Financial Authorities Deliberate on Sanctions for 'Wrap and Trust Circular Transactions'... Could Severe Punishments Be Possible?

Severe sanctions such as partial business suspension initially expected
Industry expresses concerns over chain reaction in market including issuance of promissory notes
Financial Supervisory Service official expects judgment based on "principle"

High-rise buildings in Yeouido's financial district. Photo by Younghan Heo younghan@

The financial supervisory authorities are deliberating on the appropriate level of sanctions for seven securities firms caught engaging in circular trading of bond-type wrap and trust accounts. Although severe disciplinary actions were initially expected, it is reported that there is significant internal debate within the authorities, drawing attention to the outcome. It is observed that the burden of imposing harsh penalties exists because the illegal circular trading practices due to maturity mismatches extend beyond bond-type wrap and trust accounts to include issuance notes as well.

On the 31st of last month, the Financial Supervisory Service (FSS) held a disciplinary review committee meeting to discuss the level of sanctions for seven securities firms (Mirae Asset, Korea Investment, NH Investment, Kyobo, Eugene Investment, Yuanta, and SK Securities) found to have engaged in circular trading of bond-type wrap and trust accounts. This was the second meeting following the one on September 12, with a considerable amount of time spent on each firm's explanation process.

These seven firms were included in the sanctions list on suspicion of illegal circular trading, where losses from one customer's account were shifted to another customer's account. The results of the sanctions for these seven firms will be announced simultaneously, but the timing of the announcement is undecided. The market expects it will not extend beyond this year. However, if the disciplinary review committee confirms severe sanctions, approval from the Financial Services Commission’s Securities and Futures Commission will be required, which may take additional time.

The securities industry's main concern is the level of sanctions. It is known that in mid-September, the FSS sent preliminary notices to the securities firms, including some suspensions of business. For some securities firms, disciplinary actions against the Chief Executive Officer (CEO) are also under discussion. Since firms that used Proprietary Investment (PI) funds had relatively higher CEO involvement in decision-making, there is widespread speculation that the CEO may also be included in the disciplinary targets.

In fact, at the end of June, the FSS held a disciplinary review committee meeting and confirmed sanctions including a three-month partial suspension of business and severe disciplinary actions against employees responsible for managing wrap and trust accounts at two firms with large-scale circular trading, KB Securities and Hana Securities. KB Securities CEO Lee Hong-gu received a mild disciplinary action in the form of a cautionary warning. As it was revealed that KB Securities used the firm’s proprietary assets to cover customer investment losses, the CEO was also included in the disciplinary targets. However, the severity of the sanction was reduced from severe to mild during the disciplinary review process.

Some securities firms, including KB Securities, resorted to using proprietary assets when faced with a situation where they could not guarantee returns to customers due to maturity mismatches. They subscribed to their own funds with proprietary assets and purchased corporate commercial papers (CP) incorporated into customer wrap and trust accounts at high prices through these funds. It is presumed that the CEO was actively involved in decision-making during this process.

However, some in the market have expressed concerns that if the sanctions escalate to severe penalties due to the seriousness of the maturity mismatch issue in issuance notes, the shock to the market could be significant. Currently, the domestic issuance note market size reaches 38 trillion KRW. According to a policy seminar presentation by the Korea Capital Market Institute in June last year, the proportion of products with maturities exceeding one year in domestic issuance note-related corporate finance asset composition approached 90% at its peak. In the loan product category, cases with maturities exceeding one year accounted for 87.5%. High proportions were also seen in private bonds (83.8%), corporate bonds (83.6%), beneficiary certificates (70.5%), and corporate commercial papers (29%).

A Financial Supervisory Service official stated, "Even if it is an industry practice, there is a high possibility of illegality, and although there is concern about the impact on the market in the future, it does not seem appropriate to consider this at the sanction stage," adding, "In principle, sanctions will be applied, but the disciplinary review committee will thoroughly deliberate."