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KEY TAKEAWAYS
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- Covered short sales of KRX-listed stocks will continue to be banned until March 30, 2025.
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- Any institutional investor (including offshore investors) engaged in short sale trades of KRX-listed stocks exceeding certain thresholds will be required to establish a computerized internal balance management system to monitor their sellable stock balances in real time and thereby prevent naked short sale orders.
- All institutional and corporate investors (including offshore investors) who intend to engage in short sale trades of KRX-listed securities will be required to establish internal control standards to prevent naked short sale orders.
- The Korea Exchange (KRX) will establish a central monitoring system for a better and earlier detection of naked short sales.
- Criminal penalties for illegal short sale trades will be heightened and additional sanction measures will be introduced.
- Terms and conditions for stock borrowing for both institutional investors and retail investors will be standardized to level the playing field.
I. OVERVIEW
On June 13, 2024, the Financial Services Commission (FSC) extended the temporary complete ban on covered short sales of KRX-listed stocks until March 30, 2025. This ban, which initially commenced on November 6, 2023, was originally set to expire on June 30, 2024, as summarized in our previous legal update (see link).
On the same day, the FSC announced various measures aimed at preventing naked short sales and creating a level playing field for institutional and retail investors. Highlighting that large-scale naked short sales have been repeatedly detected despite previous short sale reforms, the FSC emphasized the need for strict regulation of short sales and fair treatment for both the institutional and retail investors, given the high retail participation in Korean capital markets.
These new measures announced by the FSC require amendments to the Financial Investment Services and Capital Markets Act of Korea (FSCMA) and its subordinate decrees and regulations. The FSC plans to finalize the necessary amendments by the end of this year and implement the new measures by the end of March, 2025. Below is a summary of the new measures contemplated to be adopted.
II. INTERNAL BALANCE MANAGEMENT SYSTEM
Certain institutional investors (see below) will be required to establish a computerized internal balance management system to monitor their sellable stock balances in real time. This system will be designed to preemptively block naked short sales by ensuring that all short sale orders are backed by sellable stock balances.
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- Institutional investors subject to the requirement: Any institutional investor (domestic and foreign) whose short position of a KRX-listed stock, since January 1, 2023, has ever exceeded, or is expected to exceed in the future, either 0.01% of the outstanding listed shares or KRW 1 billion. However, investors who (i) undertake to refrain from engaging in any short sale trades or maintain their short positions below 0.01% of the outstanding listed shares and KRW 1 billion, by submitting a commitment letter to the Financial Supervisory Service, or (ii) place short sale orders only after the borrowed stocks are deposited into a securities account opened with a local securities firm will be exempted from the requirement.
- Requirements for the internal balance management system: The internal balance management system to be established within the institutional investor must have the capacity to (i) calculate sellable stock balances in real-time, (ii) block sell orders in real-time if they exceed the available sellable stock balances, (iii) issue warnings and notifications to the overall short-selling management department when there is a shortage of sellable stock balances, (iv) establish procedures to prevent errors, including additional verification, when manually adjusting sellable stock balances, (v) maintain records of stock borrowing transactions, and (vi) generate and submit necessary data required to be submitted to the central monitoring system to be established.
III. INTERNAL CONTROL STANDARDS FOR SHORT SALE TRADES
All institutional and corporate investors intending to participate in short sale trades of KRX-listed stocks will be required to establish operational rules that govern short-selling activities, including pre-trade checks, comprehensive recording, and monitoring of trading activities.
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- In connection, the Financial Supervisory Service of Korea announced preliminary guidelines on internal control standards both in Korean and English (see link).
- To ensure that investors comply with the requirements to establish an internal balance management system and internal control standards, local securities companies will be mandated to confirm compliance with investors who place short-sale orders. This will be done by verifying compliance before accepting the first short-sale order from such investors and subsequently conducting annual reviews.
IV. CENTRAL MONITORING SYSTEM (NSDS)
The Korea Exchange (KRX) will establish a central monitoring system named as the Naked Short-Selling Detecting System (NSDS) for a better and earlier detection of naked short sales. Key features include:
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- Comprehensive Verification: The NSDS will monitor all sell orders placed by institutional investors by comparing sellable stock balances and over-the-counter transactions reported by the institutional investors via their Internal Balance Management Systems, against all sell order information retrieved from the KRX.
- Expected Effects: The FSC and the KRX expect the NSDS to enable them to promptly detect and sanction illegal short sale trades that have not been easily detected, for instance, (i) naked short sales that are settled with stocks borrowed after the short sale trade is executed and (ii) naked short sale orders that are falsely placed as ordinary sales to circumvent the uptick rule.
V. PENALTIES FOR ILLEGAL SHORT SALES
Criminal penalties for naked short sales will be significantly heightened as follows:
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- Fines: Fines for illegal short selling will be raised to 4-6 times the illicit gains, up from 3-5 times.
- Imprisonment: For illegal short sales with illicit gains exceeding KRW 5 billion, penalties can include imprisonment of three years or longer. For illegal short sales with illicit gains exceeding 50 billion KRW, penalties can include a life sentence.
In addition, new types of sanctions will be introduced including (i) a ban on trading stocks and other financial investment products for up to 10 years, (ii) disqualifying individuals involved in illegal short sales from serving as executive officers for up to 10 years, and (iii) account freezes.
VI. STANDARDIZATION OF STOCK BORROWING TERMS
To ensure a level playing field between institutional and individual investors, the terms and conditions for stock borrowing transactions for both institutional and retail investors will be standardized, including the following:
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- Repayment Period: The maximum repayment period for borrowing transactions for the purpose of short sales will be standardized to 90-day renewable terms, with a maximum duration of 12 months. However, the current practices of stock borrowing transactions for institutional investors that allow lenders to issue a notice of recall upon which borrowers are required to immediately return their borrowed stocks will remain permitted.
- Collateral Ratio: The collateral ratio for cash will be standardized at 105%, aligning the requirements between individual investors and institutional investors.
VII. OTHER REFORMS
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- Lowering the Threshold for Net Short Position Disclosure: Currently, the threshold for public disclosure of a net short position in a stock is 0.5% of the total issued shares. The FSC announced that they will lower this threshold to match the following threshold for the reporting requirement. The net short position reporting of by an investor is triggered if (i) the net short position is 0.01% of the total issued shares provided that the market value of such net position is at least KRW 100 million, or (ii) the market value of the net short position is KRW 1 billion or more. With the matching thresholds, the investors will only need to fulfill the reporting obligations, after which the public disclosure will automatically follow.
- Restrictions on Acquiring Convertible Bonds (CB) and Bonds with Warrants (BW): According to the FSCMA amendment, which took effect on April 6, 2021, any person who short sells borrowed stocks after a plan for the issuer’s rights offering is announced and before the price of new shares is determined is prohibited from participating in the issuer’s rights offering. The FSC announced that they will amend the FSCMA to apply a similar restriction on short sellers with respect to offerings of convertible bonds and bonds with warrants.