Regulatory Framework:

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2 Regulatory Framework: Korea Young Kyung Lee, Attorney at law (Korean Bar) Michael Kim, Attorney at law (New York and New Jersey Bars) Eun Jip Kim, Attorney at law (New York Bar) Kim & Chang Korea Overview In Korea, the Exchange Traded Fund (ETF) was first introduced on 27 April 2002 through amendment of the now-repealed Securities Investment Trust Business Act and the Securities Investment Company Act. ETFs are now governed under the Financial Investment Services and Capital Markets Act (FSCMA). The ETF market in Korea has seen steady growth from October 2002 when the first ETFs were listed on the Korea Stock Exchange (renamed to the Korea Exchange), namely, the KODEX200 by Samsung Investment Trust Management Co., Ltd. and KOSEF200 by Woori Investment Trust Management Co., Ltd., which both track the representative index of the Korean stock market, KOSPI200. From the second half of 2007, ETFs tracking global indices were introduced in the market. On 9 October 2007, Samsung Investment Trust Management Co., Ltd. listed the KODEX CHINA H ETF, which tracks the Hong Kong H-Shares stock price index. Soon after on 20 February 2008, the KODEX Japan ETF tracking the TOPIX100 and shortly thereafter in the same year, the KRX200 ETF tracking the KRX200 Index were listed. Subsequently, various ETF products investing in specific groups of companies also debuted in Korea 1. Development of Korean ETF Market 2 (Unit: 100 Million Won / No.) End of End of End of End of End of May Net Asset 3,552 7,029 4,896 8,046 15,609 26,472 No. of Products Kim, Beom-Seok, Current Status of ETF Market and Its Activation Plan, The Financial Review, June 2008, pp Ibid, p.60.

3 Legal / Regulatory Framework The FSCMA which came into effect on 4 February 2009 currently governs the regulation of ETFs in Korea. In the same way as public funds, ETFs are subject to registration requirements prior to being offered in Korea. Additionally, they must also file a securities registration statement with the Financial Services Commission (FSC), the central policy maker in charge of setting policy for the securities, banking, insurance and asset management industries. The FSCMA defines an ETF as a fund (limited to the investment company or investment trust type): with the objective of tracking the performance of an index indicating a collective price level of a basket of securities or other assets; the beneficiary certificates (of the investment trust) or the shares (of the investment company) of which must be listed in the relevant stock exchange within 30 days of the establishment date of the investment trust or the investment company; and the beneficiary certificates or the shares of which must be redeemable. Index Requirements of ETF The FSCMA prescribes certain requirements for the underlying index in which the ETF invests, as follows: (1) the index shall be one that collectively indicates the price of the underlying assets or the level of prices of a multiple number of underlying assets traded on the exchange, a foreign exchange, or a market specified and publicly notified by the FSC; (2) the price of the underlying assets comprising the index or the index under subparagraph (1) shall be publicly announced to investors through the market; and (3) the fund should also satisfy the requirements prescribed by the FSC with respect to the requirements for prices of the underlying assets, the assets comprising the index, the weight of each asset comprising the index, the management method with which to link the performance of the ETF with the fluctuation of the index and price, among others. Regarding subparagraph (3) above, more detailed provisions can be found in the sub-regulations to the FSCMA. Exemptions from the FSCMA To accommodate for the special features of the ETF, the FSCMA has allowed for several exemptions that would normally apply to other funds. For instance, the FSCMA exempts ETFs from ownership limits on shares issued by principal shareholders and specially-related persons of financial investment servicers as 74

4 defined under the FSCMA. ETFs are also not subject to provisions related to shadow voting on shares of affiliates, asset management reports, reporting requirements on major shareholdings, forfeiture of short swing profit, reporting requirements when owning certain securities such as voting shares by officers, and provisions related to the redemption of collective investment securities. In particular, while normally funds are prohibited from investing more than 10% of its assets in a single issue, ETFs are permitted to invest up to 30% of its assets. Further, the normal restriction on investing more than 10% of the total outstanding shares of a single company is relaxed to 20%. Authorised Participant The fund manager must sell the beneficial certificates or shares of an ETF through a single distributor (Authorised Participant). The FSCMA provides that the Authorised Participant must do its best to make the market price for the shares / beneficial certificates correspond to the net asset value per share / beneficial certificate. To that end, the Authorised Participant will buy and sell shares / beneficial certificates on the market to affect supply and demand, and thus, readjust the market price of the shares / beneficial certificates. Additionally, the Authorised Participant has the following duties: To request the fund manager to create or terminate the ETF units. To sell or purchase / act as broker of securities, etc. to convert the trust money into trust assets equivalent to a Creation Unit. To conduct any other business similar to the above items. An appointed Authorised Participant should have both an investment dealing business (excluding underwriting business) and an investment brokerage business (limited to commission-based brokerage business) for securities. Such Authorised Participant shall not be deemed to engage in the discretionary investment management business (normally requiring a license to do so) in cases where it sells securities on its own account or on a third party s account in order to create or establish an ETF. Creation of ETF and Issuance of New Shares Upon receiving a request from an Authorised Participant to create an ETF or issue new shares of an existing ETF, the fund manager must do so in accordance with the provisions of the trust deed or the articles of incorporation. The Authorised Participant shall, when it seeks to make a request, acquire securities in the amount required of the Creation Unit (i.e. the minimum number of shares or beneficial certificates required to create or invest in an ETF as prescribed under the articles of incorporation or trust deed) with the investor proceeds received either directly or via an investment dealer or broker, except in cases where it is difficult to acquire such securities as prescribed by the Regulations of the Financial Investor Business. 75

5 If an investor or an investment dealer or broker provides the in-kind assets to an Authorised Participant or the appointed Authorised Participant provides such assets to a fund manager for the creation or establishment of an ETF, it must do so via account transfer through the Korea Securities Depository. An Authorised Participant may use its own named account when trading securities for purposes of creating an ETF or issuance of new shares thereof. Redemption Investors can only buy or redeem shares directly from the fund company in large-share blocks (e.g. 50,000 share blocks) equivalent to a Creation Unit, and even then, the funds require in-kind redemption where the investor would receive the underlying stocks. In practice, this would mean that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of the investors would need to go through a broker to buy and sell shares in the market. By permitting large investors to buy or redeem ETF units in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help minimize the tracking errors and help general ETF investors sell their ETF units in the secondary market. Listing and Delisting Requirements From the establishment date of the ETF, the fund must be listed on the Korea Exchange within 30 days thereof in accordance with the listing regulations for the securities market and the KOSDAQ market. The Listing Regulations of the Korean Exchange prescribes listing requirements related to the size of capital, the number of issued shares, liquidity, index contracts, index composition requirements, and others. Both domestic and foreign ETFs (an ETF tracking an index of foreign securities established in a foreign jurisdiction) can be listed. For the domestic ETF, several requirements are prescribed such as the minimum capital requirement of 10 billion Korean Won, minimum issued shares of 100,000 or more, and at least two or more Authorised Participant companies are to be appointed. For the foreign ETF, the requirements are generally identical with those applicable to the domestic ETF. Additionally however, the foreign ETF must have already been listed on a foreign exchange and registered for sale under the FSCMA. Other representative listing requirements for the domestic ETF are as follows: There shall be at least two Authorised Participants and an agreement to appoint a market maker (with one of the Authorised Participants who is qualified to be a market maker) should be executed. The relevant market where the underlying securities of the index basket are traded must be reputable and generally well-known such as the Korea Exchange, the London bullion market and foreign exchange markets. 76

6 The trust deed or the articles of the ETF must include: (i) the duties of the Authorised Participant in acquiring the assets necessary for the Creation Unit (as one of the requirements, 95% of the underlying assets of the index must be incorporated into the assets for the creation unit); and (ii) the alternative option of cash payment (instead of the usual in-kind payment) where acquiring the assets necessary for the creation unit is difficult due to liquidity issues or if the ETF s main investment method is investing in OTC derivative instruments - with an explanation of the main investment target, index tracking method, details of the underlying assets held in the ETF, etc. Certain events as prescribed by the listing regulations of the Korea Exchange require delisting of the relevant ETF shares from the exchange. A representative example of this would be when a tracking error of 10% or more occurs for three months. In this instance, the Korea Exchange has the discretion to delist the relevant ETF. Other representative grounds for delisting of a domestic ETF are shown below. The paid-in-capital is less than KRW 5 billion or the number of ETF shares listed (or the number of beneficiary certificates) is not more than 50,000 shares / units for a three month consecutive period. The number of shareholders (or beneficiaries) is fewer than 100 persons as of the fiscal year end. The above delisting requirements will also generally apply to the foreign ETF with the additional ground that if the foreign ETF is delisted from the foreign exchange, this will also trigger a delisting in Korea. In the event that the domestic / foreign ETF shares are delisted, the ETF itself must be dissolved or terminated within 10 days of the date of the delisting. An asset management company is obligated to report such dissolution or termination of the ETF to the FSC. Domestic Fund Registration and the Securities Registration Statement Like any other fund in Korea, domestic ETFs are required to be registered with the FSC pursuant to the FSCMA prior to any sales activities of the ETF. As the FSCMA prescribes several requirements in relation to the fund and the relevant parties (asset management company, trustee / custodian, distributor company, etc.), such requirements should be satisfied at the time of registration. Further, the public placement of ETF shares requires the filing of a Securities Registration Statement (SRS) with the FSC pursuant to the requirements stipulated in the FSCMA. For a private placement of ETF shares where only certain professional investors would be targeted, the SRS would not be required but the fund must still be registered with the FSC. 77

7 A. Eligibility Requirements for Registering a Domestic Public Fund In order to register a domestic fund, the FSC would require, among other matters that: the related parties (e.g. fund manager, trustee / custodian, distribution company, etc.) to the fund not be under suspension of business; the fund shall be incorporated or established in compliance with the FSCMA; and the trust deed or articles of incorporation do not violate relevant laws and regulations or are clearly contrary to investor interests. Various documents and certificates are required to be delivered to show satisfaction of such eligibility requirements. B. Registration Documentation Requirements To satisfy the disclosure requirements of the SRS, information on the public offering / sale of the fund must be detailed, including: fund information including its eligible investments, risks, redemption, commission / fee; financials and management performance of the fund; related company information, such as financial status of the management company and other procedures for protecting investors. It is also necessary to present supporting documents such as the articles of incorporation or trust deed and related agreements in support of the SRS registration. In addition to the above, a prospectus, while the content of which will be largely similar to the SRS, will also have to be submitted. C. Processing Time With respect to the processing period for registration, it may take up to one month to prepare the registration application package and an additional one month for the regulator to review the registration application package and complete the registration of the fund. Offshore Fund Registration and the Securities Registration Statement A. Registration Requirement As in the case of domestic funds, all offshore funds (including foreign ETFs) marketed and sold to Korean investors are required to be registered with the FSC. In the case of an offering to retail investors, both the fund registration application and the relevant SRS (and prospectus) must be filed with the FSC. In the case of an offering to only Qualified Professional Investors as defined under the FSCMA, only the fund registration must be completed. To date, there is no precedent of a foreign ETF being registered in Korea and therefore any registration may present practical difficulties such as extended review periods and other issues during the registration process. B. Requirements of the Offshore Fund Manager and Offshore Fund Offered to Retail Investors The offshore fund manager must have a certain level of net assets depending on the type of offshore fund being offered. For instance, if the fund is classified as a real estate fund and targeted to general 78

8 and professional investors alike, the minimum net assets would need to at least KRW 2 billion. Other requirements include a minimum level of assets under management (AUM) managed by the offshore manager and appointment of a qualified domestic contact agent. The primary eligibility requirements of the offshore fund relate to showing that the businesses of the related parties to the fund are going concerns, the fund and its constituent documents are lawfully created pursuant to the regulations of its home jurisdiction, paid in capital and a redemption-cycle of 15 days. C. Requirements of Offshore Fund Offered Only to Qualified Professional Investors The eligibility requirements are somewhat relaxed if the offshore fund is offered only to Qualified Professional Investors (QPI) as defined under the FSCMA. Unlike the case of an offering to retail investors, where both the fund registration application and the relevant SRS (and prospectus) must be filed with the FSC, in case of an offering to only QPIs, only the fund registration must be completed. Further, if the offer is limited to QPIs, the main eligibility requirements that must be met in order to register the offshore fund with the FSC will be significantly reduced. D. Registration Documentation Requirement (1) Securities Registration Statement and Fund Registration Application In the same way as a domestic fund registration, an SRS and a registration application would be required for the offshore fund. (2) Supporting Documents to the Fund Registration Application The key supporting documents to accompany the registration application are a power of attorney, confirmation of AUM levels, no sanction certificates, articles of incorporation of the fund or trust deed, financial statements and other related fund agreements. E. Onshore Marketing Under the FSCMA, onshore marketing of offshore funds should be done through a local Financial Investment Company (FIC) that is licensed to distribute fund products. Such FICs would normally include securities companies, commercial banks and the like. 79

9 Costs: Filing Fees and Exchange Fees, etc. Listing fees in the securities market relating to ETF shares are as follows: Listing Amount Rate Below 3 billion Won 0.04% of the listing amount In excess of 3 billion Won ~ 1,200 thousand Won % of the listing amount Below 10 billion Won in excess of 3 billion Won 1/3 In excess of 10 billion Won ~ 3,300 thousand Won % of the listing amount Below 20 billion Won in excess of 10 billion Won 1/3 In excess of 20 billion Won ~ 5,300 thousand Won % of the listing amount Below 50 billion Won in excess of 20 billion Won 1/3 In excess of 50 billion Won ~ 8,300 thousand Won % of the listing amount Below 100 billion Won in excess of 50 billion Won 1/3 In excess of 100 billion Won ~ 10,800 thousand Won % of the listing amount Below 500 billion Won in excess of 100 billion Won 1/3 In excess of 500 billion Won ~ 26,800 thousand Won % of the listing amount Below 1,000 billion Won in excess of 500 billion Won 1/3 In excess of 1,000 billion Won 41,800 thousand Won % of the listing amount in excess of 1,000 billion Won 1/3 Source: There are no other fees at the time of fund registration. However, the public offering of shares requires a securities issuance fee of 0.5 / 10,000 of the total issue price (in the case of open-ended funds, 0.5 / 10,000 of the net issue amount). 80