The Financial Services Commission announced that a revision bill of the Financial Investment Services and Capital Markets Act (FSCMA) intended to upgrade rules on short sale was passed by the National Assembly at the plenary session held on September 26. The passage of the revised FSCMA by the National Assembly officially brings within legal purview the short sale reform measures that have been sought by the government since the decision to ban short sale was introduced in November last year amid concerns about frequent occurrences of naked short sale activities and their disruptive effects on market’s fair pricing function.
Under the revised FSCMA, institutional investors will be required to set up their own electronic short sale processing system, while both institutional and corporate investors will need to prepare relevant internal control standards. For institutional investors, there will be a new restriction on the stock repayment period for borrowed stocks. Monetary penalties that can be imposed on unfair trading and illegal short sale activities will be strengthened, and new sanctions mechanisms will be introduced—such as a ban on trading financial investment products and restriction from being appointed or serving as an executive at listed companies—to enhance the effectiveness of punishment and sanctions.
Background
Since the announcement of the short sale reform proposal on June 13 this year, the FSC and related organizations have been swiftly working on follow-up measures. Prior to making revisions to the legislation, authorities have been proactively working to prepare for establishing an electronic short sale processing and monitoring system and limiting the stock repayment period for institutional investors.
Since August, the Korea Exchange (KRX) has been working to set up Naked Short-selling Detecting System (NSDS), which is designed to detect and identify naked short sale activities based on the records of short sale orders transmitted by institutional investors. In addition, the Financial Supervisory Service (FSS) introduced in August specific guidelines detailing institutional investors’ net short position balance management system and internal control standards and the checklist for the securities companies’ verification duty. Moreover, relevant authorities have set up and begun to operate a taskforce since September to provide tailored consultations to institutional investors and securities companies to make sure that they are thoroughly prepared for these requirements.
Securities lenders, such as the Korea Securities Depository (KSD) and the Korea Securities Finance Corporation (KSFC), have been working to update their own systems and internal rules to accommodate the change in the stock repayment period for institutional investors. They are currently working with major securities companies for system connectivity. Even before the revised law officially takes effect in March 2025, for market makers and liquidity providers that are currently exempted from the short sale ban, their stock repayment periods will be managed within maximum 12 months with 90-day extension each time from November this year.
In the meantime, the FSS introduced a comprehensive set of short sale guidelines on September 26, detailing specific criteria and standards for determining naked short sale activities by major transaction types to make sure that institutional and foreign investors are able to take voluntary steps to prevent naked short sale activities in compliance with domestic regulations.
In this regard, the passage of the revised FSCMA by the National Assembly today establishes regulatory foundations to implement the comprehensive short sale reform measures undertaken by the government.
Key Revision Details
Major details of the short sale reform measures included in the revised FSCMA are as follows.
First, institutional and corporate investors that have plans to engage in short sale transactions will be required to set up their own electronic short sale processing systems and draw up appropriate internal control standards. Securities companies will be obligated to verify whether institutional and corporate investors have done so. For institutional and corporate investors and securities companies, failure to comply with this duty may result in a fine of maximum KRW100 million even when there is no occurrence of naked short sale activities.
Details regarding measures intended to prevent naked short sales and their scope of application will be specified in the Enforcement Decree, which will be based on the previously announced short sale reform plan and the guidelines prepared by the FSS. All corporate entities will need to draw up internal control standards for short sale transactions. In addition, institutional investors, market makers, and liquidity providers will need to establish their own electronic short sale processing systems. About 101 companies that make up 92 percent or more of all short sale transactions in domestic market will be subject to this requirement. Institutional investors will be additionally required to report their net short position balances and the records of over-the-counter (OTC) transactions to the central monitoring system managed by the KRX.
Securities companies will be obligated to verify the internal control standards and electronic short sale processing systems set up by institutional and corporate investors according to a checklist once every year and report their findings to the FSS. This requirement will be specified in the Enforcement Decree.
Second, there will be a restriction placed on the stock repayment period for institutional investors under the revised law to make short sale transaction conditions equal for both retail and institutional investors. As in the case with the measure to prevent naked short sales, failure to comply with the stock repayment period may result in a fine of maximum KRW100 million.
Specific limits, which will be prescribed in the Enforcement Decree, will be maximum 12 months with 90-day extension each time.
Third, sanctions and punishment will be strengthened to prevent recurrence of unfair trading and illegal short sale activities.
For unfair trading and illegal short sale activities, maximum five years of ban on trading financial investment products and restriction from being appointed or serving as an executive at listed companies will be newly introduced. In addition, payment freeze of 6 months (plus additional 6-month extension possible) on accounts suspected for being used in unfair trading and/or illegal short sale activities will also be introduced to prevent concealment of illegally gained profits when deemed necessary. Moreover, the severity of monetary penalties imposed on unfair trading and illegal short sale activities will be increased from the current level of 3 to 5 times the amount of unfairly gained profits to 4 to 6 times the amount of unfairly gained profits. As in the case with unfair trading activities, illegal short sale activities will also be subject to aggravated penalties for imprisonment.
Moreover, similar to the restriction currently in place for short sellers in capital increase with consideration, to help prevent arbitrage transactions involving convertible bonds (CBs) and bonds with warrants (BWs), short sellers will be prohibited from acquiring CBs or BWs of a company if they engaged in short sale of stocks after the company disclosed its CB or BW issuance plan but prior to the announcement of its issue price.
Expectation
First, the revised FSCMA will help to prevent naked short sale activities through the establishment and operation of an effective electronic short sale processing and monitoring system. Since the revised FSCMA will require institutional investors to set up and maintain their own internal net short position balance management systems and transmit relevant data to the Naked Short-selling Detecting System (NSDS), a central monitoring system run by the KRX, authorities expect institutional investors to have effective systems to manage their net short position balances, thoroughly prepare internal control standards, and transmit accurate data to the central monitoring system.
Second, the revised FSCMA will help to level the playing field between retail and institutional investors and make stock borrowing conditions equal for both retail and institutional investors. For short sale transactions, both retail and institutional investors’ stock repayment period will be set at maximum 12 months. With a revision to the subordinate rules, which is scheduled to be completed soon, retail investors’ cash collateral ratio will also be reduced to the same level currently observed for institutional investors (from 120 percent previously to 105 percent).
Third, the revised FSCMA will bring about strengthened sanctions and punishment against unfair trading and illegal short sale activities to ensure a sound order in the market. Along with the introduction of penalty surcharge and criminal punishment on illegal short sale activities (in April 2021) and the creation of penalty surcharge on unfair trading activities and the establishment of a legal ground for calculating the amount of unfairly gained profits (in January 2024), the revised FSCMA establishes legal grounds to bring strict punishment and sanctions against illegal activities in the capital market through strengthened levels of monetary penalties and diversification of sanctions mechanisms. In particular, since unfair trading activities have been prone to high recidivism, the newly established ban on trading financial investment products and restriction from being appointed or serving as an executive at listed companies are expected to have the effect of forcing out rulebreakers from the capital market.
Further Schedule
The revised FSCMA will go into effect on March 31, 2025, considering the time it requires to establish an electronic short sale processing and monitoring system as initially planned until March next year. However, the penalty clauses creating new sanctions mechanisms, such as the ban on trading financial investment products, the restriction from being appointed or serving as an executive at listed companies, and the introduction of payment freeze on suspicious accounts, will become effective six months after promulgation of the law due to the need to gather sufficient comments prior to making changes to subordinate statutes. In this regard, the government will promptly work to introduce revision proposals on subordinate statutes and take follow-up steps to help improve predictability of market participants.
As a crucial component of upgrades being introduced to resolve the concern about stock market’s fair pricing function being disrupted by frequent occurrences of naked short sales, authorities will work to ensure the establishment of an electronic short sale processing and monitoring system as planned by March next year (short sale ban is in place until March 30, 2025) in close communication with institutional investors.
Meanwhile, authorities expect that the process for revising subordinate regulations, which will include (a) strengthening the disclosure duty on net short position balance (from the current level of 0.5 percent of total issuance to 0.01 percent) and (b) bringing down retail investors’ cash collateral ratio from 120 percent previously to 105 percent, the same level currently observed for institutional investors, will be completed by October this year.
In March next year, once the electronic short sale processing and monitoring system begins to operate and the revised FSCMA takes effect, the comprehensive overhaul on short sale system will be completed. Through this, authorities will make utmost efforts to resolve the problem of illegal and unfair trading activities involving stock short sales and continuously work to improve the competitiveness of domestic stock market.
* Please refer to the attached PDF for details.