On 28 June 2016, the Korean government enacted an amendment (the "2016 Amendment") to the Enforcement Decree of the Financial Investment Services and Capital Markets Act (the "FSCMA") which, among others, expands the exception (the "Wall-Cross exception") to the Chinese wall regulations, i.e., restriction on the communication and exchange of information between business sectors within financial institutions.1 The 2016 Amendment seeks to enhance the competitiveness of financial institutions by allowing them to integrate activities which do not - or are unlikely to - conflict with one another, and further simplifies the regulatory scheme by removing the exceptions to the Chinese wall regulations from the Regulation on Financial Investment Business and incorporating the same in the Enforcement Decree.
In order to facilitate understanding of the aforesaid enactment, we have summarized below the basic structure of the Chinese wall regulations and the status of its implementation in Korea, and conclude with a number of recommendations for compliance officers at financial institutions.
The Basic Structure of the Chinese Wall Regulations
Due to the high likelihood of conflicts of interest in the financial industry, the FSCMA (a) subjects certain business areas to the Chinese wall regulations, (b) prohibits in principle such business areas from sharing information, personnel and/or facilities, and (c) requires strict adherence to a set of Wall-Cross requirements of those business areas seeking to exchange information despite a Chinese wall.
Specifically, FSCMA requires that Chinese walls be erected between, among others, the following business areas (as between (x) and (y)):
- Between (x) Proprietary Trading,
Dealing and Brokerage, and (y) Collective Investment and Trust
This provision aims to prevent financial institutions from (a) acquiring financial investment products with proprietary and/or client's assets before such products are acquired with the assets held in a collective investment scheme or a clientetstrust, and/or (b) profiting by acquiring financial investment products with the assets held in a collective investment scheme or a client antrust.
- Between (x) Investment Banking
Business (the "IB business") and (y) Proprietary Trading
and Financial Investment (excluding IB business)
This provision aims to prevent financial institutions from engaging in proprietary trading and/or dealing activities based upon material nonpublic information obtained while engaging in IB business.
- Between (x) Prime Brokerage, and
(y) Proprietary Trading and Financial Investment Business
(excluding Prime Brokerage desk)
This provision aims to prevent financial institutions from engaging in proprietary trading, brokerage and/or dealings based upon information on the transaction details and investment portfolios of relevant clients (including hedge funds) obtained while engaging in prime brokerage activities.
As a departure from the foregoing, the FSCMA grants the Wall-Cross exception to certain activities for which the likelihood of conflict is perceived to be low. The details of the Wall-Cross exception are beyond the scope of this article.
The specifics of the Chinese wall regulations can be further summarized as follows:
- No sharing of information: Departments subject to the Chinese wall regulations cannot share information such as: information on trading or holding of financial investment products, information on the trading details and investment portfolios of clients, material nonpublic information acquired in the course of conducting IB business, information on the portfolio and asset management of collective investment schemes, trusts and/or assets under discretionary management.
- No sharing of personnel: Departments subject to Chinese wall must be segregated from each other, and concurrent employment of with multiple departments is not permitted.
- No sharing of facilities: Works pace and IT facilities must be segregated to the extent necessary to prevent sharing of information
Further, financial institutions are required to retain internal records of the meetings and communications among the employees who are subject to the Chinese wall regulations and to have such records reviewed by the compliance officer or the auditor.
While the Chinese wall regulations primarily concern the various departments within a single entity, the FSCMA also applies a certain set of rules (i.e., no sharing of information, personnel, and facilities) to the relationship between financial institutions and their affiliates. As such, a global financial institution should take caution that the information exchange and/or communication between its Korean affiliate/branch office and its overseas affiliate/main office do not to violate the Chinese wall regulations.
Relaxing of the Chinese Wall Regulations With a Focus on IB Business
There has been mounting criticism over the rigidity of the Chinese wall regulations which goes against the FSCMA a legislative aim of achieving synergy from integrating various financial services. In particular, there has been recurring criticisms of the impracticality of strictly distinguishing IB business from proprietary trading/dealing/brokerage activities2 given that IB business, for the most part, can be classified as dealing/brokerage activities and often inevitably involve the trading of proprietary assets.
Further, it is difficult to objectively categorize an act based on the purpose of a transaction, which may not be obvious at first glance. For instance, a financial institution may be seeking to acquire privately placed bonds simply for investment purposes, in which case it would constitute proprietary trading, while its service for acquisition of a client would constitute IB business. Similar ambiguity plagues the extent to which a proprietary trading/dealing/brokerage department may handle matters relating to the primary market and the extent to which an IB business department may handle matters relating to the secondary market.3
Accordingly, the Korean regulatory authorities have continually sought to ease the Chinese wall regulations in respect of IB business and to widen the work scope of IB business departments through a line of amendments and statutory interpretations, the most recent of which is the 2016 Amendment. The content of and background to the 2016 Amendment are as follows:
- The 2016 Amendment allows IB business departments to buy securities issued by KRX-KONEX-listed companies to finance the same and to trade derivatives with KRX-KONEX-listed companies to hedge risk, whereas in the past they could perform such activities only with respect to companies which were not listed on KRX. While such activities are classified as proprietary trading/dealing activities, the 2016 Amendment takes the view that the "financing" aspect of the aforesaid activities is well suited for corporate finance departments.
- The 2016 Amendment allows corporate finance departments to trade and/or broker "electronic short-term bonds." Previous amendment to the FSCMA also allows corporate finance departments to trade and/or broker government bonds, municipal bonds and special bonds (although such activities are classified as dealing/brokerage activities), the underlying belief being that material nonpublic information concerning such bonds are unlikely to be misappropriated.
- The 2016 Amendment allows corporate finance departments to invest in certain privately-placed collective investment schemes (although such activities are each classified as collective investment activity and proprietary trading activity). Previous amendment to the FSCMA also allows corporate finance departments to invest in private equity funds as limited partners, whereas in the past they could make such investments only as general partners.
Recommendations in Practice
It is recommended that financial institutions spend a considerable amount of time reviewing and understanding the highly complex Chinese wall regulations before structuring their management schemes. It bears particular emphasis that the Chinese wall regulations are equally applicable to all financial institutions regardless of their size, and provides no exceptions for small branch offices/affiliates of global financial institutions. Although global financial institutions typically have in place well-organized internal conflict management systems (which are oftentimes stricter than the regulatory requirements), special attention should be paid following the reallocation of duties among departments or the introduction of new businesses/products.
1. The term "financial institutions" as used in this article refers to dealers, brokers, fund managers, investment advisors, discretionary investment companies and trust companies (all of which are regulated under the FSCMA) to the exclusion of all other types of financial business entities such as merchant banks.
2. Under the FSCMA, IB business comprises the following: (1) underwriting, (2) arranging public offering and/or private placement in the primary market, (3) brokering, arranging and advising on M&As, (4) arranging and advising on project finances, and (5) managing private equity funds.
3. As IB business activities encompass underwriting and arranging public offering and/or private placement in the primary market, any work relating to the primary market (whether private or public) shall constitute IB business, and any work relating to the secondary market excluding public sales shall constitute dealing/brokerage activity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.