Prevention of risks and responsibilities of private investment fund custodians

Fraud cases have flared up in the emerging private investment funds’ business in recent years. Private investment fund custodians often need to deal with questions from investors and even from regulators, and face the risks of reputational damage. This article discusses the scope and boundaries of civil liabilities of private investment fund custodians in light of their statutory duties and the judicial cases.

Based on laws and regulations such as the Securities Investment Fund Law (Fund Law), Measures for the Administration of the Securities Investment Fund Custody Business, Instructions for the Filing of Private Investment Funds and Measures for the Administration of the Disclosure of Information on Private Investment Funds, the statutory responsibilities undertaken by the custodians of private investment funds are listed below.

Safekeeping of fund assets. Custodians should keep the fund assets in an escrow account and ensure the separation of fund assets from the property owned or managed by or under the custody of the custodians and managers.

Supervising investments. The custodians should review if the manager makes investment instructions in compliance with the investment scope under the contract and transfer funds accordingly. The custodian may request the manager to provide investment instructions, relevant transaction certificates, contracts or other valid accounting information to ensure that the fund custodian has sufficient information to judge the validity of the instructions.

Disclosing information to investors. The custodian should review and examine the net asset value, and formulate a custodian report as required by the fund contract for information disclosure by the manager or custodian to investors.

Liquidation and settlement of fund assets. In the fund liquidation and exit stage, the custodian should set up a liquidation team with the manager, monetise assets through the team, issue a liquidation report, distribute fund assets and carry out other matters.

It is worth noting that in certain circumstances such as losing contact with the manager, the Asset Management Association of China may impose higher requirements on the performance of the custodian.

Given the increasing number of disputes arising from the liability of a private investment fund custodian, the author, through extensive research of lawsuits related to fund custodians from 2018 to February 2021, summarised the main circumstances where custodians were found to be liable.

Failure in supervision. In the (2018) Su 0105 Min Chu No. 3795 case, the court found the custodian negligent as it failed to properly perform its obligation to supervise the investment and operation by the manager of the fund asset. In this case, the custodian didn’t know the fund manager had not fully performed risk control measures and that the debtor of the entrusted product was insolvent, which were relevant to the losses suffered by the investors. Therefore, the court ruled that the custodian should bear the supplementary liability at 15% of the actual loss of the investors’ fund assets.

Failure in information disclosure obligation. In the (2019) Lu 71 Min Chu No. 121 case, the court found that the custodian failed to properly perform its information disclosure obligations because the custodian violated article 96 of the Fund Law, article 24 of the Interim Measures for the Supervision and Administration of Private Investment Funds and the information disclosure provisions of the contract. The court ruled that the custodian should assume the corresponding information disclosure obligations of the fund custodian business to the investors.

Violation of contractual provisions. The custodian executed the manager’s investment instructions in violation of the contractual provisions without fulfilling the conditions for the establishment of the fund. In the (2018) Yue 03 Min Chu No. 16126 case, the court found that the custodian neglected to perform its legal and contractual obligations. The court ruled that the custodian constituted a breach of contract because it failed to perform the supervisory duties under the provisions of laws, departmental regulations and contractual provisions, and promptly alert the manager of the risk of non-compliance, even though the custodian knew that the fund establishment conditions had not been fulfilled. Thus, the custodian was found to be liable for 15% of the investors’ losses.

Improper execution of investment instructions. The custodian executed the manager’s investment instructions in the absence of a capital management plan on file. In the (2019) Jing 02 Min Zhong No. 8082 case, the court held that the custodian failed to properly perform the obligations to supervise the funds because the custodian was required to examine whether the manager was granted the right to “independently manage and apply the property under the asset management plan” and whether the manager was granted the right to issue instructions to the custodian. Since the asset management plan was not filed, and the funds supervised by the custodian were remitted according to the manager’s instructions, resulting in the loss of funds, the custodian was held liable secondarily to the loss.

In summary, based on the obligations and liability rules of custodians and the above case studies, the author raises three suggestions for custodians to improve their risk prevention capabilities and risk control mechanisms.

Strengthening the examination managers’ qualification. The custodians should improve internal review standards of the manager, and investigate whether the manager is involved in lawsuits, or suspected of escaping from debts or illegal fundraising by looking into the news and public information, as well as whether the manager is involved in situations conflicting with private fund businesses such as P2P (peer-to-peer lending) and crowdfunding.

After being entrusted, the custodian should continue to pay attention to the qualifications and operational risks of the managers, in addition to performing the entrusted duties according to the contract.

Paying attention to the duties of custodians. The first thing is to clarify the boundaries of duties. When drafting and reviewing fund contracts and custody contracts, custodians should fully consider the content and scope of entrusted matters and clarify the scope of duties in terms of “must-do” and “can-do”. The second is to clarify the ways of performing duties, distinguish between active and passive performing matters, between draft obligations and review obligations, and between format review and substantive review.

Adhering to the custodians’ obligations under the fund and custody contracts. Keep the proof of fulfilling obligations complete and prompt.

Yang Guang is a partner and Xue Yuan is an associate at Lantai Partners