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Editorial

Proposed Rule Changes to Spur Korean Hedge Funds

March 2014 - Finance. Legal Developments by Bae, Kim & Lee LLC.

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Planned changes to financial sector regulations expected to take effect September 2011
The Financial Services Commission (FSC) of Korea is poised to implement a slate of regulatory changes that will ease a number of the current constraints, and clarify standards, for the formation and operation of domestic hedge funds. First announced in draft form in late June 2011, the changes to the presidential decree promulgated under the Financial Investment Services and Capital Markets Act (FSCMA) are for the most part expected to be finalized in August 2011, and to take effect in September 2011. The stated aim is to spur growth in Korean hedge funds, known technically as "collective investment vehicles aimed at qualified investors." The new rules will broaden the scope of eligible investors; ease current hedge fund operating limits such as the leverage cap; finalize eligibility criteria for hedge fund managers; and permit a wider range of prime broker activity, including securities lending for short sales.

The rules remain subject to revision as they undergo final government review. The anticipated key rules, however, are as follows.
 
 
 
 
 
 
 
     
 


Qualification to invest in hedge fund

The new rules will permit individuals to invest in hedge funds, provided an individual has to invest KRW 500 million or more in a given fund. In contrast, the current eligible pool of investors is confined to a narrow group including financial institutions.


Fund of hedge funds

Rules for "funds of hedge funds" are still under deliberation. However, the FSC is expected to adopt guidelines requiring a minimum investment of from KRW 100 million to KRW 200 million and a minimum diversification of between 5 and 10 different hedge funds. Unclear at the moment is whether and in what respects this rule may pertain to offshore hedge funds marketed in Korea, e.g., given that at present offshore hedge funds may not be subject to such diversification rule if privately placed to qualified investors.


Fund management restrictions eased

The rules will relax or eliminate several limits on hedge fund management. The current limit on borrowings, of 300% of the fund's assets, will be raised to 400%. Maximum exposure on derivatives trades will be raised from 100% to 400% of the fund's assets. The FSC is also going to eliminate the requirement-much criticized as an obstacle to hedge fund growth in Korea-that a fund invest at least 50% of its assets in companies undergoing corporate restructuring.


Qualifying as hedge fund manager

The new regulations will establish the criteria to qualify as a hedge fund manager. Basically, securities firms, asset management firms and investment advisory firms will be eligible, provided they meet standards of capitalization, management capability or track record, and expert staffing. Minimum paid-in capital for a fund manager will be KRW 6 billion. (It was set at this level partly in light of the minimum KRW 4 billion for a securities firm, and KRW 8 billion for a comprehensive asset management firm.) Capability is to be assessed based on equity capital, assets under management (or size of portfolios), performance and other factors. According to the FSC announcement in June, minimum size requirement should be satisfied by an asset manager that has KRW 4 trillion or more in assets under management (AuM), a securities firm with KRW 1 trillion or more in equity capital, or a discretionary investment management firm with KRW 500 billion or more in discretionary investment management contracts.

Under the draft rules, a hedge fund manager must have at least three personnel with hedge fund management experience, either in Korea or overseas.


Augmented reporting obligation

At the same time, the new rules will reinforce certain reporting obligations, a move which is said to be in line with stricter reporting requirements standards globally. It is expected that hedge funds will have to file quareports that will cover, for example, investment management strategy, targeted asset types, and status of borrowings and derivatives.


Rules Governing Prime Brokers

An important part of the regulations will concern the scope for prime broker activities, seen as a key to much hedge fund activity. The revised rules in principle will permit prime brokers to offer hedge funds a broader range of services such as loans of securities, and custodian and settlement services. Securities firms, of a scale to be decided, will be eligible to serve as prime broker, according to FSC statements thus far.

The rules will newly permit prime brokers to lend stock to hedge funds for short sale transactions. Prime brokers will also be able to offer credit to hedge funds with or without collateral on securities held as hedge fund assets, whereas, under the current rules only permit lending to hedge funds against securities deposited by investors with the securities firm.

Changes will make it easier for a prime broker that has custody or handling of fund assets to provide other related services such as loans of securities. As an exception to more general rules, a prime broker will be permitted certain types of transactions between its own proprietary assets and the hedge fund assets.

There will also be certain "Chinese Wall" restrictions. Prime brokers may conduct, in the same department, selling and brokering of securities as well as custody and administrative functions for hedge fund assets. However, a securities firm's prime brokerage department must be segregated from other departments.


Outlook

The FSC's draft presidential decree to undergo high-level legislative and executive branch review, but is expected to take effect, more or less in the shape previously announced, in September 2011. The FSC has made clear its purpose is to bolster the domestic hedge fund sector within this year.

The FSC also plans to develop and adopt a set of regulations and best practice guidelines for the hedge fund system, through a task force including industry representatives and other experts. Further announcements in that regard are expected during the 3rd quarter of 2011.
 
 
 

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