On December 12, 2019, the Financial Services Commission (the “FSC”) announced their final plan on measures to strengthen the protection of investors in high-risk financial investment products (the “Final Plan”).  The Final Plan is the outcome of comments solicited from the industry with respect to the initial plans which had been announced by the FSC on November 14, 2019 (the “Initial Proposal”).

In 2019, there was a surge in the sale of derivatives-linked fund (“DLF”) and derivatives-linked securities (“DLS”) products referencing the interest rates of German Bunds or the UK/US CMS rates to retail investors.  Such products were not principal protected, and some of the products sold caused significant losses for a considerable number of retail investors.  After investigating the financial institutions involved in the sale, structuring and hedging of the DLF and DLS products, the Financial Supervisory Services (the “FSS”) announced its Initial Proposal and Final Plan to protect investors in high risk financial investment products. 

We summarize the key aspects of the Final Plan as follows: 

1.    New classification of High-Risk Financial Investment Products (“High-Risk FIPs”)

In the Final Plan, the FSC reaffirmed its proposal to introduce a new product category of High-Risk FIPs.  Products falling under High-Risk FIPs are financial products that (i) are “complex” and (ii) entail the risk of losing 20% or more of the invested amount.  If a financial institution finds it difficult to determine whether a particular financial product should be categorized as a High-Risk FIP, it may seek a determination from the Korea Financial Investment Association (“KOFIA”).

Once a product is categorized as a High-Risk FIP, financial institutions become subject to a set of obligations, including recording communications with retail investors during sales, allowing a grace period for sales and providing written explanations of the products.  The sale of such products will also be restricted to those qualified as “advisory experts for derivatives investment solicitation.”

2.    Banks restricted from selling privately placed funds investing in High-Risk FIPs

The FSC stated that banks will be restricted from selling privately placed funds or trusts investing in High-Risk FIPs.  However, banks will be permitted to sell equity-linked trusts (“ELT”) which invest in publicly offered DLS with a loss multiple of one or lower and track five major stock market indices as underlying asset (KOSPI 200, S&P 500, Eurostoxx 50, HSCEI and NIKKEI 225).

3.    Stricter application of public offering rules

The FSC concluded that many of the DLFs with similar terms that had been issued and sold at close intervals with one another should have been sold as public funds which would have compelled stricter investor protection measures than private funds.  The FSC will amend the Enforcement Decree of the Financial Investment Services and Capital Market Act (the “FSCMA”) such that offering of securities or funds with similar underlying assets and terms will be considered to be part of the same offering of securities or funds, rendering it difficult to circumvent the public offering rules.

4.    Higher investment threshold for privately placed investment funds for qualifying investors

The FSCMA currently allows private placement of investment funds targeting qualifying individual investors with individual investment amounts exceeding a certain threshold amount.  Such funds are exempt from a number of selling restrictions which would normally apply.  The FSC will continue to allow qualifying investors with sufficient risk appetite to invest in privately placed investment funds at their own risk.  However, the Final Plan seeks to raise the qualifying investment amount for such investments from the current KRW 100 million to KRW 300 million and from the current KRW 300 million to KRW 500 million for funds with a leverage of 200% or more.  The objective of increasing the qualifying investment amount is to limit the investor universe to high net worth individuals deemed to have greater risk-taking capacity.  

5.    Strengthening internal control regulations 

The FSC is seeking to make the senior management accountable for incidents of widespread losses inflicted on consumers stemming from insufficient oversight and internal control within financial institutions.  As such, financial institutions will be required to adopt internal control standards and to clearly allocate oversight responsibility to senior managers when selling High-Risk FIPs.  

6.    Code of Conduct for structuring and sale of High-Risk FIPs 

The FSC plans to prepare a Code of Conduct for financial institutions in their structuring and sale of High-Risk FIPs through KOFIA.  The proposed Code of Conduct will set out standards of conduct and internal control at each stage of designing a High-Risk FIP.  The Code of Conduct will encompass firms designing the product as well as distributors selling thereof to retail investors.

The FSC will commence the legislative process to amend the regulations with the target implementation timeline set as the first quarter of 2020.  We also note that the financial regulators have announced that they will issue administrative measures such as administrative guidance to strengthen protection of investors, even before the regulations are amended.  As the proposed changes are expected to impact the DLS and DLF markets significantly, close monitoring of the relevant progress will be necessary.