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Client Alert – Private Fund Servicing Rule Soliciting Comments

2016.12.01 XIE, Qing (Natasha)、Brigitte(Bing)Lu

On November 15, 2016, the Consultation Paper of the Administrative Measures on the Private Investment Fund Service Business (“Consultation Paper”) was released by the Asset Management Association of China (“AMAC”) for public comment. The Consultation Paper aims to regulate various professional services provided by third party institutions for private funds. Upon its official promulgation, the Consultation Paper will replace the Guidelines on the Fund Outsourcing Services (Trial) (“Guidelines”) released by the AMAC two years ago.  Below is a summary of the key content of the Consultation Paper.

Scope of Application

Based on the content of the Consultation Paper, it first aims to formulate the general principles governing the private fund services, then regulating particularly the unit registration, valuation calculation and information technology system services. The Consultation Paper specifically sets forth the scope of services that a private fund manager (“PFM”) is permitted to outsource to third party institutions, i.e. fundraising, investment advisory, asset custody, unit registration, valuation calculation and information technology system services. Additional rules will be separately formulated by the AMAC to govern the fundraising, investment advisory and asset custody services. Our understanding on this point is that the general rules of the Consultation Paper will apply to all private fund servicing activities. However, in view of the special nature of fundraising, investment advisory and asset custody business, it is necessary for such activity to be further governed by some detailed rules in addition to the general rules. 

The Consultation Paper provides specific definitions for each type of service. For instance, it defines auxiliary services as the services of data reporting, fund performance analysis, labor dispatching, and business training for senior executives and employees. Combined with other provision of the Consultation Paper that the auxiliary services shall be rendered by the valuation calculation servicing institutions, it seems that the aforementioned labor dispatching and business training may refer to those activities related to the valuation calculation. In addition, the prohibition of subcontracting under the Consultation Paper may have particular impact on some service providers that have private fund service activities which rely on resources from their groups.

It is worth noting that the Consultation Paper requires the PFM for a single private fund product shall at least perform either fundraising or investment management functions. There may be differing opinions on how to interpret this restriction: (1) the investment management of a fund may be outsourced to a third party – for one private fund, if the PFM chooses to outsource the investment management of such fund, it cannot further outsource the fundraising of such fund; and (2) for the same private fund, the PFM shall not simultaneously engage a third party servicing institution to perform the fundraising and an investment advisor for investment advices. The intent of such a restriction may be to prevent PFMs from ending up as a “channel” without any substantial business. We presume that the determination in substance on whether the PFM has performed its management function to the fund that it manages may more match the regulatory principle. We also believe that the “investment management” function shall not be equal to the “investment advisory.” and a PFM shall be able to own and perform its investment management function while using third party channels to raise funds and accepting investment advice from third parties.

Moreover, the Consultation Paper distinguishes the “asset custody” from the “fund custody” in terms of their legal relationship, which defines the “fund custody” as constituting a trusteeship between the investors and the custodian, while in case that no “fund custody” is provided to the same private fund, the “asset custody” is defined as constituting a principal-agent relationship between the PFM and the asset custodian.

Qualification Requirements

The Consultation Paper requires the servicing institutions to complete the registration with the AMAC and become a member of the association, and depending on various types of business activities, they may be subject to different qualification requirements: (i) the servicing institutions engaged in private fund raising business shall register with the China Securities Regulatory Commission (“CSRC”) and obtain the qualification for fund distribution business, (ii) the servicing institutions engaged in asset custody business shall obtain the qualification for fund custody business upon approval by the CSRC, or complete the registration with the AMAC for fund unit registration services, and (iii) those engaged in the auxiliary services shall complete the registration with the AMAC for fund valuation calculation services.

The Consultation Paper defines the conditions required for a servicing institution to develop private fund unit registration services, fund valuation calculation services or information technology system services: it shall (i) have good operation status, specifically, the paid-in capital of a servicing institution engaged in the private fund unit registration service or information technology system service shall not be lower than RMB 50 million, (ii) have an optimized corporate governance structure, and its internal control is efficient, (iii) the management and operation of the institution are code-compliant, with no record of material violations against laws or regulations or other material events such as litigation or arbitration in the last 3 years, (iv) have a complete organizational structure, and set up dedicated service business teams and senior executives in charge of the service businesses, the setup of the service business teams is adequate to ensure the completeness and independence of the business operation, and the service business teams shall have the necessary fixed place of business and safety precaution measures to satisfy the business needs, (v) have the corresponding software and hardware facilities, equipped with the safe, independent, efficient and stable business technology system, and all of the systems shall pass the related business networking tests, including the data backup platform designated by the AMAC, (vi) the person in charge of the department for the private fund service business and the legal representative of any independent third party servicing institution shall obtain the qualifications to practice the fund related business. All employees engaged in the fund related business shall respectively obtain the qualifications to practice the fund related business within 6 months after their commencement of the private fund service business, and shall participate in the subsequent professional training, (vii) any applicant institution shall evaluate its business to decide whether there is a conflict of interest, and shall set up the corresponding firewall system, (viii) the information technology system of such applicant institution shall comply with the laws and regulations, the rules of the CSRC and the AMAC and the relevant standards, establish the networking isolation, safety prevention and emergency processing and other risk management system and disaster backup system, (ix) any institution applying for the development of information technology service shall have the qualification conditions provided by the relevant national department or obtain the related qualification, have the similar servicing experience, and be equipped with the necessary conditions including the labor, equipment, technology, intellectual property rights and good safety operation records, and (x) other conditions required by the AMAC. In view of the aforementioned conditions, commercial banks or securities companies already engaged in the private fund servicing business are more easily to satisfy such conditions and obtained the related registrations.

The Consultation Paper requires the servicing institution to commence the fund service business within 6 months after completing the registration with the AMAC, otherwise it will be deregistered, which is similar to the requirement on the time limit for PFM to launch its first product. 

PFM Duties

Followed by the same regulatory requirements of the Guidelines, the Consultation Paper underscores the principle of prudent authorization for PFM regarding service outsourcing, and stipulates that any liability borne by a PFM according to law shall not be dismissed due to such authorization. To be more specific, a PFM shall: (i) conduct due diligence on the servicing institution before such servicing institution is authorized to commence services, as well as become familiar with its labor backup, business isolation measures, software and hardware facilities, professional capacities and credit condition, (ii) enter into a written service agreement with such servicing institution, under which the rights and obligations of both parties and the related responsibilities for breach of contract shall be specified, and (iii) maintain a consistent level of attention and conduct regular assessments of the operation capacity and service levels of the servicing institution. 

Risk Prevention and Fund Safety Protection

In principle, a custodian shall not be entrusted to become a servicing institution for the same private fund, unless it can properly separate its function for fund services from the custodian function, and is capable of properly identifying, managing and monitoring the potential conflicts of interest and fully discloses them to the investors. The Consultation Paper also provides the related fundraising settlement fund safety system, i.e. the special account for the settlement funds of fundraising shall be effectively monitored by a supervisory institution; the several and joint liability clauses regarding the obligation of the supervisory institution to keep the investors’ funds safe shall be specified under the supervision agreement. A supervisory institution may be: (i) a servicing institution registered with the AMAC for the fund unit registration business, (ii) the China Securities Depository and Clearing Corporation Limited (CSDC), and (iii) a securities company or commercial bank obtaining the qualification to engage in the mutual fund distribution business. 

Special Provisions on the Information Technology System Service

Pursuant to the Consultation Paper, the information technology system services include the (i) core application system for private fund business, (ii) operation maintenance for information systems, and (iii) safety protection services. Among which, the core application system for private fund business includes but not limited to the distribution system, investment trading management systems, unit registration systems, fund clearing systems and valuation calculation systems. A servicing institution offering a core application system for fund business shall not engage in the private fund service business corresponding to the systems provided by it, nor shall it involve in the relevant fund business operations directly. However, services such as the operation maintenance for information systems and the safety protection services are permissible.

For a servicing institution offering the investment trading management system, the following two requirements are particularly notable: the servicing institution shall (i) ensure that independent securities account(s) shall be opened for a single fund; no “subsidiary account”, “sub-account” or virtual account shall be opened under a single securities account; it will not conduct investment business operation directly; the duty of position liquidation or trading shall not be executed by it on behalf of a PFM, (ii) establish the fair trading system, and ensure that all private funds are managed by one PFM and all private funds are managed by different PFMs shall be treated equally. Our interpretation of the above two requirements are, the investment trading management systems provided by a third party servicing institution shall not be used to engage in the prohibited acts provided under the above item (i), while the provision of item (i) seems to require the servicing institutions to adopt measures to prevent the conflict of interest, insider trading or transfer of illegal benefit which may arise due to the use of the same investment trading management systems provided by the same third servicing institution for various private fund products. However, this interpretation remains to be further clarified by the AMAC.

The Consultation Paper requires all information systems of a servicing institution for core business processing must be deployed within the territory of the People’s Republic of China, and the storage and backup of client information, business materials and other data obtained in the course of business development shall be stored within the territory of the People’s Republic of China. No exceptions are allowed under this requirement, which seems to reflect the regulators’ inclination to strictly regulate the private funds by making reference to related rules on the mutual funds. 

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