Analysis of guaranteed redemption commitments in PE fund investments

In recent years, as products registered during the rapid development of China’s private equity fund markets have reached their exit periods, the inclusion of guaranteed redemption clauses such as capital preservation and guaranteed returns commitments in fund contracts has become an important factor for cautious investors making investment decisions. As a result, fund managers and third parties have employed various internal and external credibility enhancement measures, including providing capital preservation and guaranteed returns commitments. However, disputes often arise when fund managers or third parties fail to fulfil these commitments. This article aims to provide a brief analysis of this issue.

Legal validity

Guaranteed redemption commitments made by fund managers are invalid. Articles 2 and 19 of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions explicitly prohibit fund managers from making capital preservation and guaranteed returns commitments. When faced with redemption difficulties, financial institutions are not allowed to make up for the loss with self-owned capital in any manner, and the recognition criteria and corresponding consequences of guaranteed redemption are clearly defined. Article 15 of the Interim Measures for the Supervision and Administration of Private Investment Funds specifically prohibits private fund managers and sales institutions from promising investors that the investment principal will not incur losses or guaranteeing the minimum return. The Supreme People’s Court, in the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, clearly outlines the judicial practice of invalidating redemption clauses and supports beneficiaries in seeking compensation from trustees commensurate with their faults. It also states that regardless of the form, whether it’s through drawer agreements or other means of stipulating capital preservation or guaranteed return clauses, they should be deemed invalid. Therefore, regardless of the nature of the redemption commitment made by the fund manager, it will be considered invalid.

Guaranteed redemption commitments made by investment advisers are invalid. Article 103 of the Securities Investment Fund Law of the People’s Republic of China explicitly prohibits fund investment advisory institutions from making any form of commitment or guarantee regarding investment returns. Therefore, any guaranteed returns commitment made by an investment adviser is invalid.

Different views exist on the validity determination of capital preservation and guaranteed returns commitments made by third parties. Regarding redemption commitments made by related parties of the fund manager, external credibility enhancement measures are typically implemented through commitments such as guaranteed principal and returns commitments, shortfall makeup agreements, redemption clauses, repurchase obligations, fixed income, joint guarantees, and similar commitments. There is no clear provision in relevant laws and regulations, leading to different views in judicial practice. Some precedents consider the fund manager’s shareholders and other related parties as independent entities, and agreements signed with investors in their names represent their true intentions, without violating mandatory legal provisions, and should be deemed valid. However, other precedents believe that although the related parties are not fund managers themselves, they are associated with the fund manager’s interests, and investors are aware that the party making the capital preservation and guaranteed returns commitment is related to the fund manager. The intention of all parties to the agreement is to obtain capital preservation and guaranteed returns from the fund investment. Therefore, such commitments still violate relevant regulations and should be deemed invalid.

For third parties other than the fund manager and its related parties who make capital preservation and guaranteed returns commitments, judicial practice distinguishes and determines whether a guarantee contract relationship, joint assumption of debt, a unilateral promise or another legal relationship was established based on specific facts. Precedents often consider commitments to be valid when they represent the true intentions of the parties involved, do not violate mandatory legal and regulatory provisions, and will likely find that a creditor-debtor relationship between the parties reflected in the corresponding commitment is a borrowing and lending relationship, allowing the claimed annualised returns and penalties for breach of contract to be subject to the upper limit of private lending interest rates according to the commitment.

Agreements stipulating the return of principal after the determination of losses are generally considered valid. Judicial practice often determines that compensating investors for their losses after the fund term expires or after losses have occurred does not fall under the scope of expected capital preservation and guaranteed return commitments but represents the true intentions of the parties involved and is not prohibited by law. Therefore, the parties should fulfil their contractual obligations according to the agreement.

Different views exist on whether the invalidity of guaranteed redemption clauses leads to the overall invalidity of the fund contract. In general, the judiciary can determine that clauses that solely guarantee capital preservation and guaranteed returns are invalid based on article 92 of the court minutes, which states that “contracts containing clauses guaranteeing fixed returns on capital, principal, or redemption as agreed between trustees such as trust companies, commercial banks, and other financial institutions and beneficiaries should be deemed invalid”. However, some argue that since guaranteed redemption clauses are important factors for investors when making investment decisions, invalidating these clauses would render the purpose of the fund contract unachievable, and therefore the entire fund contract should be deemed invalid.

In conclusion, although judicial practices may vary slightly depending on the circumstances, the overall focus remains on protecting investor rights and maintaining the order of financial market transactions through lawful judgments. Private fund managers should prioritise compliance with financial regulatory provisions, conducting fund operations in a legal and compliant manner, to avoid penalties or being held responsible for the invalidity of capital preservation and guaranteed return clauses. As for investors, it is important to make rational investments with a clear understanding of the high risks associated with financial products and not easily trust various promises of capital preservation and guaranteed returns, and to maintain relevant written documentation to safeguard their legal rights.

Yang Jiamei is a partner at Kangda Law Firm. She can be contacted by phone at +86 155 2961 1206 and by email at jiamei.yang@kangdalawyers.com