In the first three articles of our series on the obligations of private equity fund managers, we introduced various situations in which private equity fund managers violated the due diligence obligations, fund investment stage due diligence obligations and fund liquidation obligations, as well as the compensation liabilities they had to bear, in combination with relevant judicial precedents and arbitration awards. This article will focus on the due diligence obligations of private equity fund managers during the post-investment management of the fund. Perhaps it is precisely because there are few specific provisions related to the post-investment management of private equity fund managers in the laws and regulations and the self-regulatory rules of the Asset Management Association of China (hereinafter referred to as "China Asset Management Association"). Therefore, even if the manager has a defective performance of duties in the post-investment stage, it is difficult to determine in practice that he has violated the due diligence obligations and needs to bear compensation liabilities to investors. This has caused many private equity fund managers to often "focus on investment and neglect management", and many private equity management institutions do not have a post-investment management department or even a post-investment management position. This management model may work in a booming economy because there is no shortage of people who can “take over the baton”. However, in the current increasingly severe economic situation, many invested enterprises are not doing well and the fund is already facing the dilemma of exit. If the manager does not actively and positively perform the post-investment management obligations, the only thing that awaits the manager is the investor’s accountability[2]. In view of this, this article intends to introduce and analyze the mainstream views of the judicial organs on the violation of the diligence obligations of private fund managers in the post-investment management stage in combination with relevant judicial precedents[3], so as to provide a useful reference for the majority of private fund managers and fund investors.
Fund managers' obligations to track and manage investment projects
The fund manager failed to carefully review the actual use of the investment funds by the lower-level funds under the nested investment situation, failed to effectively exercise the right to know as a partner of the lower-level fund, and failed to conduct reasonable post-investment follow-up management of the invested enterprises. The court, considering that the manager involved in the case had serious faults in both the fundraising and investment stages, ordered the fund manager to compensate investors for all the investment funds and interest.
In the case of [(2021) Hu74 Minzhong No. 1626] Shanghai JP Investment Group Co., Ltd. et al. vs. Cheng Mou’s entrusted financial management contract dispute, the fund involved in the case indirectly realized the equity investment in Company B by investing in the limited partnership shares of Fund A and then having Fund A acquire the equity of Company B. During the fund management stage, on the one hand, the manager involved in the case did not fulfill the obligation of prudent review of the cash flow of the investment funds of Fund A, and did not find that the amount of the transfer flow of the equity transfer funds provided by Fund A was inconsistent with the consideration for the equity of Company B acquired by Fund A in accordance with the Equity Transfer Agreement. The court held that the manager involved in the case did not fulfill the obligation of prudent review of whether Fund A used the fund funds to acquire the equity of Company B, and failed to perform the duty of active management. On the other hand, the manager involved in the case did not effectively exercise the right to know of the fund involved as a limited partner of Fund A, and did not specifically review the authenticity, accuracy and legality of the financial reports and cash flow of Fund A, but simply and passively quoted them directly in the management report and used them as the basis for introducing the fund operation to investors. In addition, during the existence of the fund, the manager involved in the case believed the statement of the executive partner of Fund A that the equity of Company B that he had acquired was held by other parties, and did not verify the relevant arrangements with Company B, nor did he conduct any reasonable post-investment tracking and management of Company B. In fact, the fund assets involved in the case were maliciously misappropriated by a third party and were not used to acquire the equity of Company B. Combined with the serious faults of the manager involved in the fund raising, investment, and management stages, the first instance court held that there was a considerable causal relationship between the aforementioned behavior of the manager involved in the case and the property losses of investors, and ordered him to compensate investors for all investment funds and interest. The second instance court upheld the original judgment.
The fund manager failed to review the financial books of the invested enterprises and failed to conduct any reasonable post-investment follow-up management of the invested projects. The court determined that the fund manager violated the management obligation of prudence and diligence. Considering that the fund manager also had faults in terms of suitability obligations, information disclosure obligations, and risk control, the court ordered the fund manager to compensate investors for all their principal.
In the case of [(2021) Hu0115 Minchu 112270] Zhou Mou and YZTD Asset Management Co., Ltd. et al., a dispute over a contract for entrusted financial management, the fund involved in the case invested in the limited partnership shares of J Fund, which then made external investments. According to the provisions of the J Fund's "Partnership Agreement", the manager involved in the case has the right to understand the operating conditions and investment project conditions of J Fund and review the property accounting books of J Fund for situations involving its own interests. After the funds raised by the fund involved in the case were transferred to J Fund, the custodian of the fund involved in the case sent a letter to the fund manager involved in the case, reminding him that he did not find any external investment by J Fund during the industrial and commercial inquiry, and asked the fund manager to perform his duties earnestly, do a good job in the confirmation of investment equity, track the operation of J Fund, and safeguard the interests of investors. In fact, after the fund raised funds were transferred to J Fund, the fund manager involved in the case did not further supervise the final use of the funds, and failed to prove that he had asked J Fund to provide account books for his review. In addition, the fund manager involved in the case did not provide any form of report to investors to reveal the operation of fund assets, and did not take any effective measures to liquidate the underlying assets after the fund expired. The court held that the fund manager involved in the case had not reviewed the financial accounts of the invested enterprises and had not conducted any reasonable post-investment follow-up management of the invested projects, violating the due diligence and diligence management obligations. Considering that the manager involved in the case also had faults in the performance of suitability obligations and information disclosure obligations, risk control, etc., the court finally ordered the manager involved in the case to compensate investors for all investment principal.
Lawyer's analysis and suggestions
Based on the above cases, it can be seen that the mainstream view of the judicial organs is that private equity fund managers should actively and proactively manage investment projects in the post-investment stage of the fund. These active management responsibilities should include: first, if there is a nested investment situation in the fund, the manager should at least conduct a formal and complete review of whether the fund funds are actually used for investment projects to ensure that the transfer vouchers provided by the lower-level funds are consistent with the investment amount and other relevant information agreed in the investment agreement of the underlying project; second, the fund manager should earnestly perform the statutory and agreed rights such as the right to know as a shareholder or partner of the invested enterprise, and timely monitor and verify important information related to the rights of the fund and investors, such as the financial status and operating conditions of the invested enterprise; third, in the process of tracking and management, the fund manager should not only rely on the information disclosed to it by the invested enterprise, but also verify the accuracy, authenticity and legality of the important information provided by the invested enterprise in combination with relevant public information or in other ways under certain conditions, so as to achieve the purpose of paying close attention to and accurately grasping the dynamics of the investment project. Otherwise, the court may comprehensively consider the degree of fault of the fund manager and the causal relationship between it and the actual loss of the investor, and order the manager to bear the corresponding compensation liability for the loss of the investor.
The fund manager failed to implement the early warning and stop-loss risk control mechanism of the private securities investment fund involved in the case as agreed, and was at fault for agreeing on fixed returns with investors. The court finally ordered the manager to bear 95% of the compensation liability for the actual loss of the principal of the investors.
In the case of Wang Moumou and GRZQ Co., Ltd. and others’ securities investment fund transaction dispute [No. (2021) Jing0102 Minchu 10068], the fund contract involved in the case clearly stipulated the net value stop loss line of the private securities investment fund involved in the case. The fund manager must irreversibly realize all non-cash assets held by the fund involved in the case from the next trading day after the stop loss line is touched until all the property of the fund involved in the case is realized. However, the fund manager involved in the case did not take timely realization measures when the net value of the fund involved in the case fell below the stop loss line, which violated the provisions of the fund contract. Therefore, the court held that the manager involved in the case should bear the investor’s loss below the stop loss line. Combined with the fault of the manager involved in the case signing a fixed income clause with the investor, the court finally ordered it to bear 95% of the loss amount of the investor’s principal minus the income already obtained and the remaining part of the liquidation distribution.
The fund manager failed to perform the agreed account supervision measures, failed to pay close attention to the dynamics of the investment targets, seriously neglected to assert the repurchase rights and guarantee rights, and failed to fulfill the fund manager's diligent and responsible management obligations during the investment and liquidation stages. The court ordered the fund manager to compensate investors for all principal and interest.
In the private equity fund dispute between Gu Moumou and Shanghai CD Asset Management Co., Ltd. and others [4], the investment scope of the fund involved in the case was to acquire the property income rights of a certain building held by E Company. The Property Income Rights Transfer Agreement signed between the manager involved in the case and E Company clearly stipulated that after the transfer of the target income rights, E Company would collect the relevant property income on behalf of the manager, and the relevant collection account would be supervised by the manager involved in the case. The Repurchase Agreement signed between the manager involved in the case and E Company stipulated that if E Company transferred the target income rights to a third party without the consent of the manager involved in the case, the manager involved in the case could require E Company to repurchase. In addition, the performance of the aforementioned repurchase obligation also stipulated that there would be corresponding guarantee measures. However, the manager involved in the case did not perform the account supervision measures agreed upon by both parties after the investment. Moreover, E Company later transferred the target income rights to a third party (such transfer information was public information). The fund manager involved in the case seriously neglected to exercise the repurchase right and guarantee right for three years. The court held that the fund manager in question had violated the obligation of honesty, trustworthiness and diligence. Considering that the fund manager in question had failed to fulfill the fund manager's diligence and responsibility in the investment and liquidation stages, the court ordered the fund manager to compensate investors for all principal and interest.
The manager failed to take active and effective measures to timely control the relevant risks when the credit project had multiple incidents that affected the debt repayment ability and guarantee ability, and there were also faults in due diligence and information disclosure. Taking into account the investment income and refunds that investors have obtained, the court decided that the manager in the case should compensate investors for 50% of the investment principal.
In the case of LCZQ Co., Ltd. and Niu Moumou’s property damage compensation dispute [(2023) Hu74 Minzhong No. 557], the asset management plan in the case issued a trust loan to the target company through a trust plan. The first instance court held that the manager in the case failed to control the relevant risks in a timely manner when the target company and the loan guarantor had multiple events that affected their debt repayment ability and guarantee ability, and did not immediately take various positive and effective measures, including requiring early termination of the contract to recover the loan, to safeguard the legitimate interests of investors, violating the manager’s prudent and diligent management obligations. In addition, the investor in the case also provided the court with the regulatory documents issued by the regulatory authority to the manager in the case, which stated that the manager in the case had problems such as inadequate post-investment management during the investment operation of the asset management plan in the case. In addition, the manager in the case also breached the due diligence of investment projects and information disclosure. However, considering that the investor has obtained part of the investment income and refund, and the direct cause of the investor’s investment loss is the default of the target company and the guarantor, the court, based on the comprehensive degree of the manager’s fault, decided that the manager in the case should compensate the investor for 50% of the investment principal. The second instance court upheld the original judgment.
Lawyer's analysis and suggestions
Based on the above cases, we believe that in the process of post-investment management of funds, fund managers should not only closely follow the dynamics of investment projects, but also take timely measures to control various investment risks discovered during the process of tracking investment projects. For private equity investment funds, since the fund contract generally stipulates an early warning and stop-loss mechanism, if the fund manager violates the early warning and stop-loss clauses clearly stipulated in the fund contract and causes investors to suffer losses, the fund manager shall bear the liability for breach of contract damages to the investors[5]. For private equity investment funds, the risk control of investment projects by fund managers may be more reflected in actively taking various reasonable and timely measures to control the risks and losses faced by the fund. Specifically, if the investment project clearly stipulates the fund's repurchase right, referring to the judgment opinions of Case (2021) Hu0115 Minchu No. 97875 and Case (2020) Hu74 Minzhong No. 371, out of prudence, the fund manager should promptly file a lawsuit or arbitration against the repurchase obligation entity to promote the fund to exit the project through repurchase as soon as possible, so as to avoid being deemed to have failed to take effective measures to recover the fund's losses when relevant disputes occur, and thereby bear relevant loss compensation liability to investors due to defective performance of due diligence obligations.
From the perspective of investor rights protection, referring to the case (2023) Hu74 Min Zhong No. 557, when filing relevant lawsuits/arbitrations, investors may consider collecting and using the administrative supervision measures or self-discipline sanctions imposed by the China Securities Regulatory Commission, local securities regulatory bureaus and the China Securities Investment Fund Association on fund managers’ violation of their due diligence obligations in post-investment management of funds as evidence to prove that the managers have failed to perform or have not properly performed their due diligence obligations in the post-investment management stage, thereby increasing the probability that their claims for compensation will be supported by the court/arbitration body.
From the above cases, it can be concluded that private equity fund managers should fully perform their duties in the post-investment management process of the fund, actively use their own professional capabilities and investment experience, and strive for the maximum interests of fund investors by actively, effectively and timely exercising the rights stipulated by law and relevant investment agreements. The diligence obligations of private equity fund managers in the post-investment management stage include but are not limited to closely following and tracking the important dynamics and possible investment risks of investment projects in the post-investment stage, and actively exercising the statutory or agreed rights over the invested enterprises; after discovering investment risks, according to the risk control measures agreed with investors, or the necessary measures made by the fund manager based on its own professional judgment, such as actively pursuing fund assets and urging performance, implementing project exit mechanisms such as repurchase, etc., to control investment risks and recover investment losses. In addition, from the perspective of investors, referring to the cases (2016) Supreme People's Court Civil Final No. 19 and (2016) Supreme People's Court Civil Final No. 94, the court's judgments all support the investors of the fund involved in the case to file a lawsuit in their own name for the benefit of the fund when the fund manager involved in the case fails to perform its manager's duties (such as failing to promptly assert debts to recover project loans, failing to file a lawsuit when the investment project may have suffered a total loss due to malicious collusion by other entities). Therefore, if the fund manager fails to exercise its legal rights over the investment project in the post-investment stage, we suggest that investors, in addition to taking appropriate measures to urge it to exercise its rights, can also choose to file a derivative lawsuit [6] to recover losses in a timely manner.
[1] The post-investment management stage of private equity funds referred to in this article refers to the period from the completion of project investment to the exit of the project by the private equity fund. Due to space considerations, the discussion of the post-investment management obligations of private equity fund managers in this article will not include their information disclosure obligations.
[2] Private equity fund managers who fail to properly perform their post-investment management obligations will also be subject to administrative supervision measures by the regulatory authorities. According to the decision of Shanghai Securities Regulatory Commission Decision [2024] No. 70, the relevant manager was found to have violated the manager's obligations of honesty, good faith, prudence and diligence for failing to take effective measures to manage the product in a timely manner, and was issued a warning letter. A decision issued by the Chongqing Securities Regulatory Bureau on September 21, 2022 also found that the relevant manager violated the manager's obligations of honesty, good faith, prudence and diligence because it failed to take timely measures to require the compensating party to compensate when the investment target triggered the relevant compensation clauses agreed in the investment agreement, and took the measure of issuing a warning letter against it.
[3] The case analysis in this article mainly discusses the circumstances in which the adjudicating authorities have determined in relevant cases that private equity fund managers have failed to perform their due diligence obligations in the post-investment management stage. The fund managers in the similar cases cited in this article may have committed various breaches of contract and violations and faults. Considering the length and theme of the article, the case facts and adjudication opinions we have summarized may not fully and in detail explain all the breaches of contract and faults of the managers involved in the case, but focus on the post-investment management stage for reference. Please refer to the facts and reasons stated in the final judgment of the relevant case for details.
[4] According to the Civil Ruling of the Shanghai Financial Court (2023) Hu 74 Min Zhong No. 92, Gu Moumou applied to withdraw the lawsuit on the grounds that he had reached an out-of-court settlement with Shanghai CD Asset Management Co., Ltd. The Shanghai Financial Court ruled to revoke the first-instance civil judgment of the case and allowed Gu Moumou to withdraw the lawsuit.
[5] Refer to the case of (2021) Jing 0102 Min Chu No. 10068.
[6] For partnership-type private equity funds, Article 68, Paragraph 2, Item (VII) of the Partnership Enterprise Law of the People's Republic of China provides that if a limited partner urges the managing partner to exercise his rights when the managing partner fails to exercise his rights or files a lawsuit in his own name for the benefit of the enterprise, it shall not be regarded as the execution of partnership affairs. For corporate-type private equity funds, Article 151 of the current Company Law of the People's Republic of China also stipulates the right of shareholders to bring derivative lawsuits. For contract-type private equity funds, since there are no clear legal provisions, there is still some controversy in judicial practice as to whether investors can bring subrogation lawsuits.
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