[Viewpoint] The Judicial Oak Tree Grown from the Legislative Acorn

“The judicial oak tree grown from the legislative acorn” is a phrase used by former U.S. Supreme Court Justice William Rehnquist to describe the Securities and Exchange Commission’s (SEC) Rule 10b-5. This rule, established by the Commission under the blank delegation of authority in Section 10(b) of the Securities Exchange Act, serves as a comprehensive catch-all anti-fraud provision applied to nearly all securities fraud cases in both civil and criminal contexts in the United States. Although it was initially created without grand intentions, through sophisticated judicial interpretation and flexible application, a versatile legal framework capable of regulating everything has been built. This process is succinctly summarized by the phrase “the judicial oak tree grown from the legislative acorn.”

The capital market is rapidly evolving, and the products traded are becoming increasingly complex, making it a specialized field that is difficult to fully understand without expert knowledge. Accordingly, unfair trading has also evolved more intelligently, and as the saying “Dogoilcheok Magoiljang (道高一尺 魔高一丈)” goes, swift and effective regulation is becoming increasingly challenging. Consequently, after continuous calls for a comprehensive catch-all anti-fraud provision like that in the U.S., South Korea introduced a nearly identical comprehensive regulatory clause under Article 178 of the Capital Markets Act in 2007, named “fraudulent trading.”

Why is the “fraudulent trading” clause called a comprehensive catch-all anti-fraud provision? The core of this clause lies in Article 178, Paragraph 1, Subparagraph 1, which stipulates “acts using fraudulent means, plans, or schemes.” In other words, anyone who uses fraudulent means in the sale or other transactions of financial investment products can be punished with a maximum life sentence and fined up to five times the amount of unjust enrichment. The indicator of blameworthiness in this fraudulent trading clause is solely the word “fraudulent.” All other elements?financial investment products, sale or other transactions, means, plans, schemes, and use?are value-neutral, making “fraudulent” the unique indicator of illegality. So, what is the standard for judging “fraudulent”? Our Supreme Court defines fraudulent trading as “any means, plan, or scheme recognized as fraudulent according to social norms.”

From the perspective of the traditional principle of legality in criminal law, this exceptionally comprehensive and abstract fraudulent trading clause has seen a sharp increase in use recently. Even looking at the prosecution cases reported in the media this year alone, the fraudulent trading clause was applied in major cases such as the Samsung C&T merger, Kolon’s Inbosa K-Ju, Shinrajen’s no-capital mergers and acquisitions (M&A), Lime and Optimus fund fraudulent sales, SangSangIn Savings Bank’s illegal loans, and analysts’ front-running trades. With the prosecution’s active use and the courts’ flexible application, it seems to be heading toward a situation similar to that in the U.S., but is this progression truly desirable? Are our legal principles identical to those of the U.S.?

In fact, in the U.S., the origin of fraudulent trading, the “fraudulent means” actively used by our prosecutors is not recognized. That is, punishment for fraudulent means, plans, schemes, practices, or methods of operation under subsections (a) and (c) of Rule 10b-5 is not acknowledged; regulation is only through subsection (b) concerning misrepresentation (false statements and concealment of facts). Another notable difference is that instead of the ambiguous term “fraudulent,” the U.S. uses the clearer term “to defraud.”

Recently, our fraudulent trading clause has evolved once again by applying it to information usage acts. In the front-running case known as the Financial Supervisory Service’s Special Judicial Police Unit’s first case, an analyst conducted nominee trading or provided information to friends to trade before publicly releasing the research report they had prepared. The prosecution, amid some controversy, charged the analyst not under the generally expected Articles 54 or 71 but for the first time under Article 178, Paragraph 1, Subparagraph 1’s “fraudulent means” clause, and in July this year, the Seoul Southern District Court upheld this and convicted the defendant. This case broke the legal community’s general perception that the fraudulent trading clause is a supplementary or preparatory provision to the market manipulation clause and declared information usage acts, a type of insider trading, as fraudulent trading. If this ruling is finalized, the fraudulent trading clause will become a true “One Ring” applicable to all unfair trading, including insider trading.

But is this progression desirable? On one hand, it might seem invalid due to vagueness, but on the other hand, considering the increasingly sophisticated and intelligent capital market crimes and the long-standing regulatory demands that led to the introduction of the fraudulent trading clause, it is difficult to definitively declare it unconstitutional for violating the principle of clarity in legality. However, excessively flexible application risks arbitrary legal application and abuse of authority, which could undermine legal stability. In Japan, which adopted the same Rule 10b-5, the fraudulent trading clause was applied only once in 1965 and is currently obsolete.

Though it is a difficult issue, one possible solution is for the courts to present specific standards for judging fraudulent trading. The “Howey test,” a standard for determining whether a financing instrument qualifies as a security in the U.S., was established by the U.S. Supreme Court in 1946 by defining the attributes of a “security” as an “investment contract” in four criteria. This test has been applied unchanged for 75 years across numerous cases, including recent ones involving Bitcoin, maintaining legal stability. Similarly, our Supreme Court should establish wise standards for the fraudulent trading clause, which cannot be abandoned but is too sharp a tool to be used as is.

Seong Hee-hwal, Professor, Inha University School of Law

This content was produced with the assistance of AI translation services.