China’s new fund custodian rules

On 10 July 2020, the China Securities Regulatory Commission (the CSRC) and the China Banking and Insurance Regulatory Commission (the CBIRC) jointly issued a revised version of the Measures for the Administration of Securities Investment Fund Custody Business (《证券投资基金托管业务管理办法》) (the Revised Measures), following public consultation earlier in May and June this year.

The amendments in the Revised Measures mainly cover the following aspects:

• allowing PRC branches of foreign banks to apply for custody qualification for securities investment funds. The applicable financial eligibility requirements such as net assets can be calculated on the basis of the overseas head office of the bank and accordingly, the head office shall bear relevant responsibilities;
• promoting centralised management of the fund custody business and refining the ongoing compliance requirements for fund custodians;
• streamlining the administrative procedures. The application materials for the custody qualification will be simplified and the approval process will be enhanced, allowing fund custodians to commence the substantive preparatory work for their custody business subsequent to obtaining approval for their applications; and
• consolidating and unifying the regulations that govern the custody business of commercial banks and other financial institutions.

To obtain a fund custodian licence, no matter for servicing publicly offered funds (retail funds) or privately offered funds (private funds), the requirements in the Revised Measures shall be satisfied. However, in the absence of black letter rules, the compliance requirements in the Revised Measures are not mandatorily applicable to the private fund industry, but would be referenced by fund managers or custodians during the legal documents negotiation and operations.

The Revised Measures set out the general duties and obligations of fund custodians from the perspectives of custody, settlement and clearing, valuation, disclosure and reports, investment supervision and review of distributions as well as governance. It is important to note that, the custodian under Chinese law bears a legal duty of a co-trustee. Therefore, in addition to custody, the custodian also bears many other unique responsibilities and seem to have very wide powers. We have revisited these points from an angle that may be of an interest to private fund managers.

Custody of fund assets

The Securities Investment Fund Law of the PRC has a sweeping provision requiring fund custodians to keep fund assets in safe custody. The Revised Measures, after laying down some basic principles such as separation of clients’ assets from each other and from that of the custodian itself, reserve room for parties to agree on their duties and obligations contractually. In practice, exchange-traded securities are usually deposited with the accounts opened with the relevant exchange, and consequently fund custodians would usually wish to explicitly exclude these kind of assets from their safekeeping scope through the fund contract/custody agreement.

Under the Revised Measures, fund custodians shall keep the accounting documents, transactions records, fund contract and other material documents for at least 20 years. This rule will equally apply to commercial banks and other financial institutions. Previously, commercial banks were required to keep the aforesaid documents for only 15 years whilst 10 years for other financial institutions acting as the fund custodian.

Settlement and clearing

Similarly, the Revised Measures allow for the fund managers and custodian to agree through the fund contract each party’s duty in the fund settlement and clearing process. It is important to note that the fund manager should take into account all of its brokerage documentation and ensure those arrangements with various brokers should be reflected in the fund contract and be honoured by the custodian. For example, the private fund manager will reply upon the custodian to act on any manager’s instructions on transfer of funds including transfer instructions on posting margins. If the private fund manager has a need to meet margin calls during a short time period under any of its brokerage agreements, it needs to request the custodian to act, through the fund contract/custodian agreement, within the given short time period.

Valuation

After the fund manager completes a valuation, the fund custodian bears the duty to verify and to prompt the fund manager to rectify and report if a wrong valuation is spotted.

The CSRC issued the Guiding Opinions in 2017 (Guiding Opinions) for the valuation of retail funds, for example, when there is an at least 0.25% difference between the verified amount and the previously calculated one, it would be considered a wrong valuation and such error shall be reported to the CSRC. Fund managers may delegate to a service provider (eg fund administrator) to carry out the valuation. However, the fund managers shall not be relieved from the relevant liabilities.

According to the Guiding Opinions, such rules may be applied mutatis mutandis to private funds, subject to the discretion of the parties. Based on our observations, many fund custodians incline to include similar provisions in the fund contracts so as to hold the fund managers/fund administrators liable to the fullest extent, but the details of the valuation process and allocation of liabilities are always negotiable.

Disclosures and reports

Under the Revised Measures, fund custodians shall disclose certain custody related matters according to the relevant laws and the stipulations agreed by the parties, including but not limited to verifying the regular reports of the fund prepared by the fund manager and issuing written opinions on a regular basis, issuing the mid-term and annual custodian reports, and notifying the fund of the change of the fund custodian’s representative officer.

Investment supervision

Unlike in other jurisdictions, fund custodians under Chinese law, in their capacity of a co-trustee, have a general obligation to “supervise” the manager’s investment activities and, if discovering a breach on the part of the manager, report to financial authorities “in a timely fashion”.

To ensure that the fund manager’s power of making investment decisions would not be improperly interfered with and overly wide:

• the fund contract should limit the fund custodian’s supervision power to specific matters and to be exercised in a passive way. For instance, a fund custodian will only review the fund manager’s investment orders to see whether there is any violation of the specified investment scope, applicable investment limitations or stop-loss mechanisms; and
• in case that the manager violates any said investment restrictions, it is advisable to request a time period to cure before the custodian exercises its right/obligation to report to Chinese regulators. Specifically the fund custodian shall firstly notify the fund manager for rectification, and only when it constitutes a severe violation of law and the fund manager fails to correct it within the specified time limit, the fund custodian will report to the regulator.

Review of distribution of proceeds

Under the Revised Measures, fund custodians shall regularly examine the distributions of proceeds, to ensure that all distributions are made in conformity with the fund contract. Therefore needless to say it is important to establish clear calculation and payment of performance fees on investment proceeds, on both realised (through dividend and redemption proceeds) and unrealised (payable on a regular performance fee calculation day) basis.

Convening of the fund unit holders meeting

The Revised Measures require that a fund custodian shall bear the duty to convene the Fund Unit Holders Meetings in the case where the fund manager fails to do so. Since 2018, there have been heated discussions on whether such requirement shall be similarly applied to private funds. As of now, most fund custodians still try to refrain from assuming the responsibility, at least at the contractual level, to convene the Fund Unit Holders Meeting and getting too involved in the governance of the fund.

Summary

In China’s market, managers now have increasing leverage which have resulted in a more competitive market for custodians. The Revised Measures would allow for a private fund manager to use their global custodian in China locally. It also allows for the manager and the custodian to agree through the fund contract on their responsibilities and risk allocations (save for their mandatory duties set forth under the law).