At the end of 2013 and in early 2014, the Chinese government issued a series of laws, regulations and policies on the regulation of private investment funds. This, however, is one in a string of recent regulatory moves relating to the private equity industry. For instance, the regulatory and supervisory authority over private investment funds was recently transferred from the National Development and Reform Commission ("NDRC") to the China Securities Regulatory Commission ("CSRC"). The Asset Management Association of China ("AMAC") also issued a series of measures on registering fund managers and filing private investment funds, while the State Council has presumably issued an internal guiding document on the regulation of "shadow banks", which are defined to include funds engaged in a debt financing. Together, these developments signal a strengthening of private fund regulation in China, and warrant the close attention of private investment funds and fund managers.
Tighter Compliance Requirements and Increased Risk
On 17 January 2014, the AMAC published the Registration of Private Fund Managers and the Filing of Funds (for Trial Implementation) ("Measures"), and they went into effect on 7 February 2014. For the first time since after the transfer of regulatory authority of private investment funds from the NDRC to the CSRC, the Measures clarified and expanded the private investment fund filing requirements.
Unlike under the NDRC, the Measures now require that "all private funds operated to carry out investment activities" are filed with the AMAC. The scope of the Measures is now broad enough to include not only private securities investment funds and private equity funds, but also a range of new fund types, such as mezzanine funds (hybrid equity and debt investment funds). This change significantly expanded the previous definition of private investment funds used by the NDRC of "funds investing in non-publicly traded equity". Now that mezzanine funds are required to be filed with the AMAC, their legitimacy, compliance, and investment projects will be subject to regulatory scrutiny (as detailed below).
The Measures also clarify and expand the specific content of the filings to be made with the AMAC. Where previously, private investment funds only had to register and file "significant matters", they now are required to file more specific business information. For instance, fund managers must disclose information on key management personnel and their compliance and credibility over the past three years, the fund's formation contracts, information on the managing shareholder (partner), and investment project information.
In addition, as part of fund filing, fund managers are required to disclose any legal proceedings they were involved in over the past three years. This is particularly worth noting as the Chinese judicial system is currently encouraging the online publication of legal documents, and a national publication platform of judicial opinions is also being established. As the publication of legal documents in China becomes more developed and sophisticated, un-disclosed past or current legal proceedings will be more readily accessible to investors.
The implications of not complying with this and other disclosure requirements under the Measures are significant. Under the Measures, offending fund managers will be exposed to charges of "providing false materials and information, or concealing materials facts". If such charges are confirmed, the AMAC may impose penalties such as issuing warnings, suspending a fund's filing, disqualify a fund's AMAC membership, publicly censuring senior management personnel and making an official record of the fund manager's credibility. For more severe misconduct, the AMAC may transfer the case to the CSRC for its handling. More importantly, the Law of the PRC on the Protection of Consumer Rights and Interests (2013 Amendment), set to take effect on 15 March 2014, will also allow investors to bring fraud charges and claim damages based on defects and dishonesty in documents provided by fund managers in investment or fund-raising activities.
In addition, compared to the previous regulatory regime under the NDRC, the Measures have left many issues open to interpretation, such as the definition of a "qualified investor" and the minimum capital requirements for fund management companies. The resolution of these issues will likely also have substantial influence on the fund structure, fund-raising activities and drafting of fund formation documents.
Shadow Bank Regulations Threaten Mezzanine-typed Funds and relevant Projects
On 6 January 2014, the scanned version of a guiding document entitled Notice of the State Council on Relevant Issues Concerning the Strengthening of Shadow Banking Regulation ("Circular 107") was leaked to the internet. The effectiveness of Circular 107 has not been officially confirmed; indeed, it is rumored to have been only an internal document circulated within certain government departments. However, its existence has been taken as an indication of regulators' desire to strengthen shadow banking regulation and place mezzanine investment activities – including the extension of loans disguised as equity investments – within the scope of shadow banking. Therefore, Circular 107 has garnered significant attention within the industry.
Circular 107 indicates that government authorities should strengthen their regulation of shadow banking activities. Circular 107 also specifically prohibits private equity funds from engaging in debt financing. This is particularly significant when viewed together with the Measures, which now require a higher degree of disclosure for investment funds. The disclosure of private equity funds' activities under the Measures may expose certain investments – particularly a number of mezzanine-typed investments – labeled as equity transactions as actually having the substantive debt financing characteristics. If so, those activities would be placed in jeopardy under Circular 107's prohibition on private equity funds engaging in debt financing. At the moment, many industry insiders seem to believe that if officially confirmed, Circular 107 would herald a crackdown on a number of mezzanine investments and other loans extended by private equity funds labeled as "equity investments".
For the time being, however, Circular 107 is still drafted to be at the level of administrative supervision, and the general guiding policies set forth therein have yet to be further elaborated. If Circular 107 is confirmed, then detailed implementing guidelines will be necessary and forthcoming.
What Can You Do?
Overall, the regulation of private investment funds in China becoming not only more unified and standardized, but also increasingly strict. Nonetheless, a number of supplemental laws, regulations and regulatory measures regarding private investment funds have yet to be issued, which further increases the compliance uncertainty for them. For the time being, we are of the view that prudent investors and fund managers should consider the following measures to mitigate the existing regulatory and compliance risk:
Strict Compliance. In terms of filing and compliance, fund managers and private funds should promptly submit relevant materials to register fund managers and other personnel, as well as undertake fund filings. More importantly, a systematic compliance review should be conducted on the fund's investor materials and information, such as prospectuses and website information. The review should being aimed at ensuring that the information to be submitted for registration and filing (e.g., past business records, legal proceedings) do not contain any untrue and misleading information. This will protect the fund and its managers from penalties imposed by the AMAC and the CSRC, as well as fraud claims by investors.
In addition, all investment projects should also be reviewed and analyzed thoroughly, particularly to identify any projects that could be deemed as mezzanine-typed investments or debt financing transactions disguised as equity investments, as those may be at risk of invalidation in the event that Circular 107 is confirmed. Appropriate countermeasures should also be formulated in advance in the event that an industry crackdown occurs.
Monitor and Respond Quickly. Private investment funds and managers should also pay close attention to, and track the latest trends regarding, the promulgation of any new laws, regulations and rules relating to the industry, such as the long-awaited Private Fund Law. Funds and managers should also be cognizant of regulatory rules relating to debt financing-type projects that may be suspected to be shadow banking activities by the CSRC, as well as judicial practice and decisions relating to mezzanine investment projects. Countermeasures should also be formulated, particularly those that would allow for adjustments to private investment funds in terms of their formation, fund-raising, investment frameworks, and plans to better respond to compliance and investment risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.