Allocation of risks between the PFM and distributor further regulated

CSRC, the regulator of China securities and fund market, has recently issued the Administrative Measures on the Supervision of Public Securities Investment Fund Distribution Agencies and relevant implementation rules (collectively the Fund Distribution Measures). The Fund Distribution Measures, starting to take effect on 1 Oct 2020, will revise the current regulations on fund distributor's licensing requirements and the compliance and regulatory matters during its daily operations. Although the name of the Fund Distribution Measures suggests that its scope of application is limited to publicly offered funds, the provisions in the Fund Distribution Measures which concern fund distribution activities and internal compliance apply to the distribution of private securities investment funds as well.

Third party distributors (eg commercial banks, securities companies and insurance companies) has long been one of the key players in fund distributions in China, given their broad access to end customers.

However, for quite some time the risk and responsibilities of a fund distributor was not clearly defined at either the regulatory or judicial level. The regulator has for the first time, via the Fund Distribution Measures, begun to add more clarity to the role of a fund distributor and more heavily regulate the charge of the commissions. On the judicial level, the Supreme Court has also clarified the liabilities that should be borne by a fund distributor. We have thus summarised below the recent regulations on distribution fees and risk allocations.

Distribution service fee

There are two common approaches for fund distributors to charge distribution fees, as follows:

1. a one-time subscription fee, to be deducted from the total investment amount of the investor at the time of subscription (the Subscription Fee Approach); and

2. a client maintenance fee or distribution service fee, regardless of what it is called, to be paid regularly and on the basis of the "maintained" AUM/holdings sourced by the distributor (the Trailing Commission Approach).

In practice, the trailing commission can be disclosed to the investors charged out of the fund assets directly or, if operating as a share of the management fee, not disclosed in the fund contract. Having it paid out of the management fee by the fund manager was the prevalent approach. Under the Fund Distribution Measures, fund distributors shall disclose in writing to the investors before subscription regarding the trailing commission, so that the investors can gain a full understanding of the distribution fee arrangement between the fund manager and distributor.

In addition, the Fund Distribution Measures places a cap on the trailing commission, ie, the amount of trailing commission charged by the distributor may not exceed 30% of the management fee with respect to an institutional investor, and 50% in the case of an individual investor. This is to respond to the current prevailing situation in China market that the trailing commission could occupy as high as 70%-80% of the management fee especially for small or medium sized managers and, furthermore, sometimes the distributor also asks for a share of the performance fees. CSRC's move to cap the fee is regarded as an attempt to direct the distributor's focus to carrying out the suitability test based on the risk profile of the product and investors' risk tolerance, from dwelling on the distributor's share of the management fee (and even performance fees).

Risk and liability allocation

In China, private fund investing in securities usually take the contractual form, and the distribution agreement is executed between the fund manager and the distributor. This means that there exists no contractual relationship between the distributor and the investor. Therefore, if any disputes arise between the distributor and the investor, for example, the distributor introduced the investor to invest in a fund with risks higher than what the investor could bear, it was very difficult for the investors to hold the fund distributor liable without any direct legal obligation imposed on the distributor.

The Fund Distribution Measures allocates an entire section to the provision of obligations on the part of the fund distributors to conduct a suitability assessment, risk disclosures, prevention of conflicts of interest etc, which provides a profound basis to hold fund distributors accountable from the regulatory perspective.

Judicially, the National Civil Commercial Trial Work Meeting Minutes (the Meeting Minutes) issued by the Supreme Court of China in December 2019, specifies the situations where the investors may directly seek legal redress from fund distributors (which are usually giant financial institutions with enough resources to compensate the investors). According to the Meeting Minutes, where investors suffer losses due to the inept performance of the investor suitability assessment by the manager or the distributor, the investor may request either the manager or the distributor to bear the relevant liability and pay compensation.

Given that fund distributors could be held accountable for its misconduct, would the fund manager be exculpated from the relevant liability? We believe, in terms of the compensatory liability for the investors, it is not impossible for the manager to be exculpated if it can prove that the distributor acted beyond the scope of its authority as agent of the principal. This is because the Meeting Minutes refers to Article 167 of the General Rules of the Civil Law (now called the Civil Code) as the legal basis for the aforesaid vicarious liability of the fund manager and the distributor. Article 167 stipulates that "Where an agent knows or should have known that the object of the mandate is illegal but still performs it, or the principal knows or should have known that an agent's performance is illegal but fails to raise any objection, the principal and the agent shall be jointly and severally liable."

On the other hand, regulatorily, under the rules of AMAC (the de facto fund regulator in China), the responsibilities of the fund manager may not be fully discharged by the engagement of a distributor. That is to say, even if the fund manager is not held by the court to be vicariously liable for the investor's loss, AMAC may still take disciplinary actions against the fund manager through avenues such as issuing a warning or an order to rectify. However, we believe a clear division of responsibilities between the fund manager and the distributor in the distribution agreement could help reduce the fund manager's liability. This is also demonstrated by the Fund Distribution Measures which requires the parties to stipulate in the distribution agreement on the division of responsibilities with respect to continual service to the investors and client due diligence work.

To conclude

The Fund Distribution Measures imposes a cap on the fee that distributors may charge fund managers, and further emphasises the distributor's responsibilities for its activities, aiming to protect the investors and fund managers. To minimise the potential liability that fund managers could face as a result of the distributor's misconduct, we suggest requesting for clear division of liabilities and proper exculpation and indemnification terms when negotiating with fund distributors.