As detailed in our previous newsletter (Link), on July 28, 2022, the Financial Services Commission (the “FSC”), Supreme Prosecutors’ Office, Financial Supervisory Service (the “FSS”) and Korea Exchange jointly announced proposed measures to strengthen the detection and punishment of illegal short sales and to improve the short sale regime. Since the announcement, investigations and enforcement actions related to short sales have continued and relevant regulations have been strengthened. In addition, the Securities and Futures Commission (the “SFC”) recently announced its decision to impose administrative penalties for short sale violations for the first time. Set out below are previous trends, recent decisions made by the SFC, and anticipated developments pertaining to short sale rules and sanctions.
Recent Sanctions on Short Sale Violations
Below is a summary of the regulatory trends on short sales by financial authorities from the date of the joint announcement (July 28, 2022) to March 8, 2023, when the SFC imposed its first administrative penalties for violations of short sale regulations:
The amended Financial Investment Services and Capital Markets Act (the “Amended Capital Markets Act”), which was effective from April 6, 2021, newly introduced the following criminal and administrative penalties for illegal short sales: (i) criminal penalties resulting in either imprisonment for one year or longer or a fine equivalent to three to five times the amount of profit earned from the breach and (ii) administrative penalties within the scope of the short sale order amount. These penalties effectively replace the administrative fines that were imposed for illegal short sales prior to the Amended Capital Markets Act taking effect.
On December 14, 2022, the SFC reviewed and imposed administrative fines for certain illegal short sale cases that occurred before the Amended Capital Markets Act took effect. Meanwhile, financial supervisory authorities have continuously investigated violations of short sale regulations that occurred on or after April 6, 2021. During its meeting held on March 8, 2023, the SFC decided to impose administrative penalties for violations of short sale regulations for the first time.
One of the two short sale violation cases for which the SFC imposed an administrative penalty on March 8, 2023 involved short sell orders placed for shares that were to be issued without consideration but were recognized in the subject company’s internal system as shares available for sale. In this case, the subject company had originally recorded the deposit of the shares in its internal system prior to their actual issuance for the purpose of valuating the fund. The other case involved short sell orders that were placed after an incorrect number of borrowed shares was erroneously recorded in the inventory management system.
Pursuant to the Amended Capital Markets Act, administrative penalties of up to the relevant short sell order amount were imposed on the subject companies of the cases mentioned above. Specifically, administrative penalties of KRW 3.87 billion and KRW 2.18 billion were imposed on the two subject companies, respectively. As significant administrative penalties may be imposed for violations of short sale regulations even if said violations resulted from simple errors or mistakes and rather than from gross negligence or intentional wrongdoing, special care should be exercised with respect to short sale trades in Korea.
Financial authorities indicated that they are observing a steady flow of short sale violations as a result of inadequate inventory management, trader negligence/error and inadequate internal controls over stock borrowing trades, and vowed to continue to strengthen their investigation and enforcement actions on violations of short sale regulations.
In addition, the Short Sale Investigation Team at the FSS, which was established in 2022, is currently leading the FSS’s efforts to investigate unfair trade practices relating to short sales in order to gather information and closely examine transactions involving local brokers and investors that participated in large volume short sale trades that potentially breached regulations. Based on publicly disclosed information, the Short Sale Investigation Team appears to be investigating not only naked short sales but also unfair trade practices related to short sales as well as short sales linked to block trades (e.g., short sale trades conducted during the book-building phase of block trades).
Changes to Short Sale Regulations
1. Partial Amendment to Financial Investment Business Regulations Relating to Short Sales
On November 9, 2022, the proposed amendments to the Financial Investment Business Regulations relating to short sales became effective. The primary purpose of the amendments was to stipulate the measures jointly announced by the relevant government agencies on July 28, 2022 in order to strengthen the detection and punishment of illegal short sales and improve the short sale regime.
Specifically, the amendments stipulate (i) the reduction of the collateral ratio for retail investors′ short sale trades (from 140% to 120%), (ii) the obligation of the party that has entered into stock lending and borrowing for the purpose of engaging in a covered short sale to report detailed information on the relevant balance of stock lending and borrowing, and (iii) the obligation to file a report to the financial authorities regarding long-term stock borrowing (over 90 days).
2. Public Disclosure of Parties Subject to Administrative Penalties for Breach of Short Sale Regulations
On December 1, 2022, the FSC announced a new measure to publicly disclose on the FSC′s website the names of each party subject to regulatory investigation that receives an administrative penalty for breaches of short sale regulations or for market disruption activities.
This new measure was first applied to the parties upon which the SFC imposed administrative penalties following its deliberation during its meeting on December 14, 2022. The names of the parties were disclosed on the FSC’s website in February 2023.
The new measure applies equally to foreign financial companies receiving administrative penalties for short sale regulation breaches and will result in the public disclosure of their names and the penalty amounts imposed. However, information on parties whose cases are referred to criminal authorities by financial regulators will not be made public even if said parties are subject to administrative penalties for violations of short sale regulations.
Announcement of Strengthened Short Sale Regulations by Financial Authorities
Financial authorities are expected to continue to strengthen short sale-related rules and measures this year, as summarized below:
The FSC’s annual Key Work Implementation Plan for 2023, which was announced on January 30, 2023, includes a proposed amendment of the Capital Markets Act to introduce new measures for parties that receive an administrative penalty for breaches of market disruption regulations or short sale rules. These measures include a prohibition on certain transactions (e.g., new transactions involving financial investment products, opening of new accounts) and disqualification from serving as an officer of a listed company for up to ten years.
In its annual Work Plan for 2023 (the “FSS Work Plan”), which was announced on February 6, 2023, the FSS proposed to monitor short sale trades more closely by implementing a new securities lending transaction reporting system, which will impose obligations to report the balance of borrowed securities and stock borrowings for short sales for 90 days or more. In addition, the FSS Work Plan calls for an overall examination of securities companies’ management and the operation of aggregation units (e.g., independence of personnel and operations, details of securities trading, lending and borrowing) and, if necessary, the introduction of improvement measures. The FSS also indicated that it plans to increase its enforcement activities regarding market manipulation and insider trading involving the use of over-the-counter (“OTC”) swap transactions such as TRS, CFD and short positions.
The Korea Exchange announced on January 31, 2023, its plan to implement measures to strengthen its monitoring of illegal short sales, including the shortening of inspection periods for short sale breaches from over one week to two days, enhancing information sharing with overseas authorities, and implementing a new process to prohibit market participation for up to ten years (i.e., ban on new tradings of financial investment products and new account openings) for parties committing unfair trade practices.
As detailed above, this year, the relevant financial authorities are continuing their efforts to strengthen the regulations and measures regarding short sales, underscoring the importance and timeliness of implementing and enhancing compliance systems and controls to prevent short sale rule breaches as well as monitoring future legislative and policy developments.