Redemption guarantee commitment for PE fund investment

IIn recent years, with the rapid development of China’s private equity fund market and the expiration of registered products, including guaranteed redemption clauses such as principal preservation and guaranteed return commitments in fund contracts has become an important factor in the investment decisions of prudent investors. As a result, fund managers and third parties have adopted various internal and external credibility enhancement measures, such as providing principal preservation and guaranteed return commitments. However, disputes often arise when fund managers or third parties are unable to fulfill these commitments. This article provides a brief analysis of this issue.

Legal validity

Any promise of redemption guarantee by the fund manager is void. Articles 2 and 19 of the Guiding Opinions on the Standardization of Asset Management Operations of Financial Institutions explicitly prohibit fund managers from making promises of principal preservation or income guarantees. Financial institutions facing redemption difficulties are not permitted to use their own capital to cover losses in any way, and the certification standards for redemption guarantees and the associated consequences are clearly defined. Article 15 of the Interim Measures for the Supervision and Administration of Private Investment Funds specifically prohibits private fund managers and sales institutions from promising investors that their investment principal will not suffer losses or guaranteeing a minimum return. In the minutes of the National Courts Civil and Commercial Trial Working Conference, the Supreme People’s Court clearly outlined the judicial practice of invalidating redemption clauses and supported beneficiaries’ request for compensation from trustees according to their negligence. It also states that regardless of the form in which the principal preservation or income guarantee clause is stipulated in the withdrawal agreement or other means, it should be considered invalid. Therefore, regardless of the nature of the redemption commitment made by the fund manager, it shall be considered invalid.

Any promise of redemption guarantee by the investment adviser is void. Article 103 of the Securities Investment Fund Law of the People’s Republic of China expressly prohibits fund investment advisers from making any form of promise or guarantee regarding investment returns. Therefore, any promise of guaranteed returns made by an investment adviser is invalid.

Differing views exist regarding the determination of the validity of third-party promises of principal protection and guaranteed returns. Regarding the redemption commitments made by the related parties of the fund manager, external credibility enhancement measures are usually implemented through commitments such as guaranteed principal and return commitments, shortfall compensation agreements, redemption clauses, repurchase obligations, fixed income, and joint guarantees. There are no clear provisions in the relevant laws and regulations, and there are various views in judicial practice. Some precedents hold that the shareholders and other related parties of the fund manager are independent entities, and the contracts concluded in their name with investors represent their true intentions, do not violate mandatory legal provisions, and should be deemed valid. However, other precedents hold that the related parties are not the fund manager itself, but are related to the interests of the fund manager, and investors recognize that the parties making the commitments of principal preservation and guaranteed return are related to the fund manager. The intention of all parties in the contract is to obtain principal preservation and guaranteed return from the fund investment. Therefore, such commitments still violate the relevant regulations and should be deemed invalid.

When a third party other than the fund manager and its related parties makes a promise of principal preservation and guaranteed income, judicial practice distinguishes and judges whether a guarantee contract relationship, joint assumption of debt, unilateral promise, or other legal relationship has been established based on specific facts. Case law has shown that if the promise reflects the true intention of the parties and does not violate mandatory laws, the promise is often deemed valid, and the creditor-debtor relationship between the parties reflected in the corresponding promise is likely to be determined to be a lending relationship, so that the annual income claimed and the penalty for breach of the contract will be in accordance with the upper limit of the private lending interest rate according to the promise.

Contracts that provide for the return of principal after losses are determined are generally considered valid. Cases have often held that compensating investors for losses after the fund matures or after losses have occurred does not fall within the scope of the promises of expected capital protection and guaranteed returns, but represents the true intentions of the parties and is not prohibited by law. Therefore, the parties are required to perform their contractual obligations in accordance with the agreement.

There are differing views as to whether the invalidity of a guaranteed redemption clause would invalidate the entire fund agreement. Generally, the courts can determine that clauses guaranteeing only the preservation of principal and guaranteed returns are invalid based on Article 92 of the Case Law Collection, which states that “Any contract containing a clause guaranteeing a fixed return on capital, principal or redemption agreed between a trustee, such as a trust company, commercial bank or other financial institution, and a beneficiary shall be deemed invalid.” However, some are of the opinion that the guaranteed redemption clause is an important factor for investors in making investment decisions, and therefore invalidating it would prevent the purpose of the fund agreement from being achieved, and therefore the entire fund agreement should be invalid.

In conclusion, although judicial practice may vary slightly from case to case, the overall focus remains on protecting investors’ rights through lawful rulings and maintaining the order of financial market transactions. Private fund managers should give top priority to compliance with financial regulatory provisions and operate their funds in a lawful and compliant manner to avoid penalties and liability due to the invalidity of principal preservation and income guarantee clauses. It is important that investors make rational investments after clearly understanding the high risks associated with financial products, not easily believe in various promises of principal preservation and income guarantees, and hold relevant written documents to protect their legal rights.

Yang Jiamei is a Partner at Kangda Law Firm and can be contacted on +86 155 2961 1206 or by email at jiamei.yang@kangdalawyers.com.