made within the context of the rules governing the corporate reorganization proceedings. The Court held that implicit in the act of avoidance is an obligation to restore the property of the company under reorganization to its original state.

Based on the ruling, it can be concluded that disposition of pledged property to satisfy a secured claim is equivalent to an act of enforcement and is thus subject to a receiver's right of avoidance. As a matter of fact, international banks can no longer be certain of the effectiveness of taking a security interest in Korean assets by way of a pledge from Korean companies.

In response, various solutions have been sought to overcome the uncertainty and deal with the practical reality of mitigating risk in their derivative and other secured lending transactions. Approaches being considered include:
   - maintaining collateral outside of Korea for use as eligible collateral under a Credit Support Agreement (CSA);
   - using repurchase agreements or trust structures; and

- adapting the automatic early termination concept to a CSA.

In practice, a financial institution engaged in derivative transactions used to have the following options:
   i) creating continuing pledge upon the collateral like cash or securities; or
   ii) exercising set-off between the counterparty's deposit of cash or securities and its own secured claims.

As a result, if a party of the transactions applied for bankruptcy or corporate reorganization proceedings, the secured party may enforce its security right by disposing of the collateral and using the proceeds to satisfy its claims. If the secured party contemplates set-off in the event of insolvency, the creditor may collect its residual claims by setting off its liability to return the deposit up to the identical amount. This kind of set-off is provided for as close-out netting in the event of insolvency of the counterparty under the ISDA Master Agreement.

Therefore, the concept of automatic early termination together with contractual close-out netting under the ISDA Master Agreement is construed effective in the event of insolvency of the counterparty of derivative transactions. However, it is unclear whether netting would be respected under the Corporate Reorganization Act. So the ultimate response to the collateralization of derivatives issue is likely to be a legislative one.

At present, it remains to be seen whether the collateral issue within the context of derivative transactions will be incorporated into a new consolidated insolvency law, whose draft will be posted again on the new agenda of the National Assembly. Otherwise, a new special act might be considered in the same manner as the Japanese Law on the Close-out Netting of Specific Financial Transactions Carried-out by Japanese Financial Institutions.

In view of the on-going North-East Asian Financial Hub Strategy of the Government, it seems to be imperative to build up a legal infrastructure for the efficient risk management and foreseeable legal stability related with derivative transactions. By doing so, we can expect more and more foreign investors come to play in the financial markets of Korea.