Abnormal LP-related risks in practice

By Zhao Liang, Merits & Tree Law Offices

The past decade has seen the booming development of the venture capital industry in China, stemming from accelerated advances of the world’s science and technology sectors as well as the country’s vibrant economic advances. Meanwhile, risks in the venture capital industry have also changed in a profound way. Important cases handled by the author basically focus on settling post-investment disputes, involving mostly general partners (GPs), but few limited partners (LPs), at investment institutions. However, consultations on some recent cases have involved the exercise and abuse of the LPs’ rights, and the reasons are intriguing.

Case I. An LP of an investment project in this case has rich professional experience in both US investment banks and Chinese investment institutions. He has participated in many high-profile projects and has great business expertise working as a GP as well. Recently, the project was approaching the exit stage, after which the return was estimated to cover the investment principal of the LP. Progress had been smooth and the LP had expected to obtain his return on capital until he was suddenly informed that the project GP decided to invest the profits into the GP’s company. The LP believed that such a related party transaction would directly damage his fundamental interests.

Zhao Liang Partner Merits & Tree Law Offices
Zhao Liang
Merits & Tree Law Offices

Risk Response. There are several ways to manage this risk. First, one can seek a remedy from an LP’s protection and restriction scheme, such as protection over the exit mechanism, where an LP often chooses to voluntarily withdraw from the partnership when he finds continuing investment in other projects may cause the partnership greater losses. However, since such an exit may trigger a loss in the interests of other LPs, they would impose strict exit preconditions, i.e., the exit must be approved by a certain proportion of partners.

Coming back to this case, an LP’s exit needs to be approved by two-thirds of the partners according to the investment agreement. Because most LPs are not familiar with each other and it can be tough to unify opinions, it makes the condition of implementing the exit too tough to reach. The LP who wants to exit in this case may hardly be able to achieve his purpose. At this point, the author tried to seek a remedy from mandatory distribution, which protects an LP’s priority in a payment order after his investment funds exit a project and after saving profits that belong to GPs. According to this principle, a GP cannot reinvest proceeds from a project since the protection mechanism has restricted the reinvestment behaviour of GPs. This principle allows an LP to recover the cost in the first place and minimize risks.

Unfortunately, the LP in this case did not stipulate a mandatory distribution protection in the agreement. Therefore, as the GP unilaterally controls the company’s investment rights, the LP cannot hold back the related party transactions initiated by the GP. Once the GP’s investment behaviour is implemented, the LP can only protect his rights by proving that the investment is a maliciously related party transaction, taking the risk that the transaction cannot be proven to be connected and that the claim on the investment funds may fail.

Case II. A GP of an investment project also encountered LP-related risks during a troublesome case. The project invested by a fund company’s GP was in a normal state and the enterprise was about to go public. Suddenly, one LP could not fulfil the final funding payment due to financial problems, so he agreed to be replaced by a new LP. However, when updating information with the industrial and commercial registration authority, another LP on the project did not agree to sign the altered file, creating a dilemma between the LP who planned to transfer the rights and the new LP, who was preparing to invest. In theory, without a new LP, the fund company cannot fulfil its investment agreement, which if cancelled will cause enormous losses to the enterprise that receives the investment. However, the fact is that the LP who objected to the transfer does not support the transaction according to normal business practices.

Risk Response. There are some thoughts on how to manage the risk. The Partnership Business Law has provisions similar to the Corporate Law in terms of whether the transfer of an LP’s rights to a third party gives other LPs preemption rights. However, there are differences. Corporate Law stipulates that if a shareholder does not exercise the preemptive rights within 30 days, it is deemed that he/she waives those rights. In practice, the industrial and commercial registration authority will only change the limited partner of a partnership in strict accordance with the written legal documents that all partners agree. The Partnership Business Law does not clarify a remedy for cases where partners fail to have an agreement on their behaviour.

But reference can be drawn from other laws to tackle this issue. Some content from the Marriage Law can be used as a good reference. The current judicial interpretation of the Marriage Law clarifies that when other LPs do not exercise the right of first refusal, it is a default that the co-owner of marital property has the right to get registered as a new LP. In view of the fact that the parties usually do not explicitly stipulate the restrictions on the right of first refusal in the partnership agreement and that laws and regulations are ambiguous about this matter, the best way is to impose limits on the preemptive rights in the partnership agreement to avoid triggering a dispute over them in the future.

From the above two cases, it can be seen that the specific legal provisions of partnership enterprises in China are not detailed. Therefore, many mechanisms and methods to restrain the behaviour of partners can only be stipulated through partnership agreements.

It is true that in today’s investment circle, collaboration of people is the most important concept, but to protect one’s rights contracts to the largest extent provide a safety net for transactions.

It can be expected that with the prosperous development of China’s investment and financing industry, a lot of disputes and friction will break out in investments and among partners. Only by complying with the bottom line of the laws and agreements can practitioners better protect the rights of all parties.

Zhao Liang is a partner at Merits & Tree Law Offices

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