Talking about Private Fund Custody from the Bankruptcy Event in Silicon Valley

2023-03-22 17:02:23 · Yang Chunbao, Sun Tian, Li Jiaxin

Preface

On March 10th US time, the California Department of Financial Protection and Innovation announced the closure of Silicon Valley Bank (SVB), and the Federal Deposit Insurance Corporation (FDIC) took over the bank due to insufficient liquidity and insolvency. It is worth noting that the closure and bankruptcy of Silicon Valley Bank, as a professional bank serving the venture capital circle in the United States and even the world, is like a huge stone throwing a huge splash in the venture capital circle and affecting the entire water surface. The CEO of Y Combinator, a well-known US venture capital company, called the bankruptcy of a Silicon Valley bank "the extinction event of a start-up company.".

According to relevant media reports, the head of a venture capital fund in Beijing told reporters that due to the involvement of the Silicon Valley Bank incident, individual domestic venture capital institutions still have deposits or other related businesses in Silicon Valley banks and are busy dealing with capital issues. From the perspective of private equity funds, we cannot help but worry: Is the bankruptcy of Silicon Valley Bank likely to affect the property safety of private equity funds entrusted to it? What warnings does this incident have for domestic private equity funds? In response, this article intends to sort out domestic private equity fund custody regulations and self-discipline rules, and provide professional advice on relevant risks.

"Three Questions" of Private Fund Custody

Which types of private equity funds must be managed？

According to the Interim Measures for the Supervision and Administration of Private Equity Investment Funds [1], the Instructions for the Filing of Private Equity Investment Funds [2], and other relevant regulations, currently four types of private equity funds must or in principle must be managed:

(1) Contractual Private Equity Investment Fund

(2) Private Asset Allocation Fund

(3) Private equity funds that indirectly invest in underlying assets through special purpose vehicles such as companies and partnerships

(4) Registered private equity or asset allocation funds with fundraising needs

In principle, contractual private equity investment funds must be placed in the custody of a custodian established in accordance with the law and qualified for fund custody, except where the fund contract stipulates the establishment of a daily institution such as a fund unit holder meeting or a fund trustee committee that can effectively perform the duties of safe custody of fund assets.

Which entities do private fund custodians include？

According to the relevant provisions of the Securities Investment Fund Law of the People's Republic of China (the "Fund Law"), commercial banks or other financial institutions may act as fund custodians, but the former shall be approved by the CSRC in conjunction with the CBRC, while the latter shall be approved by the CSRC. In addition, the Fund Law also sets forth requirements for the net assets and risk control indicators of fund custodians, relevant department settings and staffing, fund property security conditions, clearing/delivery system conditions, and other settings and equipment related to fund custody.

How should private fund custodians keep fund assets?

In accordance with the relevant provisions of the Fund Law and the Guidelines for Commercial Bank Asset Custody Business of the China Banking Association, private equity fund custodians have the responsibility to strictly ensure the integrity and independence of fund assets when maintaining fund assets. "A fund custodian shall perform the duties of safekeeping fund assets, opening fund accounts and securities accounts for fund assets in accordance with regulations, and setting up separate accounts for different fund assets under its custody. It shall not confuse its inherent assets or the assets of others with fund assets, nor use fund assets or position facilities to seek benefits and transfer benefits for itself or a third party, or even misappropriate or misappropriate fund assets.", Engaging in investment activities that harm the assets of the Fund and the interests of investors.

私募基金托管人破产相关问题

The custodian goes bankrupt, and the fund needs to...

According to the relevant provisions of the Fund Law, if a fund custodian is declared bankrupt according to law, its custody duties shall terminate. The general meeting of fund unit holders shall appoint a new fund custodian within six months; Before the creation of a new fund custodian, the CSRC shall designate a temporary fund custodian. In addition, an accounting firm should be hired to audit the fund assets in accordance with regulations, and the audit results should be announced and reported to the CSRC for filing. Moreover, the fund property does not belong to the bankruptcy liquidation property of the fund custodian. In summary, if a private fund custodian is declared bankrupt, the private fund needs to terminate its Custody Contract with the bankrupt custodian and select a new custodian. At the same time, it needs to conduct an audit of the fund assets.

The impact of trustee bankruptcy on fund assets

As mentioned above, combined with commercial practice, private equity fund custodians are mostly commercial banks and securities companies. The phenomenon of bank bankruptcy is relatively rare in China. Currently, there are only four banks with bankruptcy precedents: Hainan Development Bank, Hebei Suning Rural Credit Union, Shantou Commercial Bank, and Baoshang Bank. However, we cannot rule out the situation where commercial banks and other financial institutions fail due to poor management due to various factors such as market environment. Under such extreme circumstances, is the fund property managed by such fund custodians still "safe and sound"? As mentioned earlier, according to the provisions of the Fund Law, the fund property does not belong to the bankruptcy liquidation property of the fund custodian. Therefore, we understand that the safety of the fund property should be guaranteed on the premise that the fund custodian establishes and strictly implements a complete internal risk control system (including but not limited to the "firewall" system) in accordance with relevant laws and regulations, and fully performs the obligations of the fund custodian as agreed in the Custody Contract.

How to Deal with the Bankruptcy of Private Fund Custodian

Generally speaking, the bankruptcy of a fund custodian does not cause losses to the fund assets under its custody. However, if the bankruptcy fund custodian's own risk control system is not perfect, or even mixes its own assets with the fund assets, the safety of the fund assets will be "worrisome.". Even if there are no property safety issues, changing the fund custodian during the process and auditing the custodian fund property can involve relatively complex procedural and operational issues. In order to avoid losses or troubles caused to the fund property due to the bankruptcy of the fund custodian as much as possible, we recommend the following:

Suggestions for fund managers

(1) Prudent Selection of Custodian

When selecting fund custodians, it is recommended that fund managers give priority to large state-owned commercial banks, as they have high risk resistance capabilities and relatively complete risk control systems, and the probability of violations and breaches of contract is also low.

(2) Improve due diligence on custodians

In selecting a fund custodian, a fund manager should conduct strict due diligence on the custodian. The content of due diligence is recommended to cover the qualifications, net assets, risk control system, fund custody departments and full-time personnel, conditions for safe custody of fund assets, clearing, and delivery systems of their fund custody.

(3) Agree exemption clauses in the Fund Contract

It is recommended that the fund manager specify relevant exemption clauses in the Fund Contract. For example, if investors suffer losses due to the bankruptcy of the fund custodian or termination of operations for any other reason, the fund manager will not be liable for compensation, to avoid the situation of "the custodian goes bankrupt and the manager pays the bill.".

Suggestions for Fund Investors

(1) The Fund Agreement stipulates the obligation of the Fund Manager to carefully select and supervise the custodian and the relevant liability for breach of contract

The obligation of a fund manager to carefully select a fund custodian includes, but is not limited to, requiring the manager to provide all investors with a due diligence report on the fund custodian, and requiring unanimous consent from all investors for the selection of the custodian. In addition, it should be agreed that the manager should take appropriate measures to monitor the performance of the custodian throughout the process. Once it is discovered that the custodian has a risk of bankruptcy or termination of operations, the Custody Contract should be immediately terminated, And transfer the fund assets to an account opened with a new custodian agreed upon by all investors. Once the manager violates these obligations, it shall bear corresponding compensation responsibilities for the losses of the fund property and investors caused thereby.

(2) In the Fund Contract, it is agreed to submit the Custody Report to all investors

It is recommended that the Fund Contract clarify the rights of investors to obtain the Custody Report, so that investors can have a certain degree of initiative. If the fund manager fails to properly fulfill its obligation to supervise the custodian, investors can timely grasp the fund custody situation. Once relevant risks are discovered, investors can urge the fund manager to immediately take risk control measures to avoid the risk of fund property loss. In addition, the Custody Report can also be used as evidence material for related investment disputes.

Conclusion

Commercial banks have always been trusted partners by private equity institutions and investors, but the fact is that even high-quality banks such as Silicon Valley banks can go bankrupt overnight. At the same time, it is worth noting that there are also precedents of bankruptcy of several banks in China, such as Baoshang Bank and Hainan Development Bank. Moreover, securities companies and other financial institutions that act as fund custodians cannot rule out the possibility of bankruptcy. It is strongly recommended that private equity fund participants, including fund managers and fund investors, strengthen various risk control measures in fund custody matters (including but not limited to hiring professional lawyers to improve relevant risk control systems, conducting due diligence on fund custodians, and drafting and revising the Fund Contract and the Custody Contract), And closely monitor relevant custody risks throughout the entire process (although the bankruptcy event of the Silicon Valley Bank was unexpected for most of its customers, a small number of fund management companies and start-up companies estimated the potential risks of the Silicon Valley Bank, and promptly transferred relevant assets to "avoid a disaster"), in order to avoid "non investment" losses of the fund assets as much as possible.

[1] Article 21 of the Interim Measures for the Supervision and Administration of Private Equity Investment Funds states that "Unless otherwise agreed in the fund contract, private equity funds shall be placed in the custody of the fund custodian. If the fund contract stipulates that private equity funds shall not be placed in custody, institutional measures and dispute resolution mechanisms to ensure the safety of private equity fund assets shall be specified in the fund contract."

[2] (4)... Contractual private equity investment funds shall be placed in the custody of a custodian established in accordance with the law and qualified for fund custody, except where the fund contract stipulates the establishment of a daily institution such as the fund unit holders' meeting or the fund trustee committee that can effectively perform the duties of safe custody of fund assets. Private equity asset allocation funds shall be managed by a custodian established in accordance with the law and qualified for fund custody.

Private equity investment funds that indirectly invest in underlying assets through special purpose vehicles such as companies and partnerships should be placed in custody by custodians established in accordance with the law and qualified for fund custody. The custodian should continuously monitor the capital flow of private investment funds and special purpose vehicles, master the fund transfer path in advance, and obtain and maintain fund transfer and investment vouchers afterwards. The manager shall promptly deliver the investment certificate to the custodian.

（11） ... For registered private equity investment funds or private asset allocation funds, if the following conditions are met simultaneously, the subscribed capital contributions of new investors or existing investors can be increased, but the increased subscribed capital contributions shall not exceed three times the subscribed capital contributions at the time of filing:

... 2. The fund is held in custody by a custodian established in accordance with the law and qualified for fund custody

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