[War on Illegal Short Selling] ① Criminal Punishment Possible... Strong Perception of "Lax Detection and Punishment"

Criminal Penalties Possible with 2020 Capital Markets Act Amendment
World-Class Regulations... "Strong Punishment Cases Needed"

The Financial Supervisory Service announced on the 16th that it had uncovered two global investment banks (IBs) engaged in illegal short selling. This case attracted market attention as it was the first instance of detecting global companies that knowingly and habitually conducted illegal short selling. Most previous cases of illegal short selling detection were due to simple mistakes or errors. In particular, there is keen interest in whether the amended Capital Markets Act, revised in 2020 and enforced in 2021, applies. The amendment includes provisions for imposing fines and criminal penalties for illegal short selling, representing the highest level of punishment under the current Capital Markets Act.

Short Selling Regulations Have Been Strengthened Over Time

South Korea is a country that strictly regulates illegal short selling. Article 180 of the Act on Capital Markets and Financial Investment (Capital Markets Act) is representative. In principle, short selling is prohibited (Article 180-4), and only allowed in specific exceptional cases. The law amendment also allows restrictions on borrowed short selling, which was exceptionally permitted.

The domestic short selling system has evolved toward strengthening regulations. Following the 2000 Woo Poong Mutual Credit Cooperative short selling unsettled position incident, a "special provision for collecting entrusted margin related to short selling" was established the following year. Subsequently, in August 2012, the short selling balance reporting system was introduced; in November 2013, the obligation to disclose short selling balances by investor was mandated; and in 2016, the disclosure system for large holders of short selling balances was implemented. In March 2017, South Korea became the first country in the world to introduce a designation system for overheated short selling stocks. In 2017, the Korea Exchange built and publicly released a comprehensive short selling portal.

The direction of short selling regulation changed in 2020 when COVID-19 emerged. At that time, controversy arose as the stock prices of companies raising funds through rights offerings plummeted due to short selling positions. HDC Hyundai Development Company, which was preparing a rights offering to raise funds for acquiring Asiana Airlines, is a representative case. After the rights offering announcement, HDC Hyundai Development Company's short selling ratio surged to 23.54%. The new share issuance price sharply declined, reducing the scale of the capital increase by more than 20% compared to the plan.

In response, the amended Capital Markets Act, which includes imposing fines for illegal short selling, criminal penalties, and restrictions on investors who short sell during rights offering periods from participating in the capital increase, passed the National Assembly. Fines can be imposed based on the amount of short selling orders, and criminal penalties are now possible. Fines can be up to 3 to 5 times the gains from illegal acts, and imprisonment of more than one year can be imposed. Before the amendment passed, sanctions for illegal short selling were limited to fines of up to 100 million KRW.

Kim Seong-hoon, a senior legal officer at the National Assembly Legal Information Office, explained, "At the time of the law amendment, the members of the Legislative and Judiciary Committee's bill review subcommittee agreed that rather than completely restricting short selling or designating stocks eligible for short selling, the amendment should strengthen penalties for 'illegal short selling' to change perceptions about short selling."

Only Hong Kong Has Stronger Short Selling Regulations Than South Korea

South Korea's short selling regulations are among the strictest in the world. South Korea prohibits naked short selling and applies the 'uptick rule,' which requires that short selling orders be placed only at prices higher than the last transaction price. In the United States and Europe, naked short selling is generally prohibited but exceptionally allowed for market makers and similar purposes. Regarding the uptick rule, the U.S. applies it only when the stock price falls more than 10% compared to the previous trading day during the trading session.

Hong Kong is about the only place with stronger short selling regulations than South Korea. Hong Kong also prohibits naked short selling and only allows short selling transactions through the SHEK trading system. Since 2012, weekly reporting related to short selling transactions has also been mandatory.

Given such strong regulations, why does illegal short selling persist? In July last year, when the Financial Services Commission announced the 'Measures to Strengthen Detection and Punishment of Illegal Short Selling and Supplement Short Selling-Related Systems' together with the Supreme Prosecutors' Office and Korea Exchange, this concern was expressed. At that time, the FSC pointed out, "Compared to Japan, which imposes fines of up to 300,000 yen, or Hong Kong, where fines of up to 100,000 HKD or imprisonment of up to two years are possible, the level of punishment is not necessarily low," and noted that "the perception that detection and punishment of illegal short selling are lukewarm is the problem."

The core of the system improvement plan is summarized as strengthening planned investigations, rapid investigations, and establishing dedicated organizations. Until now, methods for checking illegal short selling focused mainly on accounts with insufficient settlement quantities. Since last year, financial authorities have been analyzing stock price trends and short selling ratios to inspect target stocks. If suspicious points are found in trading analysis, a planned investigation is immediately initiated. The recent consecutive announcements by the Financial Supervisory Service of illegal short selling detection cases are also against this background.

Will the Perception of 'Lukewarm Detection and Punishment' Change?

Particularly, attention is focused on whether the first criminal penalty case will emerge. On the 17th, at the National Assembly's Political Affairs Committee audit held at the Financial Supervisory Service, Lee Bok-hyun, Governor of the Financial Supervisory Service, said regarding the global IBs caught for illegal short selling, "(If the offenders are foreigners or overseas corporations) even if they are abroad, we will closely cooperate with investigative authorities to bring them here and ensure they receive criminal punishment under domestic law." This showed a determination to change the perception that detection and punishment are lukewarm.

There are also opinions that rather than discussing additional system improvements, it is necessary to wait for strict law enforcement cases to emerge. Hwang Se-woon, senior researcher at the Korea Capital Market Institute, said, "Since the current level of short selling regulation is very strict, if cases of punishment under current law emerge and institutions are strictly fined, awareness of naked short selling will increase."