Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds

Fordham Journal of Corporate & Financial Law, Mar 2018

This article conducts the very first empirical study exploring the contractual arrangements of Chinese hedge funds, which are organized not as limited partnerships but as trusts. Using 139 trust contracts collected by hand, this article sheds light on the structure, covenants, and compensation mechanisms used by “sunshine funds,” the local name for hedge funds in China. It shows that, while sunshine funds do have similar contractual arrangements as typical LP-organized hedge funds, they also possess many undeniable differences due to the jurisdiction-specific characteristics of China. In particular, because of the direct involvement of trust companies, sunshine funds include certain covenants and terms that could both narrow the decision-making power and dampen the incentives of investment advisers. New, but rapidly developing, sunshine funds have been frequently targeted by regulatory efforts, which, however, come at a low level of consistency and sometimes lack in-depth consideration. Growing out of gray regulatory areas, Chinese sunshine fund managers have demonstrated remarkable competence in positioning themselves by taking advantage of favorable regulations and mitigating the impact of unfavorable ones. Looking ahead, it is of key importance that a proper balance is reached in terms of what role regulators should play in dealing with the Chinese hedge fund industry.

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Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds

OF NON-LISTED COMPANIES Financial Law - 2012 Article 3 Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds Copyright c 2012 by the authors. Fordham Journal of Corporate & Financial Law is produced by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds Jing Li This article conducts the very first empirical study exploring the contractual arrangements of Chinese hedge funds, which are organized not as limited partnerships but as trusts. Using 139 trust contracts collected by hand, this article sheds light on the structure, covenants, and compensation mechanisms used by “sunshine funds,” the local name for hedge funds in China. It shows that, while sunshine funds do have similar contractual arrangements as typical LP-organized hedge funds, they also possess many undeniable differences due to the jurisdiction-specific characteristics of China. In particular, because of the direct involvement of trust companies, sunshine funds include certain covenants and terms that could both narrow the decision-making power and dampen the incentives of investment advisers. New, but rapidly developing, sunshine funds have been frequently targeted by regulatory efforts, which, however, come at a low level of consistency and sometimes lack in-depth consideration. Growing out of gray regulatory areas, Chinese sunshine fund managers have demonstrated remarkable competence in positioning themselves by taking advantage of favorable regulations and mitigating the impact of unfavorable ones. Looking ahead, it is of key importance that a proper balance is reached in terms of what role regulators should play in dealing with the Chinese hedge fund industry. Lecturer and Ph.D. Candidate, Department of Business Law at Tilburg University; MPhil. 2008, Tilburg University; LL.M. 2010, Duisenberg School of Finance; LL.M. 2004, Stockholm University; and LL.B. 2003, University of International Business and Economics. The author acknowledges with gratitude Professors Joseph McCahery, Armin Schwienbacher, and Erik Vermeulen, for the inspirational and insightful comments they had on this article at an early stage. FORDHAM JOURNAL OF CORPORATE & FINANCIAL LAW MONEY UNDER SUNSHINE: AN EMPIRICAL STUDY OF TRUST CONTRACTS OF CHINESE HEDGE FUNDS MONEY UNDER SUNSHINE: AN EMPIRICAL STUDY OF TRUST CONTRACTS OF CHINESE HEDGE FUNDS Jing Li* This article conducts the very first empirical study exploring the contractual arrangements of Chinese hedge funds, which are organized not as limited partnerships but as trusts. Using 139 trust contracts collected by hand, this article sheds light on the structure, covenants, and compensation mechanisms used by “sunshine funds,” the local name for hedge funds in China. It shows that, while sunshine funds do have similar contractual arrangements as typical LP-organized hedge funds, they also possess many undeniable differences due to the jurisdiction-specific characteristics of China. In particular, because of the direct involvement of trust companies, sunshine funds include certain covenants and terms that could both narrow the decision-making power and dampen the incentives of investment advisers. New, but rapidly developing, sunshine funds have been frequently targeted by regulatory efforts, which, however, come at a low level of consistency and sometimes lack in-depth consideration. Growing out of gray regulatory areas, Chinese sunshine fund managers have demonstrated remarkable competence in positioning themselves by taking advantage of favorable regulations and mitigating the impact of unfavorable ones. Looking ahead, it is of key importance that a proper balance is reached in terms of what role regulators should play in dealing with the Chinese hedge fund industry. TABLE OF CONTENTS INTRODUCTION ...................................................................................... 63  * Lecturer and Ph.D. Candidate, Department of Business Law at Tilburg University; MPhil. 2008, Tilburg University; LL.M. 2010, Duisenberg School of Finance; LL.M. 2004, Stockholm University; and LL.B. 2003, University of International Business and Economics. The author acknowledges with gratitude Professors Joseph McCahery, Armin Schwienbacher, and Erik Vermeulen, for the inspirational and insightful comments they had on this article at an early stage. I.  CONTRACTUAL AND GOVERNANCE STRUCTURE OF HEDGE FUNDS............................................................................................. 70  A.  LIMITED PARTNERSHIP AS THE PREVALENT BUSINESS FORM IN PRIVATE INVESTMENT FUND INDUSTRY ................................ 70  B.  COVENANTS IN HEDGE FUND PARTNERSHIP AGREEMENTS – HOW CAN THE CORRESPONDING LITERATURE ON PRIVATE EQUITY FUNDS BE HELPFUL?.................................................... 75  II.  OVERVIEW OF CURRENT REGULATORY FRAMEWORK FOR CHINESE HEDGE FUNDS................................................................. 79  A.  ALTERNATIVE FORMS FOR HEDGE FUNDS IN CHINA OTHER THAN SUNSHINE FUNDS............................................................. 79  B.  HEDGE FUNDS ORGANIZED AS TRUSTS: STRUCTURE AND BUSINESS MODELS.................................................................... 86  III.  EMPIRICAL ANALYSIS OF TRUST CONTRACTS OF SUNSHINE FUNDS............................................................................................. 91  A.  SAMPLE AND DATA COLLECTION .............................................. 91  B.  SAMPLE COVERAGE .................................................................. 94  C.  DESCRIPTIVE STATISTICS .......................................................... 97  D.  COVENANTS ............................................................................ 109 1.  Covenants on the Authority of Fund Managers Regarding Investment Decisions ..................................... 110  a.  Restrictions on Investment Size ................................ 110  b.  Covenants on Dividend Payouts................................ 111  2.  Covenants on Fund Managers' Capital Contributions.... 113  a.  Concerns of Chinese Investors .................................. 116  b.  Liability Concerns of Trust Companies .................... 118 c.  Legal Restrictions...................................................... 118 3.  Covenants on Types of Investment................................... 120  4.  Covenants on Fund Operation......................................... 125  5.  Limitation of Investment Adviser’s Power....................... 126  E.  COMPENSATION ...................................................................... 129 1.  Temporarily No Performance-Based Compensation; to be Resumed if Allowed by Law in the Future .................. 134 2.  Trust Companies’ Fixed Fees and Flexible Compensation Combined Together and Called “Trust Management Fee,” Investment Advisers’ Flexible Incentive Fees Received as “Special Trust Interests” 3. Trust Company Designated Together with Investment Adviser as Special Beneficiary to Share Special Trust Interests............................................................................ 136 4.  Flexible Fees Payable Upon Investors’ Redemption....... 137 CONCLUSION........................................................................................ 137 INTRODUCTION Although lacking a legal or regulatory definition, the term “hedge fund” usually describes a type of alternative investment vehicle that possesses four general characteristics: (1) it is a pooled, privately organized fund; (2) it is administered by professional investment managers; (3) it is not widely available to the public; and (4) it operates outside of securities regulation and registration requirements.1 Although many private equity or venture capital (“VC”) funds also share these characteristics, those funds are distinguishable because they invest in unlisted portfolio companies for relatively long-term periods for the purpose of securing lucrative exits afterwards. As a class, however, hedge funds can embark upon a broad range of investments including equities, debt and commodities. They are often associated with using active trading strategies and employing sophisticated instruments (most notably short-selling and derivatives) to hedge investment risks and increase returns. Most of the time, hedge funds tend to focus on trading publicly-listed securities; in recent years, however, they also have invested through side pockets into those assets that are comparatively illiquid or hard-to-value, 2 thus indirectly broadening their coverage further to private markets. Therefore, it is important to bear in mind that there is a wide range of variations among hedge funds, and while some hedge funds do share some or all of these characteristics, others do not. Every hedge fund has its own investment strategy that determines the type and method of investment it undertakes. As a result, it is easier to recognize hedge funds than it is to define them.3 Due to strong economic growth while major developed countries suffered from the global recession, China recently surpassed Japan to become the world’s second-largest economy.4 The value of the Chinese stock market has boomed. From a marketplace with only twelve stocks trading when its first two stock exchanges opened in 1990 in Shanghai and Shenzhen,5 the combined value of companies with stocks traded on China’s equities markets is now comparable to that of Japan’s, surpassing the latter periodically during the past two or three years.6 Furthermore, the long-anticipated margin trading 7 and stock index 4. David Barboza, China Passes Japan as Second-Largest Economy, N.Y. TIMES, Aug. 15, 2010, at B1. 5. Bai Haiyan, Ziben shichang fazhan dui gongsi zhili de zuoyong [The Impact of the Development of Capital Markets over Corporate Governance], 22 ZHONGGUO JINGMAO [CHINESE BUS. UPDATE] 83, 83 (2008). 6. The combined value of companies trading on China’s equities markets reached US$3.09 trillion as of August 16, 2010, compared with US$3.51 trillion for Japan, according to data compiled by Bloomberg News. See China to Surpass Japan as No. 2 Stock Market, BLOOMBERG NEWS, Aug. 17, 2010, available at http://business.financial post.com/2010/08/17/china-to-surpass-japan-as-no-2-stock-market/#ixzz0xRYgQnER. China briefly surpassed Japan by capitalization in January 2008, shortly after PetroChina Co. debuted in Shanghai, and again in July 2009 as a consequence of the government’s 4 trillion-yuan (US$587 billion) economic stimulus program directed at infrastructure projects and shares. 7. Margin trading was officially legalized in June 2006 by Zhengquan gongsi rongzi rongquan yewu shidian guanli banfa [Measures for the Administration of Pilot Securities Lending and Borrowing Business of Securities Companies] (promulgated by China Securities Regulatory Commission [hereinafter CSRC], June 30, 2006), LAWINFOCHINA, available at http://www.lawinfochina.com, but only materialized on Mar. 19, 2010 when the CSRC designated six securities brokerage firms as the first batch of “trial firms” to begin the business of margin trading and securities lending. Mainland China Securities Survey 2010 (KPMG China, Hong Kong), Sep. 2010, at 6, available at http://www.kpmg.com/cn/en/IssuesAndInsights/ArticlesPublications/Page s/China-securities-survey-201010.aspx. The day before the official launch of the trial program, CITIC Securities signed an agreement with Jiangsu Winfast Investment and Development Co. Ltd., offering the latter credit limits of RMB 28 million for margin trading and RMB 10 million for short selling. This is considered to be the very first of such transactions in China. See Hu Yang, China Begins Margin Trading Trial, CHINA DAILY, Mar. 31, 2010, available at http://www.chinadaily.com.cn/business/201003/31/content_9668589.htm. Jiangsu Winfast is a securities asset management company, and has several sunshine funds (one type of Chinese hedge funds) under its management. See Jiangsu Winfast Investment Holding Grp., Company Profile, http://www.jiangsuruihua.com/en/article.asp?c_id=42 (last visited Nov. 8, 2011); Jiangsu Winfast Investment Holding Grp., Securities Trust Schemes Issued by Winfast, http://www.jiangsuruihua.com/en/article.asp?c_id=56 (last visited Nov. 8, 2011). 2012] futures8 finally materialized in the spring of 2010, so it is now possible to get credit quotas for margin trading and short-selling from approved securities brokerage firms, and to trade Shanghai-Shenzhen 300 stock index futures contracts. These technical developments, combined with considerable market capitalization and strong economic growth, demonstrate China’s great potential to become an important hedge fund market. Nonetheless, a “hedge fund” is still a very novel concept in China. Given that Chinese people’s familiarity with hedge funds is somewhat limited to anecdotal knowledge,9 the apparent existence of the Chinese hedge fund industry is ambiguous. Among other things, this ambiguity partially results from the general aversion in China towards the phrase “hedge funds,” due to the negative impression they left on South-eastern Asian countries in the 1997 Asian financial crisis,10 and more recently, 8. Financial derivatives (specifically, futures) were officially legalized in March 2007 by Qihuo jiaoyi guanli tiaoli [Regulation on the Administration of Futures Trading] (promulgated by the State Council, Mar. 16, 2007), LAWINFOCHINA, available at http://www.lawinfochina.com, but only materialized in April 2010 when the Shanghai-Shenzhen 300 stock index futures contracts, the very first of such in China, were listed on the China Financial Futures Exchange. See Mainland China Securities Survey 2010, supra note 7, at 8. 9. For a collection of anecdotal articles on hedge funds in China, see generally Richard Wilson, China – Hedge Funds: Guide to Hedge Funds in China, HEDGEFUNDBLOGGER.COM, http://richard-wilson.blogspot.com/2008/05/china-hedgefunds-hedge-funds-in-china.html (last visited Nov. 2, 2011). 10. Hedge funds have been charged with playing a pivotal role in the 1997-98 Asian financial crisis due to their involvement in large transactions they have done in various Asian currency markets, such as Thailand, Malaysia, the Philippines, and then Hong Kong, South Korea, etc. In particular, the then Prime Minister of Malaysia blamed hedge fund manager George Soros for “attacks in the marketplace on the Malaysian ringgit and other currencies in order to generate profits for themselves without regard to the livelihood of the Malaysian or other local people.” See DICK K. NANTO, CONG. RESEARCH SERV., THE 1997-98 ASIAN FINANCIAL CRISIS (1998), available at http://www.fas.org/man/crs/crs-asia2.htm; see also Barry Eichengreen & Donald Mathieson, Hedge Funds, What Do We Really Know?, ECON ISSUES No. 19, International Monetary Fund (1999), available at http://www.imf.org/external/pubs /ft/issues/issues19/index.htm#5. However, it is also submitted that despite these allegations, there is no empirical evidence that George Soros, or any other hedge fund managers, were responsible for the crisis. See Stephen J. Brown et al., Hedge Funds and the Asian Currency Crisis, 26 J. PORTFOLIO MGMT. 95 (2000). accusations against them in the 2008 global financial crisis.11 As such, it would be unwise and difficult for private investment managers to raise a fund in China under a name that the public generally associates with a negative image. Rather, the hedge-fund-like investment vehicles are referred to as “sunshine privately offered funds,” 12 which can sound quite odd to outsiders. For the sake of simplicity, I refer to these funds as “sunshine funds” in this article. Another important factor contributing to the dearth of information on Chinese hedge funds is their unique organizational structure. In the United States, which has the world’s most developed hedge fund industry, 13 the limited partnership (“LP”) prevails as the prevalent business form for a hedge fund.14 On the one hand, fund managers act as general partners, actively managing the fund and bearing unlimited liability.15 On the other hand, investors are passive limited partners who 11. The financial crisis of 2008 has led to renewed debate about the impact of hedge funds on the functioning of financial markets. Although it is largely recognized that hedge funds should not be blamed for causing the crisis, there seems to be a consensus among regulators in the world that they should be more regulated, which is arguably stems more from a political fear for being criticized if no scapegoat can be spotted rather than from a real need. See Anne C. Rivière, The Future of Hedge Fund Regulation: A Comparative Approach: United States, United Kingdom, France, Italy, and Germany, 10 RICH. J. GLOBAL L. & BUS. 263, 291 (2011). 12. The term “sunshine privately offered funds” is a literal translation of the corresponding Chinese. For a brief introduction of sunshine funds, see http://www.asimu.com/knowledge/infocontent/1238/41297.html. Because this type of fund uses a trust to raise capital from investors and then manages the raised capital for them, they are legal and thus “under the sunshine.” In contrast, those funds that do not use the trust form may face various challenges such as ambiguous legal status, thus they operate “in the shadow.” Therefore, this name is actually a vivid depiction of those privately offered funds, using the trust as their business form, and primarily focusing on investing in publicly listed securities. Sunshine funds, particularly the unstructured ones (further discussion in Part II.B), are considered comparable to hedge funds, in that that they both aim to pursue absolute returns and have similar fee structures. See http://www.crctrust.com/cgi-bin/web/TemplateAction?catalogNo=ywgl,smzs. 13. As of the end of 2009, the US was the largest management center for hedge funds and also the leading location for management of hedge fund assets with over twothirds of the total. See International Financial Services London, IFSL Research Hedge Funds 2010, THECITYUK.com, (Apr. 2010), available at http://www.thecityuk.com /assets/Uploads/Hedge-funds-2010.pdf. 14. DOUGLAS L. HAMMER ET AL., U.S. REGULATION OF HEDGE FUNDS 88 (2008). 15. Jacob Preiserowicz, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 FORDHAM J. CORP. & FIN. L. 807, 812 (2005). In practice, however, the “actual” general partner of a fund is often not the fund manager 2012] are shielded with limited liability protection but have to leave investment decisions to general partners. 16 One important feature common to virtually all LP-type hedge funds is their fee structure, typically consisting of a management fee of 2% and a performance fee of 20%.17 This structure heavily incentivizes managers to generate good performance for investors. In contrast, no Chinese hedge fund was formed as a LP until March 2010, when the first LP-type private securities investment fund was created in Beijing.18 Although limited partnerships have been legally authorized in China since 2007,19 only 31 private securities investment funds were identified as LPs as of the end of 2011.20 Arguably, the low usage of LPs among Chinese hedge funds may be a result of the fact that there are virtually no precedents available to regulators, practitioners, and taxation authorities on how to deal with this new business form.21 itself, but a management company set up by it. By doing this, fund managers are shielded by the limited liability protection of the management company, thus leaving the unlimited liability at the entity level. See infra notes 15, 28 and accompanying text. 16. Alon Brav et al., Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J. FIN. 1729, 1735 (2008). 17. Id. 18. Zhao Juan & Hu Zhongbin, Shouge hehuozhi zhengquan simu jijin tanmi [Exploring the First Privately Offered Partnership Securities Fund], JINGJI GUANCHA BAO [THE ECONOMIC OBSERVER], Mar. 1 3, 2010 , available at http://www.eeo.com. cn/finance/securities/2010/03/13/165159.shtml. This first partnership fund is named Yinhe Purun, and is registered in Beijing. 19. Limited partnership was first legally permitted in 2006, when China amended its Partnership Enterprise Law. See Zhonghua renmin gongheguo hehuo qiye fa [Partnership Enterprise Law (P.R.C.)] (promulgated by the Nat’l People’s Cong., Feb. 23, 1997) (amended Aug. 27, 2006) (took effect June 1, 2007 ), LAWINFOCHINA, available at http://www.lawinfochina.com. 20. According to the database provided by Simuwang.com, a total of 11 funds were set up as limited partnerships for the entire year of 2010, and 20 funds for the entire year of 2011. See http://data.simuwang.com/product.php (follow “product type”; then select limited partnership; next choose 2010 and 2011 from under “year established”) . 21. It is submitted that in order to enhance the popularity of limited partnership among privately offered securities investment funds, four difficult questions need to be tackled first. Among other things, it remains to be seen (1) whether these LP-organized funds will be equally attractive to investors when there is no trust company involved; (2) how LP-organized funds are going to properly entertain frequent subscription and redemption needs, given the statutory requirement for unanimous approval from all partners and changing official registration with the regulatory authorities when an Instead of the LP form, the vast majority of Chinese hedge funds are created as securities investment trust plans based on a “four party cooperation platform” provided by various trust companies.22 This might explain the impression that China seems to lack a hedge fund industry – after all, these trust-like funds look quite different from the much better known LP-type funds. The very first trust-organized sunshine fund in China was created in 2004,23 yet the industry has been developing at a remarkable pace ever since. According to the Go-Goal Database for High-End Investors, there are altogether 703 trust sunshine funds in operation as of August 9, 2010, and the number increases to 838 when including those that had been terminated.24 Although it is undisputed that China’s hedge fund industry still has a long way to go, it seems equally unwarranted to simply deny its existence when a large number of funds are already in the business. Given the limited understanding of these trust sunshine funds, timely research into them is both worthwhile and practicable. Just as LP agreements provide insight into the creation and governance of American hedge funds, the best way to understand how Chinese sunshine funds are established and operated is to look at their “trust agreements for collective securities investment funds.” Fortunately, while hedge funds in developed markets are generally existing partner exits or a new partner is brought into the partnership; (3) how they are going to safely keep and use the money from investors when the Partnership Enterprise Law does not make mandatory a custodian bank to be designated for that purpose; and (4) which governmental authority should be supervising LP-organized sunshine funds. Moreover, many questions also remain unanswered as to the taxation of limited partnerships and their investors and managers. See Xiao Yongjie, Yangguang simu youxian hehuo zhi sida nanti [Four Difficulties for Sunshine Funds Organized as Limited Partnerships], ZHENGQUAN SHIBAO [SECURITIES TIMES], Mar. 15, 2010, available at http://simu.howbuy.com/xinwen/178846.html. 22. See infra Part II.B. 23. This fund was called SZITIC PureHeart, created on Feb. 20, 2004 in Shenzhen and terminated on Jan. 15, 2008. The fund is reported to have realized an accumulated return of 370.86% as of its liquidation. See Zhang Bin, Zhao Danyang: Shangwu huigui A gu shichang de jihua [Zhao Danyang: Currently No Plan to Return to a Stock Market], CAIJING, Feb. 18, 2009, available at http://www.caijing.com.cn/2009-0218/110071131.html. 24. See GO-GOAL DATABASE FOR HIGH-END INVESTORS, http://www.gogoal.com/inv_trust/basic/default.aspx. See infra Part III for further discussion of empirical data. Sunshine funds were filtered out manually by the author on the website provided. 2012] considered quite secretive due to the much lighter regulation and disclosure requirements imposed on them, the trust-like sunshine funds are somewhat more transparent because trust companies in China are subject to certain disclosure requirements as supervised and regulated financial institutions.25 In addition, some fund managers also voluntarily publish information on their websites about the funds they manage. As a result, it is possible to obtain the trust contracts of some Chinese hedge funds. Using a sample of 139 trust agreements and explanations of trust plans,26 this article investigates the contractual arrangements of Chinese sunshine funds and aims to demonstrate how the salient terms of these trust plans govern the operation of sunshine funds. Particular attention will be given to those terms that control the roles of investment advisers and trust companies, who cooperate and interact with each other in a manner analogous to fund managers in American hedge funds contracts. Part I of this article provides a brief summary of the contractual and governance structure of American LP-type hedge funds, together with an overview of previous research papers written on the contractual arrangements of alternative private investment vehicles. Part II describes the current regulatory environment surrounding hedge funds in China. Finally, Part III discusses and analyzes empirical data regarding the structure, covenants, and compensation mechanisms of sunshine funds. 25. Generally, trust companies must disclose to their clients and the relevant interested parties the key information about their business. For a collective capital trust plan, they must, at least for every quarter of a year, create a “trust capital management report” to disclose the major issues in managing the trust. They must also disclose weekly on their websites the unit net asset value of each of their securities investment trusts (such as sunshine funds). See art. 34-38 of Xintuo gongsi jihe zijin xintuo jihua guanli banfa [Administrative Measures for Collective Capital Trusts Established by Trust Companies] (promulgated by the CBRC, Jan. 23, 2007), LAWINFOCHINA, available at http://www.lawinfochina.com; see also art. 15-17 of Xintuo gongsi zhengquan touzi xintuo yewu caozuo zhiyin [Guidelines on Running the Business of Securities Investment Trusts by Trust Companies], (promulgated by the CBRC on Jan. 23, 2009) , LAWINFOCHINA, available at http://www.lawinfochina.com. 26. See infra Part III.A. CONTRACTUAL AND GOVERNANCE STRUCTURE OF HEDGE FUNDS A. LIMITED PARTNERSHIP AS THE PREVALENT BUSINESS FORM IN PRIVATE INVESTMENT FUND INDUSTRY LPs are widely used to contain the business of both hedge funds and private equity funds. The popularity of the LP in the private investment fund industry can be attributed to two primary incentives: flexible contractual structure and favorable tax benefits. Limited partners are those persons contributing substantially all of the partnership’s capital, such as institutional investors, wealthy individuals,27 and sometimes other hedge funds (giving rise to the fund of funds).28 The general partner is a management company set up by professional investment managers, who are effectively shielded from the risk of unlimited personal liability arising as a result of actively managing the partnership and making investment decisions on the pooled capital.29 Unlike a corporation, LPs are not separately taxed as an entity, so that the fund’s profits and losses are passed through to its partners without any entity level tax.30 Compared to limited partners, the general partner only contributes a nominal portion of the total assets/committed capital of the partnership, normally 1%,31 but has the right of compensation much greater than its original contribution if the fund runs well. Such compensation is often referred to as the “2-20” mechanism, consisting of a fixed management fee, usually 2% of the total assets/committed capital of the fund, and a performance-based right to share 20% of the fund’s net profits. 32 Such an arrangement serves to incentivize the general partner to work hard and manage investments diligently, providing an effective solution to the principal-agent problem. 2012] The governance structures of a typical private equity fund and hedge fund are shown in Figure 1 and Figure 2 below. Particularly, the compensation scheme in hedge fund partnership agreements is usually identified by one important feature: high-water marks. By definition, a high-water mark is the highest peak in value that an investment fund has reached.33 As already mentioned above, such performance-based compensation normally amounts to 20% of the net new profits if the previous high water mark is exceeded. The prevalence of high-water marks among hedge funds might be partially explained by the high level of reliance on fund manager expertise. Since investor payoff is presumably based more upon the expectation of superior managerial skill and less upon the expected returns to an undifferentiated or passively managed portfolio of assets, a mechanism is needed to incentivize fund managers to demonstrate their skills in order to justify their fees.34 33. William N. Goetzmann et al., High-Water Marks and Hedge Fund Management Contracts, 58 J. FIN. 1685, 1685 (2003). 34. Id. at 1686. FORDHAM JOURNAL Governance Structures of Private Equity Funds and Hedge Funds Figure 1 Private Equity Fund JOSEPH A. MCCAHERY & ERIK P. M. VERMEULEN, CORPORATE GOVERNANCE Investors (Limited Partners) Capital Contributions / Loans Repayment of Loans and Profit Distributions (80%) Capital Contributions / Services Principals Management Fee Despite a certain level of similarity between the two diagrams above, hedge funds differ from private equity funds in that hedge funds generally invest in public liquid assets via a brokerage account, whereas private equity funds typically purchase stock directly in non-listed portfolio companies. As such, hedge funds need an array of service providers working around them in order to maintain their operations. Figure 3, below, lists the typical parties involved in the operation of hedge funds. Specifically, an administrator is appointed to maintain records, as well as to independently verify the asset value of the fund. A registrar/transfer agent is responsible for processing subscriptions and redemptions and maintaining the registry of shareholders. A prime broker provides access to stock and loan financing and serves as a host 36. Id. at 186. of value-added services.37 A custodian ensures the safe-keeping of assets. At the top level, the board of directors or trustee of the fund bears a fiduciary duty to the investors to ensure that all parties involved in the fund properly carry out their respective tasks. 38 It is submitted that outsourcing a hedge fund’s functions can help to minimize the risk of collusion among hedge fund participants to perpetuate fraud, and may also mitigate liability in the event that hedge fund participants are accused of improperly performing their management duties.39 Source: Cumming & Dai (2010)40 2012] B. COVENANTS IN HEDGE FUND PARTNERSHIP AGREEMENTS – HOW CAN THE CORRESPONDING LITERATURE ON PRIVATE EQUITY FUNDS BE HELPFUL? Although both private equity and hedge funds employ the same legal structure and “2-20” compensation mechanism from the outset, there are also pronounced differences between them in terms of their operations. Such differences result from the contractual flexibility of limited partnerships, which allows investors and fund managers to enter into covenants and schemes to suit their respective investment mandates.41 A straightforward example in this regard is differing fund terms. Since investments by private equity funds are generally highly illiquid42—private equity funds focus on buying shares in unlisted firms and only hope to harvest from there after three to seven years.43 There is a need to agree on a limited fund term at the expiration of which the general partner is obliged to return to limited partners the capital together with distributed profits. Correspondingly, general partners cannot access the full amount of the committed capital from the beginning of the fund, but they have the right to call in capital contributions once they have located proper investment projects.44 Once the capital is invested, limited partners then need to remain patient and are prohibited from redeeming their partnership units until the end of the fund. In contrast, because hedge funds primarily invest in publicly listed securities, their assets are comparatively more liquid and investors can get back their contributed capital through periodically-opened redemptions. This explains why many hedge funds are perpetual in life rather than having a fixed fund term, and why limited partners have to make contributions up front. While an in-depth comparison of the difference between the two types of funds is beyond the scope of this article, it is nevertheless necessary and inspiring to bring up the topic here. As mentioned in the Introduction, a good way to understand how hedge funds are set up and operated is to look at their contracts, either LP agreements for typical American-style hedge funds or trust agreements for Chinese sunshine funds. Given the many similarities between private equity and hedge funds in terms of organizational structure and compensation mechanisms, a look into the contractual arrangements (covenants in particular) of private equity LP agreements will provide helpful guidance in understanding the contractual arrangements of hedge funds, which, however, have received scant attention in literature. The lack of literature on hedge fund contractual arrangements might result from the difficulty of obtaining access to the organizational documents of hedge funds; but it is more likely explained by the fact that hedge funds tend to rely much less on self-regulatory means like covenants due to shorter lock-up periods and the fund’s liquidity. Furthermore, those hedge fund activities that fall within the public domain, particularly in the market for corporate control, can also help to limit the principal-agent problems that may otherwise emerge. 45 The following paragraphs summarize important research on contractual covenants in the agreements of private investment funds, including both private equity funds, as well as venture capital funds, one of the most important subtypes of private equity. Although this information might not be directly useful in terms of drawing conclusions for this paper given the different topics and jurisdictions covered in this area, exploring methods of classifying covenants may be a good starting point for classifying the covenant arrangements in Chinese hedge funds. In their 1996 paper, Professors Gompers and Lerner studied covenants in a sample of 140 U.S. VC partnership agreements.46 They focused on 14 classes of covenants, which were divided into three broad families: (a) covenants relating to overall fund management; (b) covenants relating to activities of general partners; and (c) covenants restricting the types of investment. 47 According to them, contractual restrictiveness in VC funds, measured by the number and kind of covenants in the partnership agreement, is determined by two important factors, namely, the supply and demand conditions in the VC market, as 45. See MCCAHERY & VERMEULEN, supra note 35, at 190. 46. See Paul A. Gompers & Josh Lerner, The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements, 39 J.L. & ECON. 463 (1996). 47. Id. at 480. 2012] well as the variations of the cost of contracting.48 When the supply of capital is large and the demand for the services of experienced, professional VC managers is great, fewer covenants are observed, and general partners’ compensation under the partnership agreement is higher.49 Such supply and demand theory is generally supported by all types of covenants.50 In terms of variations in the cost of contracting, the rationale is that because negotiating and monitoring specific covenants can be costly, and the ease of monitoring and the potential of engaging in opportunistic behavior may vary across funds, more restrictive contracts will be employed when monitoring is easier and the potential for opportunistic behavior is greater. 51 Such theory is supported particularly by those covenants restricting the fund management and investment activities.52 In Europe, Daniel Schmidt and Mark Wahrenburg explored factors that influence the design of financing contracts in terms of covenant restrictions and compensation schemes between VC investors and European VC funds. 53 Their analyses focused on the impact of VC funds’ reputations and changes in the overall demand for VC services.54 While conventional wisdom would assume established market participants care more about their reputation and have less incentive to behave opportunistically, thus requiring fewer covenant restrictions, their findings show that established funds are actually more severely restricted by contractual covenants.55 Moreover, empirical results also show that established fund managers with stronger reputations are more often obligated to make a capital contribution than first-time fund managers.56 Such results indicate that when established funds care less RMB 10 million paid up capital; 161 as for a trust company, the law requires for at least RMB 300 million registered capital, which must be already fully paid up.162 By the same token, investors in China may find it hard to accept when a fund manager is going to use their money at his discretion and share one-fifth of what they are going to earn, while the manager only contributes a nominal amount relative to what investors have invested. In some sense, this could also sound like a sham. Comparatively, a 10% capital contribution will better bind the adviser, and the business will look more serious in the eyes of investors. Given that the idea of hedge funds is still so novel, and that the whole scheme is based on contracts, the requirement that investment adviser contributes at least 10% of the fund’s total assets serves as a quasi-legal mechanism to provide the needed sense of security to investors. This argument echoes the thesis of a paper by Professors Lerner and Schoar in 2005.163 They found that, in a private equity investment context, transactions in low enforcement and civil law nations tend to use common stock and debt, and rely on more rigid yet straightforward mechanisms such as equity and board control to monitor portfolio companies, instead of convertible preferred stock, which is more flexible yet more contractual in nature, as seen in common law countries. 164 Similarly, the higher investment adviser contribution requirement used in the Chinese hedge fund contract context serves as a more rigid and straightforward mechanism to make up for the general unfamiliarity and uncertainty of Chinese investors towards the new business, reflecting of the civil law culture in China. b. Liability Concerns of Trust Companies If an investment adviser underperforms and the sunshine fund under its management loses money, the reputation of the trust company will also be negatively affected because the fund is created and operated under its name. From a formal point of view, a trust company is the one signing the trust contract directly with the investors, while the investment adviser is standing one step back being the third-party 2012] service provider retained by the trust company through an advisory service agreement. As such, a trust company would have the incentive to preserve its reputation as a reliable market player. It need to have some reliable mechanisms to ensure that if the investment adviser fails to bring in good returns for a sunshine fund, disgruntled investors of that fund will not make its life too difficult. With a high investment adviser capital contribution at the outset, the investors may feel that their losses are at least partially shared by the person who caused the losses. Otherwise, annoyed investors will first blame the trust company for not installing a mechanism to hold the investment adviser accountable, and liability on the part of trust company may even be triggered. In this sense, it is understandable that most trust companies have included this requirement in their contracts, despite the incentive-dampening effect it is likely to have on investment advisers. c. Legal Restrictions A recent regulation, namely, Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, which took effect in February 2009,165 permitted trust companies to charge management fees and performance-based compensation by virtue of running securities investment trusts business. However, performance-based compensation can only be paid as of the termination of a trust, provided that the trust has been profitable.166 Furthermore, the fees incurred as a result of retaining third-party investment advisers should only be paid out of the management fees and performance-based compensation charged by the trust company from investors.167 This means that the investment adviser will have problems getting its incentive fees on a regular basis, as the trust company cannot get its performance-based compensation until the fund’s termination in the first place. However, if the investment adviser contributes a higher level of capital into a fund and thus gets more trust units in return, such regulatory restriction can be circumvented by paying dividends or “special trust interests” from 165. Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, supra note 25. 166. Id. art. 18. 167. Id. art. 21. time to time to the investment adviser based on its holding of trust units. In this respect, a higher level of capital contribution by the adviser as seen in many sunshine funds contracts is even necessary under the current Chinese regulatory framework. This issue will be discussed in more detail in Part III.E. 3. Covenants on Types of Investment This category of covenants serves to limit investment advisers specifically with respect to certain risky securities. Within the sunshine funds context, I identify two important types of covenants under this category, namely, restriction on types of investment and the decision power on expanding investment scope of a fund. Findings on the two types of covenants are summarized and presented in the two Tables, below. 2012] Not allowed to actively buy in derivatives on secondary markets Allowed but with certain percentage restrictions Allowed plus certain percentage restrictions if approved by the investors of the trust Restrictions on engaging in short selling/margin trading Not allowed at all Allowed, if approved by the investors of the trust Allowed, if agreed by the trust company Restrictions on investing in ChiNext168 stocks Allowed but with certain percentage restrictions Number of Funds 168. ChiNext is specially tailored to list those enterprises engaged in independent innovation and other growing venture enterprises. It was only officially launched on Oct. 23, 2009. See Samuel Shen & Fion Li, China launches second board for start-ups, REUTERS, Oct. 23, 2009, available at http://www.reuters.comarticle/2009/10/23/chine xt-launch-idUSSHA27095520091023. Restrictions on investing in the securities of related parties169 Not allowed to invest in securities of the trust company as well as the related parties thereof Not allowed to invest in securities of the companies that are related parties of the investment adviser Not allowed to engage in non-arms length transactions among other funds as managed by the same trust company and/or the investment adviser Not allowed to invest in those securities that may involve personal interests of the trust company and the investment adviser, and the managers thereof Restrictions on investing in an exchange-traded fund (“ETF”) Only trade ETF within an exchange Obligation to invest certain percent of trust assets in securities with at least “neutral” or “hold” rating 18 6 1 1 3 5 169. Note that the law does not generally prohibit related party transactions by trust companies, provided that they are carried out with fair market price and reported to the CBRC in advance on a transaction-by-transaction basis. See Measures for Administration of Trust Companies, supra note 142, art. 35. Number of Funds 1 2 13 11 2 75 4 2 2012] How can a decision of investment scope expansion be made? Investment scope not changeable All of the principals’ consent must be sought Half of the principals need to approve Sole decision by trust company but consent of investment adviser should be sought Sole decision by trust company provided that advance notice is made on its website Joint consultation and decision by the trust company and investment adviser Sole decision by investment adviser, once the trust company permits it to do so Sole decision by investment adviser In particular, Cumming and Johan’s 2006 paper finds that private equity funds in civil law countries are more likely to have covenants pertaining to the types of investment than private equity funds in common law countries.170 Since no research was presented regarding covenants in hedge fund partnership contracts, I cannot say whether their conclusion is also true within the hedge fund context by comparing the covenants from the two systems. However, one may have the impression from looking at the covenants summarized in the above two Tables that investment advisers have limited freedom in terms of the types of investments they can make. Hedge funds in developed countries usually advertise themselves as being able to make use of a wide range of sophisticated financial instruments and transactions for the purposes of delivering absolute returns. Apparently, Chinese hedge funds are far more limited in that regard. In essence, they are still at the stage of being “stock trading funds” rather than real “hedge funds.” This being said, the current cautious approach of allowing only limited types of investment is however understandable and even worthwhile, given that the Chinese capital market is a huge laboratory itself where many new things are still to be tested. It is important to note one particular point about the data presented above. Despite some variations, it is apparent that the trust company Cumming & Johan, supra note 60, at 571. plays quite a role in terms of deciding what kind of investments are to be made or not, as well as whether to allow the investment scope expansion. As already mentioned above, a trust company is more like a service provider than a de facto fund manager for the sunshine funds created under its name.171 Decisions regarding which securities to invest in, at what price to buy in or sell out, and the number to be bought in or sold out, are all made by the investment adviser and contained in a document called the “investment plan.” A trust company normally is there only to conduct a formality check upon the investment plan before executing it. It is a “formality check” in that the trust company will only refuse to carry out the investment plan if the recommendations contained in the investment plan involve investments violating the relevant legal requirements or contractual stipulations in the trust contract, or when exogenous reasons make it impossible to trade a stock as of the time of the investment plan, e.g., when that stock is suspended from trading during preparations for periodic reporting. Thus, the trust company is not there to judge whether the specific investment decisions made by the adviser in the investment plan, i.e., those regarding how, when and at what price to dispose of certain securities, are good or bad. 172 That said, a trust company does retain an important right allowing it to have a say over issues on a more general level, such as what kind of securities can a fund invest in and what kind of transactions can a fund engage in. As can be seen from the two Tables above, if an investment adviser wants to invest in risky assets, such as special treatment stocks or warrants, or deploy risky trading strategies, such as short selling, or want to have a more liberal investment scope, it is most likely that the adviser has to ask for the trust company’s permission. Therefore, compared with a manager in a classic hedge fund partnership, an investment adviser to a Chinese sunshine fund enjoys most but not full discretion in making investment decisions, and there are times that the trust company may interfere, mostly on formal and general issues. Again, the reason here relates to the liability concern of trust companies. Since their reputation and interests are on the line if the investments in risky assets lead to investors’ losses, they have the incentive to retain the power of deciding whether to allow their advisers to do so in the first place. See supra note 107 and the accompanying text. Summarized based on contracts in my sample. See also id. 2012] Covenants on Fund Operation This category of covenants covers those issues regarding the general management and operation of a sunshine fund. Some covenants shown in the Table below can also fall under the previous sub-category of investment types. Table 9, below, provides a summary of the usage of this kind of covenants in 60 sunshine funds contracts that explicitly provide information on restrictive covenants (usually in a separate section named “Investment Restrictions”). To avoid misunderstanding, I excluded covenants that deal with those restrictions already expressly stipulated in the relevant statutes.173 173. For example, there are eight funds in my sample prohibiting using the trust assets to extend loans or attach any encumbrance thereon. Such a covenant, however, is not included in Table 9 because there is an explicit statutory provision saying that trust companies shall refrain from using the trust assets for purposes other than ones stipulated in the trust contract, nor should they use trust assets to provide collateral for others. See Measures for Administration of Trust Companies, supra note 142, art. 34. 174. Such time limits are: Western Trust Cheng Nuo No.1: 14 trading days; Western Trust Mingyuan Bakelai; 14 trading days; BJITIC Tong Wei Value Increase: 15 trading days; and FOTIC Ying Rong Da No. 1: 5 trading days. 5. Limitation of Investment Adviser’s Power The last category of covenants is also unique to Chinese hedge funds. Essentially, these covenants deal with a situation where an investment adviser will lose all of its power and the trust company will take over. This could happen both in the case of a particular security in a fund’s portfolio, and in the case of the fund as a whole. The happening of the latter will directly lead to the termination of the sunshine fund. The right of a trust company to dispose securities in a fund without consulting the investment adviser is called the “special transaction right.” To be sure, this section does not lend itself to talking about the general circumstances in which a trust company has the right to terminate a sunshine fund. After all, technically it is the trust company and not the investment adviser who creates a sunshine fund; it follows that the trust company will also have a termination right. There can be a set of such circumstances where the termination will simply be a natural and logical outcome thereof. For example, the trust company can terminate a fund when all the beneficiaries (i.e., investors) decide so; when the core managers of the investment adviser leave and there is no one else to replace them; when the investment adviser cooperates with other trust companies to launch similar trust funds without obtaining prior consent of the current trust company; or when the fund is so under-subscribed that its NAV is lower than a defined minimum amount for a certain period of time. 2012] Triggers of the Special Transaction Right The situations listed Table 10, above, however, are of a different nature. In these cases, the decision of the trust company to sell a security or even to terminate a fund by selling all of the securities therein is a substantive one. The first category of triggers allows a trust company to sell certain securities if it has reason to believe that they should not be held. It encompasses, for example, the right of a trust company to sell a 175. Note that although a trust company should impose certain appropriate “alert thresholds” depending on the nature of a trust fund and the market trends, and also diligently keep track of the market on a daily basis, it is not a mandatory statutory requirement to also have a “loss-stopping threshold.” A “loss-stopping threshold” entitles the trust company to sell trust assets and stop losses for a trust fund. Whether to include a “loss-stopping threshold” clause is left to the discretion of the business parties, and if they do agree on the clause in the trust contract, the trust company should take action accordingly. See Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, supra note 25, art. 14. That said, Chinese law makes it mandatory that trust companies impose “loss-stopping thresholds” for structured trust funds, so as to limit losses for preferred class investors. See Notice of China Banking Regulatory Commission on Strengthening the Supervision of the Structured Trust Business of Trust Companies, supra note 109, art. 9. 176. This includes eight structured funds. Number of Funds 75 3 8 5 1 4 security when the investment adviser (or together with its related parties) holds more than 5% of that stock. However, this is not the real point of the special transaction right embodied in this trigger, as selling the stock to make its holding fall back under 5% is merely for legal compliance purposes, otherwise a disclosure will have to be made.177 Rather, it deals more with the situation when, for example, the market falls 3% in one day or 8% accumulatively for two consecutive days, or the value of the any stock falls under 90% of its initial cost, or trading volume of any stock doubles for two consecutive days.178 Upon the occurrence of any of these listed scenarios, the trust company will be alerted and ready take further actions, if necessary. It is no longer bound by the decisions of the investment adviser any more, even if it chooses to consult with the investment adviser first about the possible solutions. It can directly decide to sell the concerned security to stop further losses, even if the adviser wants to keep it for a longer period. As to the second category of triggers, selling thresholds (i.e., lossstopping thresholds) higher than 80% of the original NAV are mostly found within structured, as opposed to unstructured, fund contracts. The selling threshold for structured fund contracts is generally higher because investment advisers need to meet the fixed target return for their preferred class of investors, thus leading to a more acute need to limit loss than for unstructured fund contracts. Moreover, there is normally also a “capital add-in threshold” to serve as the first-step buffer before the selling threshold is reached. Therefore, a structured fund will only be terminated if the subordinated investors are not willing to contribute new capital into the fund to make up for the loss, and the fund’s NAV keeps falling toward the selling threshold. In any case, cashing out all securities and terminating a fund is a substantive right of the trust company leading to a serious outcome, as it deprives the investment adviser of the chance to reverse the losses by changing its strategy and trying again. 177. If an investor’s holdings reach 5% of the issued shares of a listed company, a disclosure must be made within three days. See art. 13, Shangshi gongsi shougou guanli banfa [Regulations on the Takeover of Listed Companies] (promulgated by the CSRC, July 31, 2006 ) (amended Aug. 27, 2008), LAWINFOCHINA, available at http://www.lawinfochina.com. 178. These circumstances are expressly stipulated in SZITIC trust contracts, and the trust company may, upon the occurrence of such circumstances, exercise its special transaction right to sell a stock without consulting the investment adviser. Trust contracts from other trust companies have similar stipulations of such circumstances. 2012] It is not hard to understand why so many trust companies choose to retain the special transaction rights. As the party signing the trust contract with investors directly, a trust company bears more risk than the investment adviser of becoming the target of a lawsuit if the fund’s losses make investors unhappy. In this sense, the existence of a special transaction rights can serve as a liability exemption or reduction disclaimer against the accusation that “the trust company has failed to fulfill its duty to monitor the investment adviser and stop losses.”179 Such disclaimer, although effectively limiting the potential liabilities that may be charged upon trust companies, comes at the cost of sacrificing investment advisers’ decision power in very important circumstances. In this sense, trust companies are not merely playing the role of transaction executors, but also the role of substantive decision makers in Chinese hedge funds. As long as trust companies are providing investment advisers with the trust platform on which to base sunshine funds, it is not likely for them to give up their special transaction rights. Industry practitioners thus would be curiously anticipating the prospective development of limited-partnershiporganized hedge funds, especially in terms of their potential to overcome the inherent shortcomings (such as special transaction rights) of trust-organized ones. E. COMPENSATION Since sunshine funds are based on trusts, the compensation mechanisms in their contracts also have some unique aspects that reflect this fact. In simple words, the fixed and flexible fees paid by investors of a fund are shared between the investment adviser and the trust company, with the former taking a larger portion. The following two Tables summarize some important features of compensation 179. Such an accusation was raised by investors in a lawsuit against SZITIC, as a result of the huge losses (more than 60%) of Xinpeng No. 1, a sunshine fund created under its name. See Dan Youwei, Huarun xintuo yu kehu duibu gongtang: cheng Xinpeng 1 qi bucunzai qizha [SZITIC Responded on the Lawsuit Brought by Its Clients: We Did Not Defraud on Xinpeng Trust Contract], SHANGHAI ZHENGQUAN BAO [SHANGHAI SECURITIES NEWS], Dec. 2 2, 2009 , available at http://news.hexun.com/20 09-12-22/122110286.html. mechanisms of 82 sunshine funds in information on fees and compensation. my sample that provided * The numbers in the Table might not add up to 82 because in some cases, the specific proportion of split is not given. ** This proportion is only applicable during the first year of the fund. Afterwards, the proportion is changed into 17%/3%. See the contract of SZITIC Hengda Tonghui No.1. *** The two columns of fixed fees should be read separately from each other. They are sorted from low to high under each column, but the numbers in the same row are not related to each other, e.g., the 0% and 0.5% in the first row does not mean a 0%/5% split of fixed fees between adviser and trust company. Flexible Fees: Investment Adviser / Trust Company Combination = 20% 12% / 8% 15% / 5% 16% / 4% 17% / 3% 17.5% / 1.5% 18% / 2% 18.5% / 1.5% 20% / 0% Combination > 20% 19% / 3%** 20% / 2% 30% / 0% 35% / 0% 67 1 3 1 37 1 3 4 17 5 1 2 1 1 1% Number of Funds 11 24 1 2 12 5 2 2 Fixed Fees: Trust Company*** 0.50% 2% Number of Funds 4 1 1 1 1 2012] Table 12 Usage of High Water Mark (N=78) Usage of High Water Mark Typical high water mark, with hurdle rate Typical high water mark, no hurdle rate Hurdle rate, no high water mark Revised or no high water mark, no hurdle rate Difference between the NAV of the compensation payment day and the purchase price of trust units Flexible fees paid yearly, based on the difference of the NAV of year end between the NAV of year beginning Difference between the NAV of the current compensation payment day and the NAV of the last payment day Highest historical NAV during the past 12 months Number of Funds 2 65 3 8 2 1 1 4 Similar to the typical hedge fund industry practice, the performance-based flexible fees in Chinese sunshine funds also largely cluster at 20%. However, what is different is that the 20% needs to be split between the investment adviser and the trust company, and the most frequently seen proportion of such a split is 17% to the investment adviser and 3% to the trust company. Fixed management fees are also split; however, if adding the investment adviser’s portion with the trust company’s portion, the sum does not cluster at 2%. As shown in Table 11, above, the level of fixed management fees charged by trust companies is generally at a higher level than that charged by investment advisers. The usage of a high water mark is also identified as a prevalent practice among sunshine funds. A high water mark is defined in most contracts as the highest historical NAV; it has been used in a few contracts with twists to this meaning to make the conditions of compensation payouts less stringent, as shown in Table 12, above. As already mentioned in Part III.D.2, a regulation that took effect in February 2009 introduced into the industry some very strange legal requirements. According to that regulation, performance-based compensation can only be paid as of the termination of a trust provided that the trust remains profitable.180 Furthermore, the fees incurred as a result of retaining third-party investment advisers should only be paid See supra note 166 and the accompanying text. out of the management fees and performance-based compensation charged by the trust company from investors. 181 Such requirements might be well-meant. For example, it may be that the regulatory authorities do not want investors to bear the obligation of paying sunshine funds managers (trust company and investment adviser) on a periodic basis, when the NAV of these funds can be so volatile182 that, in the end, investors will only earn nominal returns compared to the accumulated amount of fees they have paid out. They may also have gotten the inspiration from the compensation mechanism of private equity funds, which normally require general partners to return part or all of the capital committed or invested by limited partners before they can share the 20% carried interests.183 Moreover, it is interesting to note that certain changes have been evolving among hedge funds as a result of the shock to the industry brought about by the 2008 financial crisis. According to Job Search Digest’s 2010 Hedge Fund Compensation Report, many funds are contemplating a new form of partnership with their LPs in exchange for money being locked in for a longer period of time.184 For this purpose, they will, among other things, charge the incentive fee in two or threeyear rolling cycles as opposed to the current norm of annual or semiannual payment. In this respect, the hedge fund industry’s compensation structure is also partially converging toward that of the private equity industry.185 Although making perfect sense within a private equity context where long-horizon investments and lack of liquidity are the norm, the arrangement that carried interest is only payable upon the investors’ recoupment of their contributed capital might not be an ideal solution to incentivizing hedge funds managers. Hedge fund incentive fees are often viewed as having option-like characteristics.186 Incentive fees are earned 181. See supra note 167 and the accompanying text. 182. Indeed, it has been submitted that Chinese hedge funds in general still lack the ability to maintain a relatively stable level of high returns. Rather, their NAV curves are quite volatile, which is also a result of the high volatility of the Chinese stock market. See Zhang, Reward for Reputation, supra note 150. 183. TOLL, supra note 151, at 51. 184. Job Search Digest, The 2010 Hedge Fund Compensation Report 11 (2010) (on file with author). 185. Id. 186. See, e.g., Carl Ackermann et al., The Performance of Hedge Funds: Risk, Return and Incentives, 54 J. OF FIN. 833, 840 (1999); see also William N. Goetzmann et 2012] when the fund’s performance exceeds a high-water mark, which is analogous to a call option with the high-water mark as the strike price. Managers are incentivized to work hard and keep the fund value above the high-water mark in order to assure that their incentive options will finish in the money.187 However, if they can only exercise their options at the end of the game, but not periodically throughout the life of the fund, their incentives are dampened. Opportunistic fund managers may fail to manage their funds diligently until they approach the end of their terms. For example, if they lose money during a certain period, they may feel a less urgent need to adjust their trading strategy to stop the losses and recoup some of their losses as soon as possible, as they will not be rewarded even if they indeed manage to make money for the next period and there is enough time to try out before the end of fund term anyway. Alternatively, they could choose to comfortably maintain a conservative trading strategy so that they can secure a modest compensation at the termination. Either way, it is unlikely that fund managers will constantly exert their best efforts to maximize the net asset value when running the fund. This is apparently not in the best interest of the investors. Different from private equity, the primary focus of hedge funds on active short term trading of public securities requires fund managers to actively monitor the market and work consistently to trade in and out; otherwise many money-making or loss-stopping opportunities may be missed in the blink of an eye. In this respect, the one-time-at-termination compensation system may work poorly despite its well-meant intention. Regardless of the real motive for regulators to impose such apparently strange requirements, the rules are already promulgated and industry players should comply. It would thus be natural to predict that funds created as of February 2009, the effectuation date of the Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, should have complied by changing the language of their compensation clauses to allow payment of flexible fees only upon termination. This is because performance-based compensation can only al., supra note 33, at 1687; James E. Hodder & Jens Carsten Jackwerth, Incentive Contracts and Hedge Fund Management, 42 J. FIN. & QUANTITATIVE ANALYSIS 811, 812 (2007). 187. Hodder & Jackwerth, supra note 186. be paid at the termination of a profitable trust pursuant to the regulation. 188 However, a look at the contracts in my sample— recognizing the limited nature of the sample 189 —does not seem to support such a prediction. Only one unstructured fund190 out of the 55 fund contracts that (a) were dated prior to or in February 2009 and (b) contained information on trust company and/or investment adviser compensation stipulated for compensation payment upon termination. After this cut-off point, only two unstructured funds191 out of 27 fund contracts that were (a) dated after February 2009 and (b) contained information on trust company and/or investment adviser compensation stipulated for compensation payment upon termination.192 Given such an apparently low rate of compliance with the February 2009 regulations, one may wonder what strategies trust companies and investment advisers might have crafted to adapt to the unfavorable legal requirements. As far as my sample shows, four strategies can be identified. . 1. Temporarily No Performance-Based Compensation; to be Resumed if Allowed by Law in the Future The point of this strategy is that once the ban is lifted by a new law and the fund managers (trust company and investment adviser) are 188. See supra notes 165-67. 189. See supra Parts III.A, III.B for a discussion of the limitations of the sample. The reader is reminded that the sample consists of unexecuted documents obtained from online sources, and that the sample covers approximately one-sixth of the sunshine funds listed in the Go-Goal database as of August 9, 2010. 190. I only refer to unstructured funds here because structured fund fees are normally paid at termination with or without the 2009 regulation in place, given that these funds normally only have less than five years of life by their design anyway, see supra note 124. The name of this unstructured fund is Western Trust Cheng Nuo No. 1. 191. The two funds are: CRTrust Xin Lan Rui No. 2 and XMITIC Puer Qilin. 192. Among the 27 funds, there is one fund, namely, SZITIC Tong Wei No. 1, that did not seem to adopt any particular strategy to mitigate against unfavorable regulations. Arguably, I would not consider this a case of non-compliance, because the fund was officially set up in March 2009. Normally, it would take some time before fund managers could raise enough capital from investors and then officially set up a fund. Therefore, the March establishment of SZITIC Tong Wei No. 1 very likely shows that the trust documents were already executed by investors earlier than February 2009, thus making the regulation not applicable to the fund. 2012] allowed to charge fees periodically again, the new fees to be charged then will be substantially raised to make up for the previous loss of fees. This strategy has been adopted by one fund.193 2. Trust Companies’ Fixed Fees and Flexible Compensation Combined Together and Called “Trust Management Fee”; Investment Advisers’ Flexible Incentive Fees Received as “Special Trust Interests” Although this strategy sounds like a “words game,” it has been employed by seven funds.194 The rationale behind this strategy is quite straightforward. Previously, trust companies’ compensation was usually expressed as consisting of two portions, namely, a fixed fee (in most cases 1%) and a performance-based compensation (in most cases 3%, as shown in Table 11, above). Since the requirement in the 2009 regulation only limits the payment of performance-based compensation and not the fixed part,195 the limitations can be circumvented if the trust company is only going to receive a fixed fee and not flexible one. As such, what these seven funds did was to increase the level of the fixed management fee, effectively covering the flexible fee. The investment adviser will share with the trust company the fixed fee, without charging a performance-based “fee” in exchange for its “investment advisory services.” What it will receive is the so-called “special trust interest” as a result of its identity as the “special beneficiary” of the sunshine fund. There is usually one clause at the very beginning of fund contracts that requires fund investors to agree to appoint the investment adviser as the “special beneficiary.” This appointment, coupled with the fact that an investment adviser is usually required to contribute and hold at least 10% of the fund’s capital, will fortify its right to receive “special trust interests.” These trust interests are special in that they are paid more frequently, such as monthly or quarterly, are paid based on high water mark, and are paid prior to the receipt by normal investors of their “ordinary trust interests.” Essentially, this arrangement resembles the 193. This fund is called Ping An Fortune Tong Wei No. 1. 194. These seven funds are: SZITIC He Ying Fine Selection No.1, SZITIC Zhi Cheng No. 2, No. 3, No.4 and No. 5, SZITIC Hengda Tonghui No. 1, and FOTIC Steady Value Increase (Yongsheng Huiyuan). 195. See supra note 166 and accompanying text. old incentive-based fees, but adapts to the regulatory change by using a different structure. It is worth pointing out that, although the “special trust interests” arrangement looks more sophisticated than the idea of an “encompassing management fee,” it is actually not new to Chinese hedge funds. As far as I can see in my sample, the earliest contract adopting a “special trust interests” arrangement is PureHeart China Growth I Fund, established in May 2006 by Ping An Trust. The earlier two funds managed by the same investment adviser, including China’s very first hedge fund, PureHeart Fund, established in February 2004 by SZITIC, used the direct wording of “performance-based compensation.” It is not clear at this point why the third fund managed by the same adviser used different treatment on this issue than its previous two counterparts. A reasonable deduction may be that the name “special trust interest” sounds milder to investors and fits better into the “trust” context. After all, the hedge fund business was and still is novel in China, and Chinese investors might find it difficult to accept that someone can share as much as almost 20% of their profits simply by providing “investment advice” to their trustee. Regardless, such an arrangement apparently worked to mitigate the impact of the 2009 new regulation on China’s hedge fund industry; otherwise the consequences might have been much more severe. A related interesting finding is how this arrangement has been made more sophisticated alongside the development of sunshine funds. A typical variation to the original “special beneficiary” treatment would give an investment adviser the status of a “principal” of the trust, where it is appointed as the “representative of all principals” by all the other investors by entering into the contract. As such, the trust company has the obligation to consult and listen to the “principals’ representative” in managing the fund, and the investment adviser thus receives its “special trust interest” based on such status and work. 3. Trust Company Designated Together with Investment Adviser as Special Beneficiary to Share Special Trust Interests The third alternative is based on a similar rationale as the second one but the twist is elsewhere. Under this strategy, investors designate both the investment adviser and the trust company as the special beneficiaries of the sunshine trust fund. Since special trust interests can be paid much more frequently as long as the fund’s new profits exceeds 2012] its high water mark, this solves the problem posed by the 2009 new regulation that a trust company is only able to receive its flexible compensation as of fund termination. Two funds have adopted this strategy.196 4. Flexible Fees Payable Upon Investors’ Redemption This is a partial compliance strategy, but nonetheless based on reasonable grounds. After all, the trust company and investment adviser will not be able to get their fees if their investors have already left the fund by redemption. This strategy has been adopted by two funds.197 With these strategies adopted by Chinese sunshine funds, as discussed above, it is no longer a mystery why the compliance rate for the “flexible compensation payment upon fund termination” requirement, as stipulated in the regulation promulgated in 2009198 is so low at first sight. Chinese hedge funds emerged by borrowing from foreign experience, but they grew with their own characteristics from the very first day. They have shown remarkable competence to overcome unfavorable regulatory limitations and find new ways for further development of the business. Of course, it remains to be seen how the regulatory authorities will react to these apparent circumvention strategies of sunshine funds, and, more generally, how Chinese regulatory authorities are going to define their role in the regulation of hedge funds. New and interesting findings may be generated by further research when the industry is more mature structurally and when the regulatory framework is more developed. CONCLUSION While the hedge funds industry is already a trillion dollar business in the developed world, it is still in its infancy stage in China. Organized as trusts, Chinese hedge funds take drastically different business forms than LPs, making it more difficult for researchers to understand them. This is a very interesting area that has not been researched thoroughly, These two funds are: CITIC He Ju No. 1, and CITIC He Ying No. 1. These two funds are CQITIC Chuan Shi No. 1, and ZRTrust Hun Dun No. 2. See supra notes 165-67. and this article is, to my knowledge, the first research exploring the contractual arrangements of Chinese hedge fund agreements. Using 139 contracts and explanations of trust plans of sunshine funds collected by hand based on the list of securities investment trusts provided by Go-Goal database, this article analyzed the structure, covenants, and compensation mechanisms of sunshine funds. They have been organized as trusts primarily because private fund managers cannot legally pool capital from investors, and a trust was thus far the most appropriate platform offered under the Chinese regulatory framework for that purpose. As the article demonstrates, on the one hand, sunshine funds do have similar contractual arrangements as typical LP-organized hedge funds, such as charging, on top of a fixed management fee, a performance-based compensation, which also largely cluster at 20%. On the other hand, they are also undeniably different from LP-organized hedge funds, due to jurisdiction-specific characteristics of China. The most crucial difference is the involvement of the trust company in the fund. Normally, it is merely a transaction executor responsible for carrying out investment orders from the investment adviser. The trust company also shares with the investment adviser a small portion of performance-based compensation in exchange for such services to the fund. However, because relying on trust companies has been the only practical way for Chinese hedge fund managers to conduct the business, and trust companies are the real contractual parties signing the trust contracts with investors, investment advisers also need to accept certain conditions that are much more stringent than mere profit sharing, such as a higher level of fund manager capital contribution and narrowed decision making power. Typically, an investment adviser (de facto manager) to a sunshine fund in China is required to contribute or hold at least 10% of the fund’s total assets. If a fund fails to perform well, the trust company retains the power to sell all of the fund’s assets and terminate the fund without consulting with the investment adviser. Although harsh and even incentive dampening, these Chinaspecific covenants and arrangements in sunshine funds contracts are unlikely to be eliminated as long as trust companies remain involved. This is because trust companies require some measures to protect their pecuniary interests and reputational capital from being hurt as a result of acting as a direct contractual party with investors. Moreover, given the deep-rooted influence of civil law tradition and that hedge funds are still mostly unheard of, Chinese investors may find it difficult to accept certain highly contractual arrangements. Rather, they would prefer 1. Frank Partnoy & Randall S. Thomas, Gap Filling , Hedge Funds, and Financial Innovation, in BROOKINGS-NOMURA PAPERS ON FINANCIAL SERVICES , 23 ( Yasuki Fuchita & Robert E. Litan eds., 2007 ), available at http://ssrn.com/paper=931254. 2. Houman B. Shadab , Coming Together After the Crisis: Global Convergence of Private Equity and Hedge Funds , 29 NW. J. INT'L L . & BUS . 603 , 608 ( 2009 ). 3. Hedge Fund Standards Board , The Hedge Fund Sector: History and Present Context, HFSB .ORG, http://www.hfsb.org/sites/10109/files/what_is_ a_hedge_fund . pdf (last visited Nov. 4 , 2010 ). 27. JOSEPH G. NICHOLAS, INVESTING IN HEDGE FUNDS , REVISED AND UPDATED EDITION 16-17 ( 2005 ). 28. Id . at 39. See also Jacob Preiserowicz, supra note 15 , at 811. 29. Id . at 40. 30. NAVENDU P. VASAVADA , TAXATION OF U.S. INVESTMENT PARTNERSHIPS AND HEDGE FUNDS: ACCOUNTING POLICIES , TAX ALLOCATIONS , AND PERFORMANCE PRESENTATION 5 ( 2010 ). 31. Simon Friedman , Partnership Capital Accounts and Their Discontents , 2 N.Y.U. J.L. & BUS . 791 , 798 ( 2006 ). 32. See Victor Fleischer , Two and Twenty: Taxing Partnership Profits in Private Equity Funds , 83 N.Y.U. L. REV. 1 ( 2008 ) ; see also Friedman, supra note 31 . OF CORPORATE & FINANCIAL LAW 37 . Douglas J. Cumming & Na Dai , A Law and Finance Analysis of Hedge Funds, 39 FIN . MGMT. 997 , 1001 ( 2010 ). 38. Id . at 1001-1003. 39. See Cumming & Dai, supra note 37. 40. Id . 41. See MCCAHERY & VERMEULEN, supra note 35, at 172. 42. Josh Lerner & Antoinette Schoar , The Illiquidity Puzzle: Theory and Evidence from Private Equity, 72 J. FIN. ECON. 3 , 7 ( 2004 ). 43. Douglas Cumming & Uwe Walz , Private Equity Returns and Disclosure Around the World , 41 J. INT'L BUS. STUD . 727 , 728 ( 2010 ). 44. Ludovic Phalippou & Oliver Gottschalg , The Performance of Private Equity Funds, 22 REV. FINANC. STUD . 1747 , 1750 ( 2009 ). 48. See id. at 470. 49. See id. at 488. 50. Id . at 496. 51. Id . at 464. 52. Id . at 493. 53. See Daniel Schmidt & Mark Wahrenburg, Contractual Relations Between European VC Funds and Investors: The Impact of Bargaining Power and Reputation on Contractual Design (Risk Capital and the Financing of European Initiative Firms , Working Paper No. 8 , 2004 ), available at http://www2.lse.ac.uk/fmg/research/RICAFE /pdf/RICAFE-WP08-Schmidt.pdf. 54. Id . 55. Id . at 3-4. 56. Id . at 4. 161. See Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, supra note 25, art . 22 . 162. See Measures for Administration of Trust Companies, supra note 142, art . 10 . 163. Josh Lerner & Antoinette Schoar , Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity , 120 Q.J. ECON. 223 ( 2005 ). 164. Id . at 223.


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Jing Li. Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds, Fordham Journal of Corporate & Financial Law, 2018,