New regulations for private fund industry

Private fund managers are being held liable for non-fulfilment of information disclosure and due diligence. Current judicial practice for determining whether such obligations have been adhered to is worthy of attention.

On 9 July 2023, the Regulations on the Supervision and Administration of Private Investment Funds were officially released. They mark the first administrative-level regulatory framework for the private fund industry.

Article 3(3) of the regulations states: “Private fund managers that manage and use private fund assets, private fund custodians that take custody of private fund assets, and private fund service institutions that provide private fund services, shall comply with the provisions of laws and administrative regulations, devote themselves to their duties, and fulfil their obligations of honesty, trustworthiness, prudence, and diligence.”

This article explores the disclosure and diligence obligations in cases where private funds employ an indirect investment approach. It draws insights from the regulations and relevant legal cases.

Prone to disputes

In transactional practice, investors and managers in private funds commonly establish their investment objectives in a general manner when signing fund contracts. They provide limited details on the path to achieving the investments.

This approach allows fund managers to design various transaction structures to navigate real-world obstacles when deploying capital. Frequently, there are multiple layers of transactions before achieving the desired ownership structure in the target company. This general approach affords fund managers greater flexibility for selecting investment strategies to meet their objectives.

However, even sophisticated private fund investors frequently struggle to accurately perceive or fully grasp the intricacies of these relatively complex investment structures. In cases where a fund’s performance falls short and anticipated returns remain unrealised, investors may argue that the manager failed to meet its disclosure and diligence obligations, seeking compensation for the loss or even seeking to terminate the contract.

Obliged to disclose

Article 11 of the regulations stipulates that private fund managers are obligated to provide investors with information on fund management activities as agreed in the fund contract.

Regarding the question of whether it is necessary to disclose the underlying transaction structure of indirect investments, current judicial practices reveal that most courts hold the view that if a fund contract does not explicitly outline the matters that require disclosure, the information does not significantly impact investors’ legitimate rights and interests. Therefore, this information does not need to be extensively disclosed.

For instance, in Xu Linzhen v Shenzhen Superstar Dragon Venture Capital Fund Management Partnership and The Bank of Shanghai Beijing branch, the court pointed out that the fund’s investment status primarily revolved around whether the actual use of the fund’s assets aligned with the contractual agreements about investment direction, investment scope and specific projects.

This mainly refers to the investment direction of the raised funds and the investment amounts. It does not encompass the specifics of the underlying transaction structure, nor does it delve into the precise operations of the fund unless the fund contract imposes a mandatory obligation for detailed disclosure or involves a “material matter that could impact the interests of the fund’s principals”.

Furthermore, a mere breach of information disclosure obligations by the manager does not automatically translate into liability for compensation. In practice, investors often find it challenging to establish a causal link between a manager’s breach of disclosure obligation and their losses.

Consequently, most courts tend to attribute investors’ losses to the inherent risks of their investments, which are not directly connected to disclosure obligation. They rule that the manager does not need to bear the responsibility of compensation.

Duty of diligence

Chinese judicial practice widely recognises that the foundational relationship between an investor and a manager is fiduciary in nature. The regulations designate the Trust Law as the upper-tier law and specify that private fund assets remain distinct from those of the manager. Grounded in the principles of the Trust Law, managers should enjoy greater freedom in determining how to employ these entrusted assets. In judicial practice, when managers employ indirect investment strategies through multi-tier transactions that do not substantially affect the applicant, and they ultimately invest in predefined targets, courts are generally hesitant to conclude that a manager has breached the terms of the fund agreement.

For instance, in the case of Shanghai Duomi Private Fund Management v Wang (an investor), the court determined that the dispute between the investor and the manager regarding the appropriateness of the investment scope boiled down to the distinction between direct and indirect investments.

The critical factor in assessing the reasonableness of the investment approach was whether it aligned with the agreed-on investment scope. Consequently, the court considered the manager’s investment approach was reasonable.

Furthermore, the court noted that factors such as the suspension and subsequent significant price fluctuations in company stock trading had led to a concentration of liquidity risk. As a result, the losses incurred were not causally linked to the manager’s investment strategy.

When investors claim a manager has breached its diligence duty, they often seek damages and contract termination to recover their entire principal investment and exit the fund.

In judicial practice, courts tend to adopt a cautious approach towards terminating fund contracts in consideration of preserving the overall integrity of the fund’s assets. Typically, courts will rule that the conditions for fundamental breach are not met and, therefore, the fund contract cannot be terminated.

In examining judicial practice, it becomes evident that a court will only order the termination of a contract when the manager’s fundraising, investment or management activities significantly deviate from the agreement or legal provisions, leading to a complete failure of the investor’s investment objectives without jeopardising the overall integrity of the private fund’s assets.