28 September 2014

Important Tips on Contractual Fund Documentation

The Promulgation and implementation of the Interim Measures for the Supervision and Administration of Private Investment Fund (《私募投资基金监督管理暂行办法》)(the "Circular 105") has attracted tremendous attention in the capital market for the breakthrough it brought about to asset management business.

Well drafted legal documents for this new type of contractual fund will help define the legal relationship of the contractual fund and mitigate potential legal risks in its operation. This article aims to briefly flag a few important points in drafting legal documents:

Trust relationship

Article 1 of the Circular 105 expressly provides that Circular 105 is legislated pursuant to the PRC Securities Investment Fund Law. This suggests that private investment fund, especially the contractual fund, is subject to the regulation of trust relationship under the PRC Securities Investment Fund Law, where the holder of the fund is the settler and beneficiary of a trust, and the fund manager and fund custodian (if any) are the trustee of the same trust.

Accordingly, we advise that when preparing legal documents for a contractual fund, a clear trust relationship should be unequivocally defined, accompanied by a clear statement that the share of the fund held by relevant investor represents the beneficiary interest of the trust. This could help reinforce the effectiveness of the bankruptcy remoteness for a contractual fund.

The must-have in the document

Circular 105 provides that the contract for "other types of private fund" shall be drafted by reference to article 93 and 94 of the PRC Securities Investment Fund Law.

More specifically, the must-have according to the preceding paragraph include: (a) the rights and obligations of the holder of fund, fund manager and fund custodian; (b) operation of the fund; (c) capital contribution, amount of contribution and contribution period; (d) investment scope, investment strategy and investment limitation; (e) rules for income distribution and enforcement; (f) fees incurred by the fund; (g) the content and method of information disclosure; (h) the process and method for subscription, buy-back or transfer of the share; (j) reasons and procedures for the modification, suspension and termination of the contract; (k) settlement of fund asset; and (i) any other agreement reached by parties.

We believe the above sample contracts shed some light on CSRC’s attitude towards the kind of core mechanisms that should be incorporated into a private fund contract, especially in relation to fund raising, entry and exit, risk disclosure, information disclosure, distribution of asset and settlement. As such, accurate understanding of the above sample contract will be of great help to the drafting of legal documents and mitigation of legal risks.

Fund raising and asset in custody

Similar approach could be adopted by contractual fund with other types of asset management plans in relation to fund raising. This include specifying a fund raising period and minimum amount, making the completion of raising the minimum amount as a conditions precedent to the establishment of the fund, and setting a minimum investment amount as the investment threshold .

In addition, In terms of asset in custody, fund custodian may ring fence the asset through trust relationship. Notably, however, the appointment of a fund custodian is not a mandatory requirement under Circular 105, as long as relevant security measures and dispute resolution mechanism required by Circular 105 are in place.

Asset investment

There are two types of contractual fund: single project contractual fund and multi project contractual fund. For single-project contractual fund, similar approach with other types of asset management or trust could be adopted, by specifically and sufficiently disclosing the underlying investment project under the fund,relevant information and risks. For multi project contractual fund, investment scope, investment method and investment goal shall be unequivocally specified, and the investment thereof shall be strictly confined to the agreed scope and timely disclosure shall be made to investors.

Distribution to investors

Distribution to investors made by contractual fund is similar to the conventional arrangement in a securitisation: by artificially setting a calculation period to determine a clear distributable fund in the current period, and by setting an interest period (applicable to fixed income fund) and waterfall to consolidate and integrate the cash flow obtained from asset investment. This could help crystalise and reflect the distribution mechanism in an unequivocal, succinct, and integral manner in transaction documents.

Credit enhancement and the use of leverage

Circular 105 specifically requires a fund manager to regularly update any information relating to the “operation of investment and usage of leverage” by filling out relevant form in a regular manner. This indicates that CSRC acquiesces to the use of leverage in contractual funds. As such, general leverage mechanism commonly used in securitisation transactions including setting a senior/junior tranche structure could also be used in a private contractual fund and this arrangement could be implemented through reaching an agreement on the above mentioned waterfall.

Besides, credit enhancement measures could be put in place by reference to other debt financing or mezzanine financing transactions. More specifically, by setting up a reserve account, introducing third party security provider and providing liquidity support etc.

Risk disclosure and information disclosure

Circular 105 imposes a strict requirement on investor investigation and risk disclosure, by requesting fund managers to use questionnaire or similar method to evaluate an investor’s ability to identify and take risks, accompanied by a covenant to be entered into by the investor whereby he undertake to be a qualified investor. Additionally, the questionnaire and risk disclosure report shall be form a part of the complete transaction document, and shall make the fulfillment of such as a condition precedent to the subscription of fund.

In terms of information disclosure, fund managers and fund custodians (if any) shall undertake in the transaction document to make honest disclosure to investors about the investment, asset and liability of the fund, distribution of the income, fees incurred by fund and its income, potential conflict of interest and any other material information capable of affecting the legal interest of investors. Furthermore, once the Asset Management Association of China released rules on information disclosure, further adjustment could be needed in relation to the information disclosure clause in a transaction documents.

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