OPINION
2022 Jun/14
Fractional Investment Guideline in Korea: Importance and Challenges
Jun. 14, 2022
PDF
- Summary
- On April 28, 2022, the Financial Services Commission published the Guideline on Securities Businesses Dealing with Fractional Investment. The Guideline is of significance in that it intends to increase predictability for market participants and protect investors against regulatory risk in response to the digitalization of financial instruments in the capital markets. It specifies the standards for determining whether a fractional investment product qualifies as a security under the Financial Investment Services and Capital Markets Act and the checklist for confirming the legitimacy of fractional investment. It also recommends that a fractional investment business, not legally permitted under the existing legal framework but recognized for its innovativeness and necessity, be carried out through the financial regulatory sandbox program. In this regard, the Guideline can be seen as an approach to achieving a balance between regulation and development of fractional investment.
Given that the designated period of financial regulatory sandbox is up to four years (two years + two years), if a fractional investment business is recognized for its innovativeness and necessity and proven to take sufficient investor protection measures, its legitimacy should be guaranteed to ensure sustainable business operation. This necessitates reform of the related regulations. Relevant regulatory improvements should be reviewed with a focus on regulatory exemption cases applicable to the sandbox program for fractional investment. Aside from the legal framework for promoting fractional investment, it is necessary to explore measures to control the speculative nature of fractional investment. To this end, further discussions are needed to find improvement measures, such as qualification requirements for an issuer of fractional investment securities, a stricter obligation of a broker-dealer regarding disclosure of information and tougher suitability and adequacy principles to protect financially vulnerable investors.
Introduction: Significance of the fractional investment guideline
On April 28, 2022, the Financial Services Commission (“FSC”) published the Guideline on Securities Businesses Dealing with Fractional Investment (the “Guideline”). On April 20th, eight days prior to the publication, the FSC published a press release stating that the music copyright fee participation claim issued by Musicow Inc. (“Musicow”) constitutes investment contract securities. According to the press release, the FSC has required Musicow to establish an investor protection system while holding off imposing sanctions on its violation of the Financial Investment Services and Capital Markets Act (“FSCMA”). The Guideline is designed to prevent fractional investment business entities like Musicow from recruiting a large number of investors and transferring related regulatory risks to the investors. It aims to support legal stability and market predictability with respect to fractional investment.
With the advancement of ICT such as distributed ledger technology (DLT), there is a growing trend of fractional investment that enables investors to purchase a portion of investment assets such as artworks, music copyrights and real estate properties and to receive profits generated from the assets. In fractional investment, issuers of a certificate of ownership usually have a computerized trading platform that allows service users to handily invest a small sum. However, fractional investment poses serious risks to investors due to an ambiguous contractual relationship, information asymmetries between investors and issuers, and high possibility of unfair transactions. As a new form of investment not prearranged by the existing legal framework, fractional investment entails a high degree of uncertainty about the applicability of relevant laws. If a business entity only seeks to expand a pool of investors based on its arbitrary interpretation of relevant laws and regulations, regulatory risk can be passed on to the investors, thereby inflicting enormous damages on them.
In new forms of financial investment such as fractional investment, transactions are frequently carried out in large volume through online trading platforms. This means that such financial services are more likely to transfer regulatory risk to service users and give rise to losses on them. This is well observed in US cases including the Ripple XRP case where if the Securities and Exchange Commission (SEC) conducts a Howey test on a virtual asset traded through crypto trading platform and then recognizes it as a security, the holder of relevant security tokens would end up holding securities unregistered with the SEC and suffer a huge loss.
The Guideline consists of the standards for deciding whether a fractional investment product qualifies as a security and the principles of dealing with fractional investment securities. The standards and principles are meaningful in that they could enhance predictability for fractional investment businesses. They are also beneficial to investors as regulatory risk posed by unfair business entities could be prevented from further spreading and inflicting serious damages on the investors. Against this backdrop, this article intends to outline the FSC Guideline and to discuss future challenges that should be tackled to create a sound fractional investment ecosystem.
Overview of the fractional investment guideline
The Guideline published by the FSC on April 28 aims to determine whether a fractional investment product is considered a security, to set forth the principles of dealing with fractional investment securities, and to present a financial regulatory sandbox program.
1) Determining whether a fractional investment product qualifies as a security
First, the Guideline recognizes as a security a fractional instrument that meets the definition of securities under the FSCMA “on a case-by-case basis and regardless of the method, formality or technicality, taking into account various factors related to the instrument”.1) This approach is based on technology neutrality and inclusiveness of financial instruments under the FSCMA. Given technology neutrality, even though a fractional investment product is issued in a digitalized form and is considered innovative, the product should be subject to securities regulation in principle if it falls under the definition of securities specified in the FSCMA. Major countries including the US, the EU and the UK have introduced technology neutrality to describe the definition of security tokens and the applicable scope of securities laws.2) The inclusiveness principle indicates that if a fractional investment product does not fall into a category of typical securities under the FSCMA but is classified as investment contract securities or derivative-linked securities, it would qualify as a security. The principle is intended to “reinforce competitiveness by designing and offering a wide range of new financial instruments”3) to keep up with changing business conditions such as the digitalization of investment assets.
When it comes to determining whether a product is considered a security, the Guideline attempts to increase predictability by explaining the elements of investment contract focusing on applicability to digitalized fractional investment products. Additionally, it offers an appendix to specify examples of “fractional investment products that are likely to qualify as sescurities”.4) In such examples, it is required to strengthen investor protection by applying securities regulations including mandatory disclosure and anti-fraud to new forms of securities.
2) Principles of dealing with fractional investment securities
Second, concerning the principles of dealing with fractional investment securities, the Guideline provides a checklist for confirming the legitimacy of fractional investment businesses. The items on the checklist include “whether a fractional investment product is considered a security”, “whether a service (business) to be provided qualifies as a financial investment business” and “whether other laws except for the FSCMA apply”.5) “Whether a fractional investment product is considered a security” would be determined based on the aforementioned definition of a security under the FSCMA. As for “whether a service to be provided qualifies as a financial investment business”, the threshold issue is whether a particular business needs a license for broker-dealer, collective investment business, or securities exchange. If a financial investment product issued by a fractional investment business is considered a security or the relevant business falls under the financial investment business category, the fractional investment business would be subject to regulations under the FSCMA including disclosure obligation and prohibition on unfair transactions. In addition, a fractional investment business to which the FSCMA does not apply could be subject to other laws. There are many cases where a fractional investment business entity could face difficulties in deciding whether their products are securities or whether their business is a financial investment business only by referring to the legitimacy checklist in the Guideline. Accordingly, a business entity that intends to engage in fractional investment should make an inquiry about legitimacy with the supervisory authorities, rather than depending on its own arbitrary interpretation of relevant laws.
3) Financial regulatory sandbox for fractional investment securities
Third, the Guideline specifies issues to consider before applying for the financial regulatory sandbox. “Innovativeness and necessity should be rigorously reviewed and recognized” for a fractional investment business to be designated as the financial regulatory sandbox. Key safeguards should also be put in place for investor protection.6) A fractional investment business should set up the following investor protection mechanisms: the standards and procedures for prospectus and advertisement, separating deposits or invested assets of investors from the business entity’s deposits or assets; insulating the investors’ rights from the risk of bankruptcy of fractional investment businesses; sufficient material facilities and professional personnel; and conflict resolution process and a damage compensation system for investors. These safeguards are well reflected in conditions that the FSC required Musicow to fulfill when deciding to hold off imposing sanctions on April 20, 2022.7)
When applying for the financial regulatory sandbox, it is worth noting that in principle, an issuer of fractional investment securities is not permitted to operate a trading platform for the securities. If an issuer of fractional investment securities operates a trading platform and distributes the securities through the platform, the trading platform is less likely to promote fair transactions of the securities and maintain proper market prices. Furthermore, the platform operator may pursue its own interests by boosting trading fees or profits from the relevant transactions while trying to keep higher the price and trading volume of the securities. In a virtual assets market, when the market operator or related parties issue virtual assets, they are restricted from engaging in distributing the virtual assets on the trading platform operated by the issuer (Article 10-20 of the Enforcement Decree of the Act on Reporting and Using Specified Financial Transaction Information). This restriction aims to prevent a business entity from conducting unfair transactions by exploiting its dual status as a trading platform operator and an issuer of investment products. However, if there exists no other markets than the trading platform operated by the issuer and suspension of platform operation could cause huge damages to investors, the platform operation may be permitted temporarily according to the financial supervisory authorities’ judgment. Even if the temporary operation is permitted, the Guideline requires the trading platform operator to take proper investor protection measures such as the conflict of interest prevention. The Guideline prescribes that in principle, fractional investment securities should be traded on a platform operated separately from the issuer. In this respect, the financial regulatory sandbox is expected to bring about a new trading platform dedicated to fractional investment securities.
Conclusion: Future challenges for creating a sound fractional investment ecosystem
The Guideline is of significance in that it intends to increase predictability for market participants and protect investors against regulatory risk in response to digitalization of financial instruments in the capital markets. It specifies the standards for determining whether a fractional investment product qualifies as a security and the checklist for confirming legitimacy of fractional investment. It also recommends that a fractional investment business, not legally permitted under the existing legal framework but recognized for its innovativeness and necessity, be carried out through the financial regulatory sandbox program. In this regard, the Guideline can be seen as an approach to achieving a balance between regulation and development.
Given that the designated period of financial regulatory sandbox is up to four years (two years + two years), if a fractional investment business is recognized for its innovativeness and necessity and proven to take sufficient investor protection measures, its legitimacy should be guaranteed to ensure sustainable operation. This necessitates reform of the related regulations. Relevant regulatory improvements should be reviewed with a focus on regulatory exemption cases applicable to the sandbox program for fractional investment. The measures include relaxing the disclosure regulation on the sales of fractional investment securities and the restrictions on how securities are traded on a platform (competitive bidding or negotiated transactions). Furthermore, how to legalize distributed ledger as a form of electronic registration under the Act on Electronic Registration of Stocks and Bonds should be discussed to effectively establish the fractional investment trading platform based on DLT. Aside from the legal framework for promoting fractional investment, it is necessary to explore measures to suppress the speculative nature of fractional investment. To this end, the followings should be discussed: qualification requirements for an issuer of fractional investment securities, a stricter obligation of a broker-dealer regarding information disclosure, and tougher suitability and adequacy principles to protect financially vulnerable investors.
1) FSC, April 28, 2022, the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.4.
2) For instance, the MiCA (Markets in Crypto-Assets) regulation adopted by the EU prescribes that crypto-assets that qualify as financial instruments should not be subject to MiCA, emphasizing that financial services should not favor one particular Technology ((6) in the overview of MiCA Regulation).
3) The Ministry of Finance and Economy, 2006, Details of a proposal for the Financial Investment Services and Capital Markets Act, p.110.
4) FSC, April 28, 2022, Appendix to the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.2.
5) FSC, April 28, 2022, the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.5.
6) Id. at 6-7.
7) FSC, April 20, 2022, Determination whether the music copyright fee participation claim offered by Musicow constitutes investment contract securities and related administrative measures, press release, p.4.
On April 28, 2022, the Financial Services Commission (“FSC”) published the Guideline on Securities Businesses Dealing with Fractional Investment (the “Guideline”). On April 20th, eight days prior to the publication, the FSC published a press release stating that the music copyright fee participation claim issued by Musicow Inc. (“Musicow”) constitutes investment contract securities. According to the press release, the FSC has required Musicow to establish an investor protection system while holding off imposing sanctions on its violation of the Financial Investment Services and Capital Markets Act (“FSCMA”). The Guideline is designed to prevent fractional investment business entities like Musicow from recruiting a large number of investors and transferring related regulatory risks to the investors. It aims to support legal stability and market predictability with respect to fractional investment.
With the advancement of ICT such as distributed ledger technology (DLT), there is a growing trend of fractional investment that enables investors to purchase a portion of investment assets such as artworks, music copyrights and real estate properties and to receive profits generated from the assets. In fractional investment, issuers of a certificate of ownership usually have a computerized trading platform that allows service users to handily invest a small sum. However, fractional investment poses serious risks to investors due to an ambiguous contractual relationship, information asymmetries between investors and issuers, and high possibility of unfair transactions. As a new form of investment not prearranged by the existing legal framework, fractional investment entails a high degree of uncertainty about the applicability of relevant laws. If a business entity only seeks to expand a pool of investors based on its arbitrary interpretation of relevant laws and regulations, regulatory risk can be passed on to the investors, thereby inflicting enormous damages on them.
In new forms of financial investment such as fractional investment, transactions are frequently carried out in large volume through online trading platforms. This means that such financial services are more likely to transfer regulatory risk to service users and give rise to losses on them. This is well observed in US cases including the Ripple XRP case where if the Securities and Exchange Commission (SEC) conducts a Howey test on a virtual asset traded through crypto trading platform and then recognizes it as a security, the holder of relevant security tokens would end up holding securities unregistered with the SEC and suffer a huge loss.
The Guideline consists of the standards for deciding whether a fractional investment product qualifies as a security and the principles of dealing with fractional investment securities. The standards and principles are meaningful in that they could enhance predictability for fractional investment businesses. They are also beneficial to investors as regulatory risk posed by unfair business entities could be prevented from further spreading and inflicting serious damages on the investors. Against this backdrop, this article intends to outline the FSC Guideline and to discuss future challenges that should be tackled to create a sound fractional investment ecosystem.
Overview of the fractional investment guideline
The Guideline published by the FSC on April 28 aims to determine whether a fractional investment product is considered a security, to set forth the principles of dealing with fractional investment securities, and to present a financial regulatory sandbox program.
1) Determining whether a fractional investment product qualifies as a security
First, the Guideline recognizes as a security a fractional instrument that meets the definition of securities under the FSCMA “on a case-by-case basis and regardless of the method, formality or technicality, taking into account various factors related to the instrument”.1) This approach is based on technology neutrality and inclusiveness of financial instruments under the FSCMA. Given technology neutrality, even though a fractional investment product is issued in a digitalized form and is considered innovative, the product should be subject to securities regulation in principle if it falls under the definition of securities specified in the FSCMA. Major countries including the US, the EU and the UK have introduced technology neutrality to describe the definition of security tokens and the applicable scope of securities laws.2) The inclusiveness principle indicates that if a fractional investment product does not fall into a category of typical securities under the FSCMA but is classified as investment contract securities or derivative-linked securities, it would qualify as a security. The principle is intended to “reinforce competitiveness by designing and offering a wide range of new financial instruments”3) to keep up with changing business conditions such as the digitalization of investment assets.
When it comes to determining whether a product is considered a security, the Guideline attempts to increase predictability by explaining the elements of investment contract focusing on applicability to digitalized fractional investment products. Additionally, it offers an appendix to specify examples of “fractional investment products that are likely to qualify as sescurities”.4) In such examples, it is required to strengthen investor protection by applying securities regulations including mandatory disclosure and anti-fraud to new forms of securities.
2) Principles of dealing with fractional investment securities
Second, concerning the principles of dealing with fractional investment securities, the Guideline provides a checklist for confirming the legitimacy of fractional investment businesses. The items on the checklist include “whether a fractional investment product is considered a security”, “whether a service (business) to be provided qualifies as a financial investment business” and “whether other laws except for the FSCMA apply”.5) “Whether a fractional investment product is considered a security” would be determined based on the aforementioned definition of a security under the FSCMA. As for “whether a service to be provided qualifies as a financial investment business”, the threshold issue is whether a particular business needs a license for broker-dealer, collective investment business, or securities exchange. If a financial investment product issued by a fractional investment business is considered a security or the relevant business falls under the financial investment business category, the fractional investment business would be subject to regulations under the FSCMA including disclosure obligation and prohibition on unfair transactions. In addition, a fractional investment business to which the FSCMA does not apply could be subject to other laws. There are many cases where a fractional investment business entity could face difficulties in deciding whether their products are securities or whether their business is a financial investment business only by referring to the legitimacy checklist in the Guideline. Accordingly, a business entity that intends to engage in fractional investment should make an inquiry about legitimacy with the supervisory authorities, rather than depending on its own arbitrary interpretation of relevant laws.
3) Financial regulatory sandbox for fractional investment securities
Third, the Guideline specifies issues to consider before applying for the financial regulatory sandbox. “Innovativeness and necessity should be rigorously reviewed and recognized” for a fractional investment business to be designated as the financial regulatory sandbox. Key safeguards should also be put in place for investor protection.6) A fractional investment business should set up the following investor protection mechanisms: the standards and procedures for prospectus and advertisement, separating deposits or invested assets of investors from the business entity’s deposits or assets; insulating the investors’ rights from the risk of bankruptcy of fractional investment businesses; sufficient material facilities and professional personnel; and conflict resolution process and a damage compensation system for investors. These safeguards are well reflected in conditions that the FSC required Musicow to fulfill when deciding to hold off imposing sanctions on April 20, 2022.7)
When applying for the financial regulatory sandbox, it is worth noting that in principle, an issuer of fractional investment securities is not permitted to operate a trading platform for the securities. If an issuer of fractional investment securities operates a trading platform and distributes the securities through the platform, the trading platform is less likely to promote fair transactions of the securities and maintain proper market prices. Furthermore, the platform operator may pursue its own interests by boosting trading fees or profits from the relevant transactions while trying to keep higher the price and trading volume of the securities. In a virtual assets market, when the market operator or related parties issue virtual assets, they are restricted from engaging in distributing the virtual assets on the trading platform operated by the issuer (Article 10-20 of the Enforcement Decree of the Act on Reporting and Using Specified Financial Transaction Information). This restriction aims to prevent a business entity from conducting unfair transactions by exploiting its dual status as a trading platform operator and an issuer of investment products. However, if there exists no other markets than the trading platform operated by the issuer and suspension of platform operation could cause huge damages to investors, the platform operation may be permitted temporarily according to the financial supervisory authorities’ judgment. Even if the temporary operation is permitted, the Guideline requires the trading platform operator to take proper investor protection measures such as the conflict of interest prevention. The Guideline prescribes that in principle, fractional investment securities should be traded on a platform operated separately from the issuer. In this respect, the financial regulatory sandbox is expected to bring about a new trading platform dedicated to fractional investment securities.
Conclusion: Future challenges for creating a sound fractional investment ecosystem
The Guideline is of significance in that it intends to increase predictability for market participants and protect investors against regulatory risk in response to digitalization of financial instruments in the capital markets. It specifies the standards for determining whether a fractional investment product qualifies as a security and the checklist for confirming legitimacy of fractional investment. It also recommends that a fractional investment business, not legally permitted under the existing legal framework but recognized for its innovativeness and necessity, be carried out through the financial regulatory sandbox program. In this regard, the Guideline can be seen as an approach to achieving a balance between regulation and development.
Given that the designated period of financial regulatory sandbox is up to four years (two years + two years), if a fractional investment business is recognized for its innovativeness and necessity and proven to take sufficient investor protection measures, its legitimacy should be guaranteed to ensure sustainable operation. This necessitates reform of the related regulations. Relevant regulatory improvements should be reviewed with a focus on regulatory exemption cases applicable to the sandbox program for fractional investment. The measures include relaxing the disclosure regulation on the sales of fractional investment securities and the restrictions on how securities are traded on a platform (competitive bidding or negotiated transactions). Furthermore, how to legalize distributed ledger as a form of electronic registration under the Act on Electronic Registration of Stocks and Bonds should be discussed to effectively establish the fractional investment trading platform based on DLT. Aside from the legal framework for promoting fractional investment, it is necessary to explore measures to suppress the speculative nature of fractional investment. To this end, the followings should be discussed: qualification requirements for an issuer of fractional investment securities, a stricter obligation of a broker-dealer regarding information disclosure, and tougher suitability and adequacy principles to protect financially vulnerable investors.
1) FSC, April 28, 2022, the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.4.
2) For instance, the MiCA (Markets in Crypto-Assets) regulation adopted by the EU prescribes that crypto-assets that qualify as financial instruments should not be subject to MiCA, emphasizing that financial services should not favor one particular Technology ((6) in the overview of MiCA Regulation).
3) The Ministry of Finance and Economy, 2006, Details of a proposal for the Financial Investment Services and Capital Markets Act, p.110.
4) FSC, April 28, 2022, Appendix to the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.2.
5) FSC, April 28, 2022, the Guideline for Securities Businesses Dealing with Fractional Investment, press release, p.5.
6) Id. at 6-7.
7) FSC, April 20, 2022, Determination whether the music copyright fee participation claim offered by Musicow constitutes investment contract securities and related administrative measures, press release, p.4.