The author’s team previously handled a pledged-style financing repurchase dispute with securities firm guaranteed settlement at a financial court. This case involved the contentious issue of whether the manager should bear liability when a contractual fund is unable to pay its external debts. The case was ultimately settled through mediation with the efforts of the court and all parties. Therefore, no adjudicative outcome was made on the relevant disputed issues. However, the question of whether the manager should be liable when a contractual fund is “insolvent” deserves further exploration.

This case was a dispute over pledged-style financing repurchase with securities firm guaranteed settlement. In simple terms, Fund A (a contractual private securities investment fund) pledged Bond B held by it to Securities Firm C (the custodian, which also served as the brokerage institution handling settlement on behalf of the fund in the financing repurchase transaction). Fund A used the standard bond conversion rate of Bond B to calculate the number of standard bonds and used that quantity as the limit to conduct pledged financing through the exchange platform. Upon maturity of the product, Fund A was supposed to repay the funds to the exchange platform. If it failed to repay on time, Securities Firm C would make the payment on its behalf (i.e., guaranteed settlement). Due to Securities Firm C’s compensatory payment, it formed a creditor’s right against Fund A. In this case, Securities Firm C paid RMB 140 million on behalf of Fund A and subsequently filed a lawsuit demanding that Fund A repay the principal and interest of the matured financing repurchase, and that Fund A’s manager, Company D, bear joint and several liability for satisfaction.

Undoubtedly, Fund A needed to pay the matured repurchase funds to Securities Firm C. The contentious issue was whether Company D, as the manager, should bear payment or satisfaction liability.

The first question: How does a fund become “insolvent”?

Generally speaking, a fund invests the raised funds externally. This investment may succeed or fail. In the event of investment failure, at most the fund’s assets become zero; there would not be a situation where fund assets become negative. In other words, if the fund’s investment fails, it may lose all its assets, but generally there would not be external debts remaining after the loss. However, this case had special circumstances. Fund A raised RMB 200 million and used all of it to purchase Bond B. If it had simply held Bond B, there would be no issue of fund “insolvency.” However, Fund A pledged the Bond B it held for further financing, used the funds obtained from financing to purchase more Bond B, then pledged again for financing, repeating this cycle. Ultimately, Fund A had converted all its cash into Bond B. Once the valuation of Bond B decreased or it defaulted, the amount of Fund A’s external debts far exceeded the value of the Bond B it held, creating a situation of “insolvency.” In this case, the underlying bond (Bond B) defaulted at maturity. Therefore, even though Securities Firm C held a certain quantity of pledged bonds, it could not liquidate them to recover the funds and could only sue Fund A and its manager to assume repayment liability.

The second question: Should the manager bear liability for the fund?

Generally speaking, from an organizational form perspective, private funds are divided into three types: corporate, limited partnership, and contractual funds. In a corporate fund, if the manager is a shareholder, it is only liable for the company’s debts to the extent of its capital contribution. If the manager is not a shareholder, it does not need to bear liability for the company’s debts. In a limited partnership fund, if the manager is also the general partner of the partnership, according to the Partnership Enterprise Law (合伙企业法), when the fund cannot satisfy its due debts, the manager shall bear unlimited joint and several liability. However, a contractual fund is not a legal entity. When a contractual fund cannot satisfy its due debts, whether the manager needs to bear liability is not clearly stipulated by law.

Because a contractual fund is not a legal entity, in a series of activities such as signing the Pledged Financing Repurchase Entrustment Agreement, opening bank accounts, and conducting online transactions, all operations were carried out in the name of the manager, Company D, on behalf of Fund A. Wherever a seal was needed, Company D’s seal was affixed. Therefore, one view holds that the contracting party in a series of contracts is Company D, and the transaction subject is also Company D. The relationship between Company D and Fund A is an internal relationship that does not affect Company D’s external legal liability. Another view holds that Company D, as the manager, continuously leveraged financing operations, resulting in substantial liabilities and causing significant losses to the fund and, consequently, to Securities Firm C as a creditor. Therefore, Company D should bear joint and several liability.

Based on the considerations of the above two issues, our view regarding this case is:

First, the relationship between a contractual fund and its manager should be a trust relationship.

Article 88 of the Minutes of the National Conference on Civil and Commercial Trial (九民纪要) points out that “…asset management business conducted by other financial institutions that constitutes a trust relationship shall be governed by the Trust Law (信托法) and other relevant provisions when disputes arise.” Meanwhile, the Drafting Explanation of the '' (《<私募投资基金合同指引>起草说明》) issued by the Asset Management Association of China states: “Contractual funds themselves do not have legal entity status; their relationship with the fund manager is a trust relationship…” In this case, Fund A is a contractual fund. The manager, “entrusted by others, handles matters faithfully,” managing and disposing of fund assets for the benefit of the principals. The underlying legal relationship is a trust relationship. Therefore, in handling this dispute, the relevant provisions of the Securities Investment Fund Law (证券投资基金法) and the Trust Law should apply.

Second, the law provides for the independence of fund assets.

Article 5 of the Fund Law (基金法) stipulates that debts arising from fund assets shall be borne by the fund assets themselves. Fund assets are independent from the fund manager’s and fund custodian’s own assets. Property and income obtained by the fund manager or custodian through the management, use, or other circumstances of fund assets shall be included in the fund assets. Article 16 of the Trust Law stipulates that trust property shall be distinguished from the trustee’s own property and shall not be incorporated into the trustee’s own property or become part of the trustee’s own property. Article 95 of the Minutes of the National Conference on Civil and Commercial Trial again clarifies that trust property is independent from the respective own property of the settlor, trustee, and beneficiary during the trust period.

Thus:

First, according to the above legal provisions, fund assets are independent from the manager’s own assets.

According to the obvious literal interpretation, fund assets and the manager’s own assets are independent of each other, with each bearing responsibility for its own debts. If it were one-way — i.e., fund assets do not need to bear liability for the manager’s own debts, but the manager’s own assets must bear liability for the fund’s debts — this would constitute a connection or joint liability relationship, with no independence whatsoever. This clearly contradicts the legislative intent. Second, fund assets have independence. For the operation of fund assets, the income belongs to the fund assets, and the debts are also borne by the fund assets themselves. The fund manager, as trustee, apart from the management fees stipulated in the fund contract, neither obtains additional income from the fund assets nor needs to bear liability for the fund’s external debts.

Again, external debts arising from handling fund affairs shall be borne by the fund assets.

Article 37 of the Trust Law stipulates that expenses paid by the trustee in handling trust affairs and debts owed to third parties shall be borne by the trust assets. It also stipulates that if the trustee breaches management duties or improperly handles trust affairs, resulting in debts owed to third parties, such debts shall be borne by the trustee’s own assets.

Thus: First, regarding the issue of external debts of fund assets (trust property), the above provisions clearly stipulate that external debts arising from managing and using fund assets and handling fund affairs shall be borne by the fund assets (trust property) themselves. The manager and custodian do not need to use their own assets to bear the external debts of the fund or trust. Second, the exception is that only when the manager breaches management duties or has material fault does it need to bear external debts with its own assets.

Furthermore, Securities Firm C knew that the subject of the transaction was Fund A, not Company D, and should therefore assert its rights only against the fund assets.

In this case, Securities Firm C had a dual identity and dual legal status. It was both the custodian of Fund A and the securities brokerage institution handling settlement on behalf of the fund in the financing repurchase transaction. Securities Firm C was always aware that the subject of the financing repurchase transaction was Fund A. Because the contractual fund itself has no legal personality, the manager had to represent the fund in conducting the financing repurchase transaction. However, the rights and obligations are borne by the fund assets themselves. Securities Firm C was not only aware of this but also participated throughout the entire transaction process as the custodian and brokerage institution.

Therefore, we believe that even if Fund A is “insolvent,” the manager should not bear liability.

Of course, each case has its unique transaction relationship and facts. In this case, the plaintiff was both a brokerage institution and the custodian, fully participating in the entire financing repurchase transaction process, and all transaction documents stated that Company D represented Fund A in performing rights and obligations. If the relevant facts change in other cases, the ultimate legal judgment may also change — i.e., the fund manager may be held jointly and severally liable for the debts arising from the fund’s “insolvency.”