China’s private equity (PE) industry has made great progress in the past two decades. With the rapid development of the PE industry, the number of disputes between investors and PE managers has also shown an upward trend. To judge whether the PE manager violates the obligation of suitability, and to decide how to bear the liability of the investor’s losses, have become the main causes of disputes between investors and PE managers.
On 1 July 2017, the China Securities Regulatory Commission (CSRC) released the Measures for the Suitability Management of Securities and Futures Investors, which clarified for the first time that fund managers should comply with the requirements of suitability on management of investors, and that business institutions that sell securities and futures products should bear legal responsibility for violations of suitability obligations during the sales process.
Meanwhile, the Asset Management Association of China issued the Guidelines for Implementing Suitability Management of Institutional Investors in Fund Raising (Trial), which detailed regulations on suitability for management of investors in the PE industry. However, in practice, the questions on how to determine if the manager has fulfilled the suitability review obligations, and whether the suitability examination of investors should be conducted in terms of substance or form, have not yet been resolved.
The Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts clarified the suitability obligation – a series of obligations that the business institutions, as sellers, need to perform in order to achieve the goal of “selling appropriate products to suitable investors”, including at the least product risk assessment, investor risk tolerance assessment, and risk warning obligations.
Business institutions shall bear the burden of proof for whether they have fulfilled the suitability obligation. They should provide the product risk assessment and corresponding management system they established, the test on the risk perception, risk appetite and risk tolerance of financial consumers, and the evidence that business institutions have informed financial consumers of the products’ income and the main risk factors, etc.
Regarding the question of whether the suitability examination of investors should be conducted in terms of substance or form, the provisions in the minutes pointed out that: “If the business institution claims that it has fulfilled its obligation of notification and explanation by simply proving that the financial consumer has hand-written contents, such as ‘I clearly understand that there may be a risk of principal loss’, and cannot provide other relevant evidence, the people’s court will not support its defence; if the business institution can provide evidence to prove that, based on the financial consumers’ past investment experience, education level and other facts, the breach of the suitability obligation does not affect the financial consumers to make their own decisions independently, the people’s court will support its defence that financial consumers should bear the investment risks themselves”.
According to such provisions, examination as to substance is the mainstream of judicial adjudication, and it also fits with the principle of “buyers bear liability themselves, if sellers have duly performed their responsibilities”.
For example, in an arbitration case of fund contract disputes between an investor and a fund manager, the arbitration tribunal held that, on the surface, the manager had performed the procedures for investigating the risk tolerance of investors, the investor was a qualified investor of PE funds, and the fund it subscribed for was a stable fund product which did not exceed the investor’s risk tolerance capability.
However, the manager’s investment behaviour had actually made the investor an unsuitable investor after thorough consideration; the manager’s investment decisions and investment behaviours were not stable. The manager had invested all funds in the aggressive shares of a certain asset management plan, which was a particularly aggressive high-risk investment behaviour, and the consumer was very likely to incur loss, or even lose the whole principal.
These investment behaviours of the investor do not match the description of the above-mentioned risk-return characteristics that it is suitable for “stable investors”. Therefore, the subsequent investment behaviour of the manager failed to strictly comply with the risk-return characteristics stipulated in the fund contract, resulting in the fact that the actual risk-return characteristics of the fund product did not match the risk tolerance of the investor. In fact, the manager sold extremely risky fund products to an investor with limited risk tolerance, and violated the manager’s suitability obligations.
Business institutions that sell funds should also perform the investor suitability obligations during the promotion and sales process. In a dispute case over property damage compensation between an investor and a business institution that sells funds, sales staff in the institution actively promoted fund products to the investor when they knew that the investor was not qualified to purchase. They then forged the investor’s proof of income and made the investor sign the fund contract and subscribe the fund.
The court held that when the institution promoted the funds to the investor, it failed to investigate and verify the major lawsuits involving the targets invested by the fund, or to carefully assess the risk level of the fund in question, which directly affected the investment decisions of ordinary investors, and the final investment results. In addition, sales staff sold the high-risk financial products to the investor, forged the investor’s personal proof of income, and introduced the investor, who did not meet the access requirement, into the PE investment field. Therefore, the institution shall be liable for compensation for reasonable losses claimed by the investor.
In summary, combining the minutes and judgment opinions from judicial practice, PE managers should perform substantive examination obligations for investor suitability. If they do not fully fulfill their obligations of suitability and have faults, which causes the investor to suffer loss from failure to recover the principal and interest of the investment, mangers should bear the corresponding civil compensation liability for the reasonable loss claimed by investors.
Yang Guang is a partner and Wang Meiling is an associate at Lantai Partners
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