SEOUL (Reuters) — US buyout fund Lone Star scrapped a $7.3 billion deal to sell Korea Exchange Bank (KEB) because of an escalating legal battle, denting foreign investor confidence in South Korea.The decision also leaves the buyer, Kookmin Bank, in limbo as it had pinned its strategy on buying the smaller rival.

The deal had been regarded as a litmus test for foreign investment into South Korea, which has been on the decline since last year amid a backlash against big profits made by foreign funds following the 1997-98 Asian financial crisis.

“The case heightens fears among foreign investors that they can’t invest and just walk out of South Korea with fat gains,” said Ryu Jae-Cheol, an analyst at Tongyang Investment Bank. “It will be almost impossible for Lone Star to find a new buyer from overseas when potential buyers don’t know whether the prosecutors will block a deal yet again.”

Lone Star, the most active private equity fund in Asia’s third-largest economy, had been prevented from completing the deal agreed in May as prosecutors looked into allegations that financial data on KEB was understated to help Lone Star buy the bank at a bargain price of $1.2 billion.

The nine-month legal battle led to the indictment of KEB and a Lone Star unit, and escalated with arrest warrants against two Lone Star executives. Lone Star and KEB have denied any wrongdoing.

“We have concluded that we cannot move forward with the sale of KEB to Kookmin Bank due to the continuing investigations surrounding Lone Star’s investment in KEB and KEB’s subsequent rescue of its credit card subsidiary, which have been extended several times and now have no firm completion date,” Lone Star Chairman John Grayken said in statement.

Kookmin, South Korea’s biggest bank, said it would seek internal growth but didn’t discount the possibility of buying KEB if Lone Star put it up for sale again.

“We had already been preparing for various alternatives for growth other than the KEB acquisition,” Kang Chung-won, Kookmin’s chief executive, told a news conference.

The Lone Star decision shattered a central plank of its expansion plans, though, analysts said.

“For Kookmin, KEB was a great opportunity to drive growth momentum and expand. Now that momentum is gone, and they are going to have to find a new strategy,” said Ku Yong Uk of Daewoo Securities. “Kookmin doesn’t seem to have any clear acquisition target, but buying abroad may be the most probable strategy.”

The Supreme Prosecutors’ Office also alleged KEB’s top management artificially pushed down the share price of a credit card affiliate it bought out in early 2004.

The latest twist will not affect the prosecutors’ investigations, Chae Dong-wook, superintendent prosecutor, told Reuters. He declined to give a timeframe for the probe results.

“Lone Star may not be able to exit Korea right away. This is not going to look good to other potential foreign investors,” said Thomas Choi, head of research at PCA Asset Management.

Lone Star was likely to focus on extracting dividends from KEB, which could reach 1.3 trillion won ($1.4 billion) at a maximum, to appease its investors before putting the bank up for sale again, analysts said.

“With a new takeover deal seemingly unlikely for the time being, Lone Star could raise dividends in a bid to recoup some returns from their investments,” said Tongyang’s Ryu.