For years, the Chinese private fund industry has operated in regulatory limbo, but a recent series of legislative and regulatory actions should provide greater certainty and help create a more favourable environment for the incipient hedge fund industry in the People’s Republic of China (“China” or the “PRC”). Please note that these changes, which are summarised below, apply only with respect to domestic PRC private funds, although non-PRC private fund managers may wish to bear them in mind as they seek to access China’s burgeoning investor base.
The new regulatory framework
The cornerstone of the newly designed regime is a set of amendments to the Securities Investment Fund Law of the PRC and accompanying regulations (collectively, the “Amendments”)1 that took effect on June 1, 2013. Previously, PRC law explicitly regulated only publicly-offered securities investment funds, causing private funds (both domestic and non-PRC) to operate in an opaque regulatory environment. The Amendments address this uncertainty, at least in part, by providing a framework applicable to private funds that invest in publicly-offered securities, such as so-called ‘sunshine hedge funds’. In addition, the China Securities Regulatory Commission (CSRC) and the Asset Management Association of China (“AMAC”, the self-regulatory organisation of the fund industry in China), released draft rules on private fund registration and reporting that are intended to complement the Amendments. Although these draft rules are not yet final, most industry participants appear to be proceeding on the assumption that the draft rules will be implemented substantially as proposed.
In adopting the Amendments, PRC authorities have taken a relatively ‘light touch’ approach with respect to private funds, leaving many aspects of the regulation and operation of private funds to AMAC and the contractual arrangements applicable to the funds, as discussed below. In addition, many details of the new regulatory regime will need to be clarified via future rulemaking and emerging market practice.
Following is a summary of the key points reflected in the Amendments.
Types of funds covered
The Amendments apply only to domestic PRC private funds that limit their investments to securities (including stocks, bonds and investment funds) that are publicly offered and/or traded in the PRC, as well as other securities and derivatives specified by the CSRC.2 Accordingly, private equity funds and venture capital funds are not subject to the new regulatory regime, nor are non-PRC private funds. The CSRC may further expand the scope of private funds covered by the Amendments at a future date.
The Amendments provide an exemption from CSRC registration for private funds with no more than 200 qualified investors. Each individual investor must invest a minimum of RMB 1 million in the fund. To be a ‘qualified investor’, an individual investor must possess sufficient knowledge to identify and to undertake investment risks, and satisfy at least one of the following conditions: (i) total financial assets (personal or household) of at least RMB 2 million; (ii) personal average annual income of no less than RMB 200,000 for the last three years; or (iii) household average annual income of no less than RMB 300,000 for the last three years. An institutional investor qualifies if it has net assets of at least RMB 10 million. Draft regulations indicate that, in the future, investment products duly established and managed by CSRC-supervised financial institutions, such as investment trust products, also will be deemed to be qualified investors for purposes of the Amendments.
Interests in a private fund may not be offered or sold to unqualified investors, or marketed through mass media such as newspaper, radio, television, internet, or seminars. A private fund manager may promote and sell fund products directly, or the manager may entrust a third-party placement agent to do so. The fund manager and any placement agent are required to fully disclose investment risks to potential investors, and must avoid providing false, incomplete, misleading or exaggerated information in the course of marketing a private fund.
In addition, the sale of interests in a private fund must be appropriate in light of an investor’s risk profile. However, PRC regulations do not yet provide guidance on how to assess the risk profile of prospective private fund investors. The only current guidance suggests that funds should be ranked on the basis of relative investment risk, and a fund manager or placement agent should only offer an investor a fund with a suitable risk ranking. In the absence of further regulatory guidance, use of an investor questionnaire to document the qualification of investors and the suitability of the offer and sale is recommended.3
Regulation of the fund manager
Under the Amendments, AMAC assumes a primary role in overseeing the operations of private funds and private fund managers. A private fund manager must register with AMAC if it manages one or more private funds with cumulative assets under management of at least RMB 100 million.4 Absent such registration, a fund manager cannot use terms such as fund, fund manager or similar terms in its name. In order to register with AMAC, fund managers must also: (i) have paid-in capital of at least RMB 10 million; (ii) employ two licensed responsible officers and one compliance and risk control responsible officer; and (iii) have had a clean legal and administrative record for the last three years.
The fund contract
Under PRC law, private funds generally operate pursuant to a ‘fund contract’ – a management contract entered into among the fund manager, each investor in the fund and the fund’s custodian. A fund contract typically will cover key issues such as the duties and rights of the fund manager and the custodian (if any), various operational matters, and investment objectives, strategies and limitations. The purpose of a fund contract is to document the manner in which a fund operates and the relationship among each of its parties, including their respective rights and obligations. An offeree becomes an investor in a private fund only when it enters into a valid fund contract.
Under the new regulatory framework, the parties to a private fund contract have greater leeway than in the past to define their contractual relationships, including allocation of gains and losses, as well as the extent of information to be disclosed by the manager and custodian to investors.5 However, under the Amendments, private fund contracts must include, at a minimum, provisions addressing the following matters: (i) investment (investment scope, strategy, and limitation on investment activities); (ii) profit distribution; (iii) allocation of expenses; (iv) manner of disclosing fund-related information; (v) subscription, redemption and transfer of fund interests; (vi) amendment, rescission and termination of the fund contract; and (vii) circumstances under which the fund may be liquidated.
Fund filing requirements
Under AMAC's proposed rules, when a private fund offering is closed, a filing must be made with AMAC through the AMAC filing system within five business days after closing.6 The filing will convey certain basic information concerning the private fund, such as the name of the fund, the amount of capital raised, the number of fund investors and the fund contract. The fund should update the information within five business days after the end of each month. Funds offering interests on an ongoing basis should make the required filing within five business days after the end of the month in which the offering commences, and update the information on a monthly basis. AMAC will notify the CSRC of any private fund having assets under management in excess of RMB 100 million or more than 50 investors.
Unless the fund contract stipulates otherwise, a private fund must engage a commercial bank to serve as custodian of the fund’s assets. Private fund custodians must be members of AMAC.
While PRC authorities need to provide additional guidance for the full implementation of the new rules applicable to offering domestic private funds in the PRC, the Amendments provide a welcome regulatory framework for PRC private fund managers that, to date, have had to operate in an opaque environment. By officially recognising the existence of domestic private funds and providing a regulatory regime that seeks to strike a balance between oversight and operational flexibility, the Amendments should foster growth of the PRC’s hedge fund industry and broaden participation in the PRC’s domestic securities markets. In addition, the Amendments may provide the basis for the eventual further opening of the PRC to non-PRC private funds seeking access to Chinese investors interested in diversifying their investments.7
Keith Robinson is a partner in Dechert’s Financial Services practice in Washington, D.C. Mr. Robinson previously led the firm’s Asian Financial Services practice during his residency in Dechert’s Hong Kong office from January 2008 through May 2011. His practice includes advising U.S. and international financial institutions on a host of corporate and securities issues.
Karl Paulson Egbert is a Registered Foreign Lawyer in Dechert’s Hong Kong office. Mr. Paulson Egbert advises private and registered funds on regulatory, corporate and business matters. His experience also includes advising Hong Kong and Asian hedge fund managers with respect to fund structures and global fund offerings utilizing various investment styles and strategies.
Jingzhou Tao is the Managing Partner responsible for developing Dechert’s Asia Practice, and he is resident in the firm’s Beijing office. Mr. Tao has represented major American, European and Japanese companies in transactions in China involving joint ventures, tax planning, strategic alliances and intellectual property protection. He also has significant experience in international arbitration proceedings, both in China and before the major international arbitration institutions.
Gregory Louvel is an associate in Dechert’s Corporate and Securities practice in Beijing. Mr. Louvel leads mergers and acquisitions transactions in China for both international and Chinese clients. He also represents clients in the natural resources, technology, life sciences and financial services industries.
Dechert is a global specialist law firm. Focused on sectors with the greatest complexities, legal intricacies and highest regulatory demands, Dechert lawyers excel in delivering practical commercial judgment and deep legal expertise for high-stakes matters. In an increasingly challenging environment, clients look to the firm to serve them in ways that are faster, sharper and leaner without compromising excellence. Dechert is relentless in serving its clients – delivering the best of the firm to them with entrepreneurial energy and seamless collaboration in a way that is distinctively Dechert. For more information, please visit www.dechert.com.
2 The Amendments require (i) any fund wishing to raise capital within the PRC to invest in offshore securities markets, and (ii) any qualified foreign institutional investor (QFII) wishing to invest in PRC securities markets to first obtain approval from the CSRC for making such investment.
3 Use of investor questionnaires is already standard market practice in the PRC with respect to the offer and sale of retail investment funds.
4 Managers of smaller private funds with assets under management below RMB 100 million apparently may not register with AMAC and may not take advantage of the new regulatory framework.
5 Unlike with respect to PRC retail fund contracts (which are subject to CSRC review as both a primary fund organizational document and investor disclosure document), PRC law does not impose significant disclosure requirements on private funds. Instead, private fund disclosure practices are primarily determined by negotiations between the parties, as well as by market practice.
6 It is not clear at this stage whether the contents of this filing will be made available online.
7 Among other possible options, the Qualified Domestic Limited Partner (QDLP) program will provide non-PRC private fund managers with a direct avenue to connect with Chinese institutional investors. Details about the rollout of the QDLP program will be announced publicly shortly and will be discussed in a separate DechertOnPoint.