Venture Capital Law in China 1108423558, 9781108423557

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VENTURE CAPITAL LAW IN CHINA

China’s venture capital market is not just the world’s largest and fastest developing market, it also has the unique distinction of being engineered through heavy governmental intervention. This book breaks new ground by examining and testing established legal theories regarding the law of venture capital through the lens of the Chinese venture capital market. Using a hand-collected dataset of venture capital agreements, interviews with practitioners, and Chinese court judgments, it provides a comprehensive and insightful analysis of the Chinese venture capital market from the legal perspective. Topics covered include the roles of law and governmental intervention in developing the market, the state of investor protection, unique contractual developments, and exits of venture capital investments. By providing an in-depth comparative analysis against the American venture capital market, it provides critical context and makes the Chinese venture market accessible. It is an invaluable resource for venture capital scholars, policymakers, and practitioners. Dr Lin Lin is an assistant professor at the Faculty of Law, National University of Singapore. She specialises in corporate law, corporate finance, alternative investments, and Chinese corporate law. She has held visiting appointments at Stanford, Oxford, and Melbourne. She practised corporate and securities law prior to entering academia.

c am br i d g e un i v er s i t y p r es s International Corporate Law and Financial Market Regulation Corporate law and financial market regulation have major implications for how the modern economy is organized and regulated and for how risk is managed and distributed – domestically, regionally and internationally. This Series seeks to inform and lead the vibrant scholarly and policy debate in this highly dynamic area by publishing cutting-edge, timely and critical examinations of the most pressing and important questions in the field. Series Editors Professor Eilis Ferran, University of Cambridge. Professor Niamh Moloney, London School of Economics and Political Science. Professor Howell Jackson, Harvard Law School.

VENTURE CAPITAL LAW IN CHINA LIN LIN National University of Singapore

University Printing House, Cambridge CB2 8BS, United Kingdom One Liberty Plaza, 20th Floor, New York, NY 10006, USA 477 Williamstown Road, Port Melbourne, VIC 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 79 Anson Road, #06–04/06, Singapore 079906 Cambridge University Press is part of the University of Cambridge. It furthers the University’s mission by disseminating knowledge in the pursuit of education, learning, and research at the highest international levels of excellence. www.cambridge.org Information on this title: www.cambridge.org/9781108423557 DOI: 10.1017/9781108528795 © Lin Lin 2021 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2021 A catalogue record for this publication is available from the British Library. ISBN 978-1-108-42355-7 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

To Xudong, Yuexin, Yide, and my parents

CONTENTS

List of Figures page viii List of Tables ix Preface and Acknowledgements List of Abbreviations xiv

xi

1 An Introduction to the Venture Capital Market in China 1 2 Venture Capital Fundraising 3 Venture Capital Investing 4 Venture Capital Exits

44 143

213

5 Lessons from China and Ways Forward Appendix – List of Chinese Legislation Index 338

vii

305 323

FIGURES

1.1 New VC commitments against new VC funds 2006–2018 (RMB 100 million) page 7 1.2 Timeline of PE and VC regulation in China 24 1.3 Regulatory framework of PE and VC in China 27 2.1 Typical structure of a limited partnership-type VC fund in China 2.2 Examples of dual GP structures 82 2.3 Government Guidance Funds in China (2006–July 2019) 95 4.1 China’s multi-layered capital markets 223 4.2 Current IPO review process 236 4.3 IPO process of the STAR market 237

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TABLES

1.1 The evolving regulatory framework of PE and VC in China page 29 2.1 Different types of business forms used for newly raised VC funds in China (2012–2017) 49 2.2 Limited partnerships in China and Delaware: a comparison 57 2.3 Different types of VC funds in China: a comparison 64 2.4 Percentage of capital raised by LPs in China’s VC and PE market (by investable amount) (2011–2017) 68 2.5 Percentage of types of limited partners in China’s VC and PE market (by number) (2011–2017) 71 2.6 The development and evolving regulatory framework of GGFs in China 95 2.7 Amount of foreign and domestic VC funding: number of foreign VC funds and RMB funds, as well as the annual amount raised by the respective types of funds (2008–2018) 107 4.1 Number of exits via IPO, M&A, and share transfer for VC-backed companies, as well as the corresponding amount of new capital committed to VC funds in China (2006–2018) 218 4.2 Number of exits via IPO and M&A for VC-backed companies, as well as the corresponding amount of new capital committed to VC funds in the United States (2004–2018) 219 4.3 China’s stock markets: a comparison 225 4.4 Investor eligibility for China’s stock markets 240 4.5 Information disclosure in China’s stock markets 244 4.6 Key Chinese IPOs in NYSE or NASDAQ in 2018 251 4.7 Illustration of relative shareholding and voting power 266

ix

PREFACE AND ACKNOWLEDGEMENTS

The inspiration for this book stemmed from designing and teaching three courses at the Faculty of Law of the National University of Singapore (NUS): Alternative Investments; Private Equity and Venture Capital: Law and Practice; and Chinese Commercial Law. The importance of China’s venture capital market has grown as rapidly as its size. It is now the fastest growing and second largest market in the world. However, there is no academic textbook focussing on the law and practice of venture capital in China. Furthermore, China’s venture capital market has the unique distinction of being one of very few engineered venture capital markets in the world. Despite the immense potential for research, there remains little literature on the role of law and governmental intervention in developing the Chinese venture capital market. This lack of material has been compounded by the difficulty of accessing source materials in Chinese and a general unfamiliarity with Chinese bureaucracy. The fast pace of regulatory change and market development in China adds a further element of complexity for anyone seeking to study and understand the Chinese venture capital market. This book seeks to fill the gap in the literature by providing sophisticated and systematic case studies of China’s venture capital market, examining how China created the world’s second largest venture capital market within a short period of time, analysing how the growth of a venture capital market may be sustained, and illustrating the lessons which may be extracted from this crucial, but yet to be completely studied, experience from China. It also aims to break new ground by examining and testing established legal and economic theories and assumptions regarding venture capital through the lens of the Chinese venture capital market. Relying on my professional experience in China, the United States, and Singapore, this book provides a critical examination of the extensive hand-collected data set and reveals the special characteristics of the Chinese venture capital market and the peculiar legal problems within the Chinese market. Adopting a comparative xi

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preface and acknowledgements

perspective between China and the United States, this book aims to make the Chinese venture capital market accessible for all scholars, policy makers, and practitioners. I have been assisted by a large number of people in writing this book. I have had the privilege of discussing the issues covered in this book with my learned colleagues in my home faculty, the NUS Faculty of Law, including Hans Tjio, Wee Meng Seng, Dan Puchniak, Umakanth Varottil, Wang Jiangyu, Lim Wee Kuan Ernest, Christian Hofmann, Michael Ewing-Chow, Tan Zhong Xing, and Hu Ying. I am immensely grateful to Simon Chesterman, Damian Chalmers, David Tan, Ho Hock Lai, Tan Yock Lin, Dora Neo, Sandra Booysen, Stephen Phua, Lan Luh Luh, Teo Keang Sood, Swati Jhaveri, Gary Bell, Loi Kelry, and Yeo Hwee Ying for their invaluable advice, encouragement, and support. I have also benefitted from the fresh views shared by many cohorts of very bright students who have challenged and taught me more than I have imparted to them. I am also thankful for the opportunity to glean insights from conversations and interviews with a large number of practitioners working in this field, including especially Sir Robin Saxby, Alex van Someren, He Weiping, Zhang Ping, Zou Jing, Ma Lingjun, Tang Jieren, Dong Yutao, Han Li, Tian Hongfei, Ding Xinyan, Shao Jun, Guo Junhui, Lin Li, Chen Shu, Shao Yubing, Kang Qiuning, Chen Jingyuan, Wang Ruoxi, Lu Liwei, Li Rui, Wu Di, and Xu Kaixi. I am grateful to Zhu Jinwen, Walter Wan Weiqi, and Tan Yann Xu for their research assistance. I deeply appreciate the rigorous review and unanimous approval by the thirteen referees, comprising ten anonymous readers and the three series editors of the Cambridge University Press (Eilis Ferran, Niamh Moloney, and Howell Jackson). I would like to thank Stanford University, the University of Oxford, the University of Chicago, University College London, Peking University, Tsinghua University, the University of Hong Kong, National Taiwan University, China University of Political Science and Law, Southwest University of Political Science and Law, East China University of Political Science and Law, the University of International Business and Economics, and Sun Yat-sen University, where I presented or wrote parts of this book. My deepest thanks go to Ronald Gilson, William Bratton, Joseph Grundfest, Michael Klausner, Paul Davies, John Armour, Luca Enriques, Jennifer Payne, Emilios Avgouleas, Iris Chiu, William Hubbard, Curtis Milhaupt, Joseph McCahery, David Donald, Dirk Andreas Zetzsche, Erik P.M. Vermeulen, Zenichi Shishido, Zheng Yongnian, Chen Kang, Yu Xingzhong, Zhang Wei, Zhu Ciyun, Liu

p r e f a c e an d a c k n o w l e d g e m e n t s

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Yan, and Guo Li for the insightful and incisive comments that they shared with me. This project would not have been possible without the support from the Singapore Ministry of Education Academic Research Fund Tier 1. Finally, my deepest thanks go to my parents, husband, and my two wonderful children for their unconditional love and tremendous support during this project. This book is dedicated to them. I have endeavoured to state the law as of 1 June 2020.

ABBREVIATIONS

AGM AIC AIGF AMAC CBIRC CBRC CIETAC CIRC CPC CSRC DARPA DCS DRULPA EFG EJV FOF GDP GEM GGF GP HKEx ICO ILPA IPO IRR JSC LBO LLC LP LSE M&A MOF MOFCOM

annual general meeting Administration for Industry and Commerce Angel Investment Guidance Fund Asset Management Association of China China Banking and Insurance Regulatory Commission China Banking Regulatory Commission China International Economic and Trade Arbitration Commission China Insurance Regulatory Commission Communist Party of China China Securities Regulatory Commission Defense Advanced Research Projects Agency dual-class share Delaware Revised Uniform Limited Partnership Act Shanghai Technology Entrepreneurship Foundation for Graduates equity joint venture fund of funds gross domestic product Growth Enterprise Market government guidance fund general partner Hong Kong Exchanges and Clearing Market initial coin offering Institutional Limited Partners Association initial public offering internal rate of return joint stock company leveraged buyout limited liability company limited partner London Stock Exchange merger and acquisition Ministry of Finance Ministry of Commerce

xiv

list of abbreviations NASA NASDAQ NDRC NEEQ NSSF NVCA NYSE NZVIF OTC PBOC PE P/E ratio PEL PRC QFLP RDA RMB ROFR RQFLP SASAC SAFE SBIR SCSC SCGC SGX SME SME Board SOE SSE STA STAQ STAR Market SVCIGF SZSE UK ULPA UPA US USD VAM VC VIMA WFG

xv

National Aeronautics and Space Administration National Association of Securities Dealers Automated Quotations National Development and Reform Commission National Equities Exchange and Quotations National Social Security Fund National Venture Capital Association New York Stock Exchange New Zealand Venture Investment Fund over-the-counter People’s Bank of China private equity price-to-earnings ratio Partnership Enterprise Law People’s Republic of China Qualified Foreign Limited Partner regionally decentralised authoritarianism renminbi right of first refusal RMB Qualified Foreign Limited Partner State-owned Assets Supervision and Administration Commission State Administration of Foreign Exchange Small Business Innovation Research Securities Committee of the State Council Shenzhen Capital Group Co. Ltd Singapore Exchange small and medium-sized enterprise Small and Medium-sized Enterprise Board state-owned enterprise Shanghai Stock Exchange State Taxation Administration Securities Trading Automated Quotation Science and Technology Innovation Board State Venture Capital Investment Guidance Fund Shenzhen Stock Exchange United Kingdom Uniform Limited Partnership Act Uniform Partnership Act United States US dollar valuation adjustment mechanism venture capital Venture Capital Investment Model Agreements Wagnisfinanzierungsgesellschaft

1 An Introduction to the Venture Capital Market in China

1.1 The Engineering Problem Venture capital (VC) is widely recognised as a powerful engine that can drive a nation’s innovation, job creation, knowledge economy, and economic growth.1 Governments around the world, such as Germany,2 Australia,3 Japan,4 Israel,5 Chile,6 Taiwan,7 and Singapore,8 have tried to

1

2 3

4

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6 7

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See J. Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed – And What to Do About It (New Jersey: Princeton University Press, 2009), Chapter 3. R. J. Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’, Stanford Law Review, 55(1067) (2003), 1068–1107. On the importance of VC, see generally P. A. Gomers and J. Lerner, The Money of Invention: How Venture Capital Creates New Wealth (Cambridge, MA: Harvard Business Review Press, 2001); Marco Da Rin et al., ‘The Law and Finance of Venture Capital Financing in Europe: Findings from the RICAFE Research Project’, European Business Organisation Law Review, 7 (2006), 525–547. See R. J. Gilson, supra note 1, at pp. 1094–1096. See ‘The Treasury and the Department of Industry, Innovation, Science, Research and Tertiary Education of Australia, Review of Venture Capital and Entrepreneurial Skills’ (2012), available at http://ict-industry-reports.com.au/wp-content/uploads/sites/4/2013/ 09/2012-Venture-Capital-and-Entrepreneurial-Skills-DIISRTE-Dec-2012.pdf. See Zenichi Shishido (2009) ‘Why Japanese Entrepreneurs Don’t Give Up Control to Venture Capitalists’, online: SSRN, http://bit.ly/2w8JrdA. See R. J. Gilson, supra note 1, at p. 109. See also J. Lerner, supra note 1. (New Jersey: Princeton University Press, 2009). See R. J. Gilson, ibid., at p. 1098. Christopher J. Gulinello ‘Engineering a Venture Capital Market and the Effects of Government Control on Private Ordering: Lessons from the Taiwan Experience’, George Washington International Law Review, 37(4) (2005), 845–883. L. Lin, ‘Venture Capital in Singapore: The Way Forward’, Journal of Business Law, 5 (2019), 363–387.

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develop their VC markets.9 Empirical studies show that many governmentled programmes have not been particularly successful.10 It is in this context that China’s efforts stand out: over three decades, China has created the world’s second largest VC market in terms of annual VC investment,11 after the United States (US). Against the more moderate results achieved elsewhere, China’s success is especially prominent considering that it has surpassed the US in terms of the amount of VC investments raised by startups12 and number of unicorns,13 despite the relative youth of its market. The key challenge for governments seeking to engineer a VC market is ensuring the simultaneous availability of three factors – a challenge that Gilson termed the ‘simultaneity problem’.14 The first factor is investment capital. Venture capitalists provide a special type of capital for earlystage, high-growth, high-risk, and often technology firms that need capital to finance their development.15 Because of venture capitalists’ appetite for high-risk, high-return investments and because of the managerial skills, technological background, and industrial connections that they can offer to start-ups, VC plays an important role in commercialising cutting-edge science and innovation.16 The second factor is the availability of specialised financial intermediaries that serve as the ‘nexus of a set of sophisticated contracts’ and that are able to incentivise the venture capitalists and entrepreneurs in a VC cycle.17 There are two major contracts that place financial intermediaries between venture capital and start-ups.18 The first contract arises at the 9

10 11

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13

14 15 16

17 18

L. Lin, ‘Engineering a Venture Capital Market: Lessons from China’, Columbia Journal of Asian Law, 30(1) (2017), 160–220, at p. 162. See generally J. Lerner, supra note 1. R. J. Gilson, supra note 1, at p. 1070. See Pitchbook Data,‘PitchBook Analyst Note: Venture Capital in China’ (15 March 2019), online: Pitchbook, https://pitchbook.com/news/reports/1q-2019-pitchbook-analyst-note -venture-capital-in-china See Jason D. Rowley, ‘Chinese Startups Lead US Rivals In 2018 Venture Race’ (17 October 2018), online: Crunchbase, https://news.crunchbase.com/news/chinese-startups-lead-usrivals-in-2018-venture-race/?utm_source=twitter&utm_medium=organic&utm_campaign= crunchbase-news&utm_content=chinese-startups-lead&fbclid=IwAR1Q-A_7GjPfSOdNAH EVo5nlsycThAMyTP1GiSt0VKmc0InxOTteV4mJ6mk See Hurun Research Institute, ‘Hurun Global Unicorn List 2019’ (21 October 2019), online: Hurun Report, www.hurun.net/EN/Article/Details?num=A38B8285034B. R. J. Gilson, supra note 1, at pp. 1076–1078 and 1093. Ibid., at p. 36. Ibid., at p. 1068. See also, J. Lerner, supra note 1, at pp. 181–182 (emphasising the importance of a large domestic market with investors willing to take risks with younger firms in the development of a VC market). Ibid., at pp. 1069 and 1093. Supra note 9, at p. 166.

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fundraising stage between the investor and the VC fund/venture capitalist, which is typically organised in the US and China as a limited partnership.19 This contract alleviates the agency costs between the investor and venture capitalists and incentivises the latter through mechanisms such as fixed-term, mandatory distributions, and structuring of the venture capitalists’ compensation.20 The second contract arises between the VC fund/venture capitalist and the portfolio company.21 This contract addresses the uncertainty, information asymmetry, and agency costs between the VC fund and entrepreneurs and incentivises both participants through mechanisms such as staged financing, allocation of control to the fund, structuring of the entrepreneur’s compensation, and incentivised exit.22 The ‘braiding’ of the two contracts enhances the efficiency of both contracts in respect of incentivising exit of VC investments and constraining VC funds from engaging in opportunistic behaviour against entrepreneurs.23 The third essential factor for creating a national VC market is the availability of entrepreneurs. Gilson assumes that the supply of entrepreneurs is the ‘sole function’ of the availability of capital and specialised financial intermediaries.24 In his view, by providing funding through the right contractual vehicle, government can encourage a supply of entrepreneurs,25 and increase the willingness of highly skilled managers and engineers to work in entrepreneurial environments.26 These elements of the ‘simultaneity problem’ are not to be taken in isolation, but must emerge simultaneously. For example, if there is no capital available for high-risk businesses, entrepreneurs would not emerge to form such businesses, and intermediaries could not identify the best of those entrepreneurs and channel investment funds to them.27 In addition, there are other determinants in engineering a VC market, including the fundamental technological innovation in the economy, the presence of liquid and competitive stock markets for VC to exit, the degree of protection provided to intellectual property rights, as well as the presence of ‘agglomeration economies’ in the region with the presence of professionals 19 20 21 22 23 24 25 26 27

Ibid. R. J. Gilson, supra note 1, at pp. 1087–1090. Supra note 9, at p. 166. R. J. Gilson, supra note 1, at pp. 1078–1087. Ibid., at pp. 1091–1092. Supra note 9, at p. 166. R. J. Gilson, supra note 1, at pp. 1102–1103. Supra note 9, at p. 167. R. J. Gilson, supra note 1, at p. 1093.

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such as lawyers and accountants who are able to lower the transaction costs associated with forming and financing start-ups.28 There is a cultural dimension as well – Japan, for example, has a shortage of young entrepreneurs, which is in part due to parental pressure.29 Gilson attributes the success of the American VC market in solving the simultaneity problem to private ordering,30 and explains that it was the ‘idiosyncratic’ history of the US VC market that encouraged the simultaneous emergence of entrepreneurs, investors, and financial intermediaries, which collectively incentivised all the parties in the VC cycle.31 However, his view of the development of the American VC market may be contrasted with other more government-centric accounts of how this market developed. Josh Lerner’s account of the development of the US VC market states that ‘the government played a critical role in shaping Silicon Valley’.32 ‘[P]ublic subsidies – particularly during the two world wars – catalysed growth in Silicon Valley and shaped its critical features.’33 Mariana Mazzucato also found that ‘[P]revious missionoriented policies were those driven by military or national security motives (such as those behind the origin of Defense Advanced Research Projects Agency (DARPA) in the US Department of Defense or NASA) . . . ’34 Government-led programmes in the US, such as the Small Business Innovation Research (SBIR) programme, have supported the development of tech firms by taking on capital-intensive risks long

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30 31 32 33 34

See Paul Alan Gompers and Joshua Lerner, The Venture Capital Cycle (Cambridge, MA: MIT Press 2004), at pp. 316–317. Elise Hu, ‘A Startup Scene That’s Not So Hot: Japan’s Entrepreneur Shortage’ (7 May 2015), online: NPR, www.npr.org/sections/alltechconsidered/2015/05/07/404376767/ a-startup-scene-thats-not-so-hot-japans-entrepreneur-shortage. The cultural aspect is, by its very nature, multifaceted; suffice to say even foreign entrepreneurs find it difficult to set up businesses in Japan, due to the various hoops one has to jump through (i.e. in Japan the process of obtaining start-up visas or opening corporate bank accounts is complicated and multi-staged). See further in Masumi Koizumi, ‘Japan Wants Foreign Entrepreneurs, but What’s Missing?’ (25 November 2019), online: the Japan Times, www .japantimes.co.jp/news/2019/11/25/business/japan-foreign-entrepreneurs/#.Xl -4pagzbIU. However, it is difficult to offer a convincing cultural explanation without sufficient and reliable data, and this book will not address culture elements in detail. R. J. Gilson, supra note 1, at p. 1069 and p. 1093. Ibid. J. Lerner, supra note 1, at p. 34. Ibid., at p. 41. Mazzucato and Penna, ‘Beyond Market Failures: The Market Creating and Shaping Roles of State Investment Banks’, Levy Economics Institute, Working Paper No. 831, at p. 43.

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before they were viable businesses.35 Some of America’s most dynamic companies, including Apple, Intel, Chiron, and Compaq, have benefitted by the support of these federal programmes while they were privately held.36 These competing accounts raise the question of whether it is possible for governments to successfully engineer VC markets. International experience reveals that resolving the simultaneity problem is not an easy task.37 Some government programmes and policies in other jurisdictions that seek to provide capital to the VC market failed because they could not adequately respond to the three fundamental problems inherent in VC financing: uncertainty, information asymmetry, and agency cost.38 For example, Germany’s Deutsche Wagnisfinanzierungsgesellschaft (WFG)39 was unable to effectively incentivise venture capitalists to invest. This was because the German government provided a guarantee and insured up to 75 per cent of WFG’s losses and because profits were limited by the entrepreneur’s call option.40 Nevertheless, some government programmes such as the Israeli Yozma programme41 and New Zealand’s Venture Investment Fund 35

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37 38 39

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The SBIR programme provided over $13 billion to small high-technology firms between 1983 and 2003. See supra note 28, at p. 309. See Ibid. See also Pierre Bienaimé, ‘This Chart Shows How The US Military Is Responsible For Almost All The Technology in Your iPhone’ (30 October 2014), online: Business Insider, https://www.businessinsider.com/the-us-military-is-responsible-for-almost-allthe-technology-in-your-iphone-2014-10 (noting that there is little in Apple’s devices, for example, that did not owe its existence in some way to the US Department of Defense). Supra note 9, at pp. 166–168. See J. Lerner, supra note 1. Deutsche Wagnisfinanzierungsgesellschaft translates roughly to ‘German Venture Financing Fund’. R. J. Gilson, supra note 1, at p. 1094 N. 66, citing Ralf M. Becker and Thomas F. Hellmann. ‘The Genesis of Venture Capital: Lessons from the German Experience’, in Vesa Kanniainen and Christian Keuschnigg (eds.), Venture Capital, Entrepreneurship, and Public Policy (Cambridge, MA: The MIT Press, 2004). Martin Selter and Thomas Pruever (2015). ‘Liquidity Meets Perspective: Venture Capital and Start-ups in Germany 2015’, VC Trends Initiative By EY, online: EY, https://go.ey.com/2tljvd8. See also R. J. Gilson, supra note 1, at pp. 1094–1097. As of 2013, the average VC investment in Germany stands at merely €780,000, compared to €6,000,000 in America. See ‘A Slow Climb’, The Economist, 3 October 2013, online: http:// econ.st/1sYYdea. WFG proved a failure due to the form of interference undertaken by the government: capital allocation was determined by WFG’s board committee, which was largely composed of bureaucrats. Further, WFG personnel were not incentivised to provide technological or management assistance (that usually comes packaged with VC investment) to portfolio companies due to the restriction on profits accruing to WFG. See R. J. Gilson, supra note 1, at pp. 1094–1099. See R. J. Gilson, supra note 1, at pp. 1097–1099.

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(NZVIF)42 have achieved a certain degree of success.43 This can be traced to differences in programme design. For example, unlike the WFG, the Israeli Yozma programme avoided making investment decisions, allowing these to be made by investors, and required no guarantee against loss.44 Accordingly, investments were made by highly incentivised fund managers who bore the investment’s risk and possessed the control rights to directly monitor the portfolio companies.45 As this book will discuss, China has adopted a unique approach to address the simultaneity problem. China’s VC market did not emerge from the interplay of market forces alone, but was, from its inception in the 1980s, a creature of governmental design. Specifically, the government issued various policies to facilitate the development of the VC market in order to encourage innovation and technological development, and to develop the country’s labour-based economy into a knowledge-based economy. The Chinese experience is valuable in helping to evaluate the potential of various regulatory approaches to the VC market. China offers a fascinating case study of how a VC market is developed, having nurtured one of the fastest developing and largest engineered markets in the world.46 Before 1985, China did not have a VC market;47 yet three decades of development has allowed China to rank as the second largest market in terms of annual global VC investment. As can be seen from Figure 1.1, the amount of newly raised VC as well as the number of new VC funds being established in China have been steadily increasing throughout the years from 2006 to 2018. Despite the fact that a decline in both the 42 43

44 45 46

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J. Lerner, supra note 1, at pp. 132–133. World Bank studies have also confirmed the role of governmental intervention in igniting innovation in emerging markets in Europe and Central Asia, stating that ‘the government plays a special role in promoting start-ups to generate new activities and support sustainable job creation because of the high risk that deters the entry of new ventures and the high failure rate once such ventures are established’. See Goldberg, Itzhak; Goddard, John Gabriel; Kuriakose, Smita; Racine, Jean-Louis, Igniting Innovation: Rethinking the Role of Government in Emerging Europe and Central Asia. World Bank, https://openknowledge.worldbank.org/handle/10986/2358, at p. 33. See R. J. Gilson, supra note 1, at p. 1097. Ibid. Anette Jönsson, ‘Venture Capital Continues to Flow into Chinese Startups’, The Wall Street Journal, 28 April 2015, online: www.wsj.com/articles/venture-capital-continues-toflow-into-chinese-startups-1430244889. ‘Venture Capital Soars and Investor Expectations Follow’, Nikkei Asian Review, 18 February 2016, online: Nikkei, http://asia .nikkei.com/Politics-Economy/Economy/Venture-capital-soars-and-investorexpectations-follow; Lucinda Shen, ‘China is the Biggest Venture Capital Firm in the World’, Fortune, 9 March 2016, online: http://for.tn/2tZyM0S. Supra note 9, at pp. 160–161.

an introduction

7 1,125

900 3,000.00

675 2,000.00 450

Number of New Funds

Amount of Newly Raised VC (RMB100Mil)

4,000.00

1,000.00 225

08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18

20

20

20

07

0 06

0.00

Source: Zero2ipo Amount of Newly Raised VC (RMB100Mil)

Number of New VC Funds (Total)

Figure 1.1 New VC commitments against new VC funds 2006–2018 (RMB 100 million)

number of funds and the volume of fundraising was experienced in the period of 2012 to 2013, and more recently in 2018, this does not detract from the clear upward trend.48 These successes come despite the ineffectiveness of private ordering in China,49 as demonstrated by weak investor protection50 and lack of judicial 48

49

50

The declines in 2012–2013 and 2018 could have been due to macro factors such as the economic slowdown in China (during 2012–2013), the US–China trade war (which has been ongoing since 2018), and the tightened regulations on fundraising in China. See generally Jiangyu Wang, ‘China: Legal Reform in an Emerging Socialist Market Economy’, in E. Ann Black and Gary F. Bell (eds.), Law and Legal Institutions of Asia: Traditions, Adaptations and Innovations (Singapore: Cambridge University Press, 2011); Donald Clarke, Peter Murrell and Susan Whiting, ‘The Role of Law in China’s Economic Development’, in Loren Brandt and Thomas G. Rawski (eds.), China’s Great Economic Transformation (Cambridge, England: Cambridge University Press, 2008). See generally Nicholas C. Howson and Vikramaditya S. Khanna, ‘The Development of Modern Corporate Governance in China and India’, in Muthucumarasawamy Sornarajah and Jiangyu Wang (eds.), China, India, and the International Economic Order (Singapore: Cambridge University Press, 2010) (on investor protection).

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independence.51 As of February 2020, a total of 28,681 private equity (PE) funds and 8,269 VC funds have registered with the Asset Management Association of China (AMAC), the asset under management by all registered VC funds has reached a total value of RMB 1,217.071 billion,52 and a total of 14,937 PE and VC fund managers have been registered with AMAC.53 Although VC is increasingly regarded as an important component of the Chinese economic landscape, little is known about the regulatory and policy measures employed by China and the real impact of such regulatory and policy measures. This book will explore the engineering of China’s national VC market from the legal perspective, consider the current concerns about the continued growth of the market, and illustrate the lessons, which may be extracted from this crucial but as yet incompletely studied experience. In particular, the book will answer the following key questions: 1. How did China create the world’s second largest VC market within such a short period of time? 2. Are there any lessons of general applicability which may be extracted from China’s VC story? 3. What are the ways forward for China’s VC market?

1.2 The Concept of ‘Venture Capital’ in the Context of China The concept of VC was first debated in China in 1985, in the central government’s Decision to Reform the Science and Technology System.54 The term ‘venture capital’ was initially reflected as ‘risk capital (fengxian touzi)’ in the official documents to reflect the ‘high-risk’ nature of this 51

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53 54

See generally Jianfu Chen, Chinese Law: Context and Transformation (Netherlands: Martinus Nijhoff Publishers, 2008), Chapter 4, at pp. 147–170. AMAC Data, ‘私募基金行业数据’ (Data on the Private Equity Industry), February 2020, online: AMAC, https://www.amac.org.cn/researchstatistics/datastatistics/privategrave fundindustrydata/. Ibid. CPC Central Committee, 13 March 1985, ‘关于科学技术体制改革的决定’ (The Decision to Reform the Science and Technology Systems) (No. 6 [1985] of the CPC Central Committee) (China). Prior to these developments and before the launch of the open-door policy and economic reform (gaige kaifang) in 1978, the legacy of the planned economy was such that all decisions regarding production and investment were embodied in a plan formulated by the government. Consequently, there were no private enterprises in China, let alone start-ups, entrepreneurship, or venture capital.

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investment method. In order to encourage entrepreneurship and innovation, several government agencies, including the National Development and Reform Commission (NDRC) and the Ministry of Science and Technology, began instead to use the term ‘entrepreneurial capital (chuangye touzi)’ in the text of their regulations.55 Today, most Chinese professionals understand ‘VC’ to be a subset of PE, and this understanding is consistent with international practice.56 VC usually refers to investment in high-growth, high-risk, and often high-technology firms that need capital (in the form of equity instead of debt) to finance product development or growth.57 It usually entails heavy involvement in advising the management of each company which is invested in, while most of these companies are not profitable in the short term. Although VC and PE share many similarities (e.g. similar legal structures, incentive schemes, and investors), there are major differences in the behaviour of firms involved in the respective activities, among other things. For instance, VC and PE invest in different types and sizes of companies. While VC generally focusses on early-stage, high-risk, and high-technology companies, PE invests in virtually every industry, especially later-stage companies.58 VC generally does not include restructuring or leveraged buyout financing whereas it is more common for PE firms to acquire an existing or mature firm from its current owners.59 These differences are sometimes glossed over in the Chinese market. Due to the youth of the Chinese VC industry and the lack of differentiation between VC and PE in Chinese regulations, the understanding of VC amongst investors remains limited. As a result, the term ‘venture capital’ is commonly confused with ‘private equity’.60

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58 59 60

Li Junchen, ‘感悟涅槃：中国风险投资和非公开权益资本的崛起’ (The Rise of China’s Venture Capital and Private Equity) (Beijing: Tsinghua University Publisher, 2007), Chapter 1(2). My interviews with lawyers, legal counsels, and venture capitalists indicate that their understanding on venture capital is consistent with the international definition of venture capital (on file with author). Tom Nicholas stresses (i) there is heavy involvement and advising of each invested company, (ii) most investments are not profitable, but (iii) a few produce ‘long-tail’ or ‘hockey stick’ -shaped returns making the activity profitable. See Tom Nicholas, VC: An American History (Cambridge, MA: Harvard University Press, 2019). Ibid. See R. J. Gilson, supra note 1; see also Becker and Hellmann, supra note 39. My interviews with lawyers, legal counsels, and venture capitalists indicate that individual investors do not have a clear idea on the difference between PE and VC (on file with author).

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The number of VC firms which strictly invest in the VC sector but not the PE sector is much smaller than reported.61 Many existing Chinese VC firms arose with the boom of the capital market and have limited experience in the VC industry.62 A large number of local venture capitalists were investment bankers prior to entering the VC market and hence do not possess sufficient engineering expertise or market track records relative to their counterparts in the US.63 Local individual investors also tend to be more conservative than American investors in making investments. Some of these Chinese investors are more inclined to make investments in later-stage portfolio companies in traditional industries to achieve quicker returns, rather than take chances with high-risk and potentially long-term investments into start-ups.64 Further, unlike a typical VC cycle in the US, which usually lasts for seven to ten years, the average cycle in some Chinese VC firms is shorter at about five to seven years.65 In recent times, the boundary between VC and PE has become increasingly blurred. Many VC firms that used to invest in early-stage start-ups, having had to cope simultaneously with fundraising difficulties following the 2008 global financial crisis as well as investors’ expectations for higher returns, have become more inclined to invest in later-stage matured companies, especially pre-initial public offering (IPO) companies, to gain quick returns.66 Meanwhile, recent government efforts in building up a multi-layered capital market framework, coupled with the rapid development of the mobile internet industry, have motivated traditional PE firms to shift their investment preferences from later-stage and preIPO companies to early-stage companies.67 Significantly, the phrase used to reflect the industry trend in China has changed from ‘quanmin PE’ (meaning ‘everyone invests in the PE industry’ particularly in 61

62 63

64 65

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67

Telephone interview with Mr A (anonymity requested), Vice President, Chengwei Capital, on 12 November 2015. For the number of registered PE funds and VC funds in China, visit AMAC website: www.amac.org.cn/researchstatistics/datastatistics/ privategravefundindustrydata/ Ibid. L. Lin, ‘The Private Equity Limited Partnership in China: A Critical Evaluation of Active Limited Partners’, Journal of Corporate Law Studies, 13(1) (2013), 185–217, at p. 200. Ibid., at pp. 187 and 192. The cycle for RMB funds is generally shorter than that of USD funds. Telephone interview with Mr Tian, Partner, iVision Ventures, on 20 June 2020. See Zhou Ming, ‘PE与VC投资双双后移’ (PE and VC investments both shift to later stages), China Securities Journal, 17 March 2008. See ‘新三板持续火爆的PE/VC大举进入掘金’ (The Booming of the New Third Board), China Securities Journal, (17 January 2015).

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2010–2011) to ‘quanmin VC’ (meaning ‘everyone is keen on VC investment’) since 2014.68 The recent regulatory rules made by the AMAC have helped to sharpen the distinction between VC and PE funds. First, fund managers have to clearly state whether a fund is a VC fund or PE fund at the time of registration. AMAC has also differentiated between the investment objectives that each type of fund can engage in.69 AMAC specifies that the main purpose of VC funds is to make equity investments in unlisted start-up companies with potential for high growth.70 The new class of ‘growth funds’ are regarded as VC funds if they are not involved in investments in companies listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange.71 The focus of this book is on the VC market and not on PE, generally. However, both markets share many similarities, and Chinese laws and regulations often do not clearly distinguish between the two. Hence, where necessary, this book will also touch on relevant issues in the PE market. It must be noted that the VC funds in China can be divided into funds denominated in renminbi (RMB) – RMB funds, and funds denominated in US dollars (USD) – USD funds. The fundraising and operations of these two kinds of fund are very different. USD funds are subject to specific investment restrictions and requirements under Chinese law. Unless specified in this book, this book will focus on RMB funds.

1.3 The Desirability of a Venture Capital Market in China The importance of a national VC market is widely accepted by governments around the world.72 The VC market provides ‘a unique link between finance and innovation, providing start-ups and early-stage firms – organisational forms particularly well-suited to innovation – with capital market access that is tailored to the special task of financing 68

69

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Yu Tian Er, ‘长江国弘投资合伙人李春义: ‘全民PE到全民VC是时代产物 ’ (Everyone PE to Everyone VC is the Result of the Era), PE Daily, 3 December 2014, online: https:// www.briankreed.com/m/news/374595. See ‘中基协在资产管理业务综合报送平台’ (Asset Management Business Electronic Registration System (‘AMBERS’)), AMAC, online: AMAC, https://ambers.amac.org.cn/ cas/login?service=https://ambers.amac.org.cn/web/. For this purpose, companies listed on the National Equities Exchange and Quotations (NEEQ, known as the New Third Board) are not regarded as listed companies. Han Kun Law Offices, 中国私募基金监管蓝皮书 (Private Equity Regulations in China), 2nd version (Han Kun Law Offices, 2018), at p. 9. See J. Lerner, supra note 1, at pp. 63–64, pp. 312–313.

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these high-risk, high-return activities’.73 Extensive literature has proved that encouraging technological innovation and developing the VC market can serve as a key contributor to the development of high-technology start-ups, which in turn is a key component of achieving sustainable economic growth.74 Developing a VC market is high on the agenda of the Chinese government for three major reasons: first, to satisfy the demand for capital from start-ups, and small and medium-sized enterprises (SMEs); second, to meet the supply of investors and entrepreneurs; and third, to re-chart the economic development of the nation.75

1.3.1 Satisfying Demand for Capital The financing challenge facing entrepreneurs and start-ups is common in many countries. On one hand, entrepreneurs rarely have the capital to see their ideas to fruition and must rely on outside financiers. On the other hand, it is difficult for these young entrepreneurs to receive financing from traditional financing sources such as bank loans, due to the characteristics of these start-up firms (i.e. uncertainty, asymmetric information, the lack of tangible assets). In China, the growth of start-ups and SMEs has long been constrained by a substantial capital gap. First, China’s stock markets are unable to serve as viable exit channels for VC investors. This has a direct impact on the investment behaviour of VCs, who generally provide funding to portfolio companies before they can fund themselves. If VC investors cannot exit their investments comfortably, then they will be less willing to undertake the risk of investing in promising start-ups, as their ability to profitably liquidate their interest in those companies would be in question. There are various issues affecting the ability of China’s stock markets to serve the needs of the VC industry. Apart from dealing with the prohibitively high costs and long waiting times (caused by the approval system) involved in an IPO, start-ups and SMEs, by virtue of their youth or size, also face difficulties in meeting the stringent listing requirements set by the two Main Boards.76 Moreover, unlike state-owned enterprises (SOEs), 73 74 75

76

R. J. Gilson, supra note 1, at p. 1068. See J. Lerner, supra note 1, at pp. 306–307. Developing science and technology was one of the ‘Four Modernisations’ set forth by Premier Zhou Enlai in 1963, and enacted by Deng Xiaoping from 1978, to modernise the four fields of ‘agriculture, industry, national defense, and science and technology’. L. Lin, ‘Venture Capital and the Structure of Stock Markets: Lessons from China’, Asian Journal of Comparative Law, 12(1) (2017), 1–40, at p. 17.

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which are able to receive low-interest loans from state-owned banks (in part due to financial repression),77 private companies face enormous difficulties in securing bank loans in China.78 Such problems faced in securing debt financing are exacerbated for start-ups, which typically have insufficient collateral to offer as security. Meanwhile, the number of businesses in China has been increasing rapidly, particularly after a streamlining of the business registration process in 2014, spearheaded by the enactment of the revised Company Law of the People’s Republic of China (PRC),79 as well as the business regulatory reforms.80 From January to September 2015, a total of 3.16 million new companies were registered, a 19.3 per cent rise over the same period in the previous year.81 In Beijing’s Zhongguancun district, the so-called Chinese Silicon Valley, an average of seven new companies were registered every minute from March 2014 to May 2015.82 This inadvertently contributed to a high demand for VC as an important means of start-up financing. Such a demand is appositely complemented by venture capitalists’ appetite for high-risk, high-return 77

78

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82

McKinnon was among the first economists to theorise and analyse the effect of ‘financial repression’. It is a term that describes measures by which governments channel funds from the private sector to themselves as a form of debt reduction. The overall policy actions result in the government being able to borrow at extremely low interest rates, obtaining low-cost funding for government expenditures. These measures are ‘repressive’ because they disadvantage savers and enrich the government. His 1973 book Money and Capital in Economic Development laid the foundation for the conceptualisation of financial development theory. Later in 1993, McKinnon outlined the policy progression necessary for financial liberalisation in his book The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy (2nd edition), which provided great guidance for economic reforms in countries with a planned economy, including China. See Lan Yuping, ‘风险投资可有效解决融资难’ (Venture Capital Can Effectively Solve the Problem of Capital Financing of Small and Medium-sized Enterprises), International Financing, 8 September 2010. Standing Committee of the National People’s Congress, 27 October 2005, ‘中华人民共和 国公司法(2005修订)’(Company Law of the People’s Republic of China (2005 Revision)) (Order No. 42 [2005] of the President, 1 January 2006). China has significantly improved its ranking on the World Bank’s index on the ease of doing business after constant regulatory reforms. See World Bank, News Release, ‘Doing Business 2020: China’s Strong Reform Agenda Places it in the Top 10 Improver List for the Second Consecutive Year’, online: www.worldbank.org/en/news/press-release/2019/10/24/doingbusiness-2020-chinas-strong-reform-agenda-places-it-in-the-top-10-improver-list-forthe-second-consecutive-year Xinhua, ‘China’s New Companies Surge 19.3% in Q1-Q3’, China Daily Asia, 15 October 2015, online: www.chinadailyasia.com/business/2015-10/15/content_15329850.html. Zhang Lulu, ‘China’s Startup Boom: 7 New Firms Every Minute’, China.Org.Cn, 9 June 2015, online: www.china.org.cn/business/2015-06/09/content_35775291.htm.

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investments, and their ability to provide access to industrial connections and managerial skills. Moreover, China’s innovation and IT infrastructure has been greatly improved after the launch of various state programmes promoting science and technology, such as the 985 Programme83 and the Torch Programme launched in 1988.84 As of December 2018, there were more than 4,849 technology incubators supporting a large number of start-ups.85 In 2019, China saw 1,401,000 invention patent applications, with 453,000 of them being authorised.86 The importance of VC is further exemplified by the fact that many of today’s Chinese internet giants that have assumed macroeconomic significance and influence, such as Sina,87 Sohu,88 and Alibaba,89 were former recipients of VC backing in their early days.

1.3.2 Meeting the Supply of Investors and Entrepreneurs On the supply side, the number of high-net-worth individuals and families is increasing, generating large amounts of available capital for the VC industry. As of 2019, China had the second largest population of high-net-worth individuals in the world (1,993,005), holding a combined wealth of USD 3.763 trillion.90 Increased economic prosperity and the recent internet boom have also helped to attract investors into the VC sector. Moreover, the government 83

84

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87 88 89

90

Project 985 was launched in 1998 by the PRC Ministry of Education, and it was aimed to develop world-class universities. The Torch Plan was launched in 1988 as a guiding plan for the development of high-tech industries. OCN (Shenzhen Chinese Investment Consultation Co., Ltd.), ‘2020–2024 In-depth Research and Investment Forecast Report of the Chinese Technology Incubator Industry’ (Shenzhen: OCN Publishing, 2020), online: www.ocn.com.cn/reports/1368keji fuhuaqi.shtml. National Intellectual Property Administration of the PRC, News Release, ‘2019 Intellectual Property Key Data Release: Main Indications of Steady Progress, Improvements to the Qualities and Benefits of Intellectual Property’ (15 January 2020), online: www.sipo.gov.cn/zscqgz/1145388.htm; Aaron Wininger, ‘Chinese Patent Filings Drop 9% in 2019’ (14 January 2020), online: National Law Review, online: www .natlawreview.com/article/chinese-patent-filings-drop-9-2019. Sina is one of the largest Chinese online media companies for Chinese communities. Sohu is one of the largest Chinese internet companies. Alibaba is the largest Chinese e-commerce company, which provides consumer-toconsumer, business-to-consumer, and business-to-business sales services via web portals. China Banking News, ‘China Now Home to World’s Second Largest Number of Wealthy Individuals’, online: www.chinabankingnews.com/2019/11/03/china-now-home-toworlds-second-largest-number-of-wealthy-individuals.

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has taken a more liberal approach and broadened the scope of eligible institutional investors in the domestic VC market. More foreign investors are now permitted to make equity investments in part.91 Additionally, young entrepreneurs are emerging in the Chinese VC market. It is reported that 3 per cent of the university graduates of 2018 have chosen to start businesses.92 The interest in VC among young entrepreneurs has been further encouraged by the State Council’s 2015 Guidelines on Mass Entrepreneurship and Innovation.93 The Chinese VC market has also benefitted greatly from the large number of overseas returnees (haigui), who contribute their technological knowhow, expertise, valuable overseas resources, and personal connections. In 2018, the number of overseas returnees stood at 519,400, which is 8 per cent more than the number in 2017.94 Since 1978 to 2018, the number of overseas returnees has accounted for 84.46 per cent of overseas graduates.95 In short, China’s need for sustainable economic development has resulted in a greater emphasis on innovation and IT infrastructure, a huge increase in eager investors with excess capital, and a new generation of entrepreneurs. This mix of factors translates into a strong demand for high-risk, high-return investments, an increasing supply of entrepreneurs, resulting in an increased number of small businesses. Pertinently, all these exemplify the need for VC.

1.3.3 Re-charting Economic Development After years of rapid economic growth, the labour market in China is facing serious manpower shortage and gradually losing its comparative advantage of low labour costs. With its gross domestic product (GDP) per capita surging from merely USD 2,600 in 2007 to USD 9,736 in

91 92

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Ibid. Chao Huang, 2018 Report on Fresh Graduate Entrepreneurship, (22 November 2018), online: Zhihu, https://zhuanlan.zhihu.com/p/47371864. State Council, 11 June 2015, ‘国务院关于大力推进大众创业万众创新若干政策措施的 意见 ’ (The Opinions of the State Council on Several Policies and Measures for Vigorously Advancing the Mass Entrepreneurship and Innovation) (No.32 [2015] of the State Council, 16 June 2015) 2015. Education Channel, ‘The Number of Overseas Returnees hit 519,400 in 2018’, (2 April 2019), online: People.cn, http://edu.people.com.cn/n1/2019/0402/c1053-31009898.html Ibid.

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2018,96 China can no longer rely on the labour-intensive paradigm of expansive growth. Moreover, China’s GDP growth rate fell from 10.4 per cent in 2010 to 6.6 per cent in 2018,97 with traditional economic sectors such as manufacturing and real estate showing signs of weakening.98 Furthermore, with a population of 1.3 billion and a labour force numbering 900 million, China faces strong pressure to address an increasingly significant unemployment issue.99 It is thus imperative for the government to foster the development of hightechnology industries and a knowledge-based economy to enhance competitiveness and promote sustainable growth.

1.4 The Rise of the Venture Capital Market in China The historical development of China’s VC market can be divided into the following five chronological periods. It is pertinent to note that the role of the government in the market did not remain static, but instead evolved based on the exigencies of the respective periods.

1.4.1 Emerging Phase (1985–1990) Venture capital has had a much shorter history in China than in the US.100 It was only in the 1980s that the Chinese government first sought 96

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‘新中国成立70年经济社会发展伟大飞跃’ (A new China, since its founding 70 years ago, has made great achievement in its social and economic development), CCTV News Platform, 2 July 2019, online: Xinhuanet, http://www.xinhuanet.com/fortune/2019-07/ 01/c_1124696168.htm. Statista, ‘China: Growth Rate of Real Gross Domestic Product from 2011 to 2024’, (April 2019), online: www.statista.com/statistics/263616/gross-domestic-product-gdp-growthrate-in-china/; see also ‘GDP Growth (Annual per cent)’, World Bank, 11 February 2016, online: http://data.worldbank.org/indicator/NY.GDP.MKTP.CD/countries/CN?dis play=graph./sc>. Mark Magnier, ‘As Growth Slows, China Highlights Transition from Manufacturing to Service’, The Wall Street Journal, 19 January 2016, online: www.wsj.com/articles/asgrowth-slows-china-highlights-transition-from-manufacturing-to-service-1453221751; Michael Lelyveld, ‘China Growth Slows Despite Stimulus Spur’, Radio Free Asia, 2 May 2016, online: www.rfa.org/english/commentaries/energy_watch/china-growth-slowsdespite-stimulus-spur-05022016102142.html. State Council, 11 June 2015, ‘国务院关于大力推进大众创业万众创新若干政策措施 的意见’ (Views of the State Council on Policy Measures relating to Mass Public Entrepreneurship) (No. 32 [2015] of the State Council, 16 June 2015), online: gov.cn, www.gov.cn/zhengce/content/2015-06/16/content_9855.htm. See J. Lerner, supra note 1, at p. 8. The US has over 70 years of experience in venture capital since the 1940s.

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to replicate America’s success in developing an effective VC market, with the official introduction of VC into China occurring as late as 1985.101 The industry only began to emerge in the same year when the first VC firm, the China New Technology Venture Capital Company (zhongguo xinjishu chuangye touzi gongsi), was set up by the Ministry of Finance and State Scientific and Technological Commission as a governmentinitiated project.102 Prior to that, there were no VC firms, let alone a market for VC in China. To facilitate technology and innovation, the Ministry of Science and Technology launched the influential Torch Programme in 1988, which kick-started a nationwide focus on hightech development and innovation. However, VC developed slowly in this period due to the lack of a stock market and unfamiliarity with the new concept.103 Thereafter, a number of government-backed VC firms were set up to provide financing to high-tech start-ups.104 At this time, the VC market had not adopted the business vehicle of limited partnerships. A majority of such funding was provided by government and state-related corporations, usually via grants set up by the government to promote financial technology.105

1.4.2 Experimentation Phase (1991–2001) The year 1998 marked a turning point, when Mr Cheng Siwei,106 the then vice chairman of the National People’s Congress Standing Committee, 101

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103 104

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After the open-door policy and economic reform, Chinese policymakers have made consistent efforts to study the experience of Silicon Valley in developing the venture capital industry. In the 1980s, a large number of scholars were sent to the US to pursue higher degrees. Some of them, including the ‘Godfather’ of venture capital in China, Mr Cheng Siwei, brought back the idea of venture capital and started to promote it. See ‘A Historical and Modern Look at the Chinese Venture Capital Market’, Xinhuanet, 13 May 2008. See Siwei Cheng, ‘Developing Venture Capital, Revitalizing China’, China Venture Capital, 3(2) (2004), at p. 1. See Shaoping Zhu and Immanuel Gebhardt (eds.), The Amendment of the Partnership Enterprise Law of the People’s Republic of China: Materials on the Drafting Process, 2001 – 2002 (China: CITIC Publishing House, 2004). See also Haitian Lu, Yi Tan and Gongmeng Chen, ‘Venture Capital and the Law in China’, Hong Kong Law Journal, 37 (2007), 229. Ibid. Siwei Cheng, ‘The History and Status Quo of China’s Venture Capital’, in Siwei Cheng (ed.), Cheng Siwei on Venture Capital (Beijing: Renmin University Press, 2008). PE Daily, ‘中国创投简史’ A Brief History of Venture Capital and Private Equity in China (Beijing: Posts & Telecom Press, 2017), at p. 3. Mr Cheng Siwei is known as the ‘Godfather’ of VC in China. He began to promote the concept of VC when he returned from his MBA studies from the University of

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presented the groundbreaking ‘No. 1 Proposal’ urging the development of a VC market in China.107 After the proposal, a series of policies were issued, including the Strategy of Invigorating China through Science and Education (kejiao xingguo) and the Law on Promoting the Transformation of Scientific and Technological Achievements 1996.108 Meanwhile, a number of government funds were set up to provide capital to hightechnology start-ups.109 Foreign VC firms like IDG Capital Partners, GIC, Goldman Sachs, Morgan Stanley, and Walden International also began preliminary explorations of the Chinese market. Significantly, the establishment of the Shanghai Stock Exchange and the Shenzhen Stock Exchange in 1990 offered new exit channels for VC investments. Prior to the introduction of these two exchanges, VC-backed firms were unable to exit via IPOs in China. In 2000, the State Council agreed with the China Security Regulatory Commission’s (CSRC) proposal to facilitate the exit of VC-backed companies. This sparked the first wave of establishment of local VC firms.110 Nonetheless, government-backed VC firms still dominated the industry during this period.111 The role of private VC firms was very limited due to the narrow range of available business vehicles and the lack of the limited partnership under the then Chinese law.112

107 108

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California, Los Angeles, in 1984. He presented this proposal to the first meeting of the 9th Chinese People’s Political Consultative Conference. Siwei Cheng, supra note 104. In 1999, the Ministry of Science and Technology, the State Development Planning Commission, the State Economic and Trade Commission, the People’s Bank of China (PBOC), the Ministry of Finance, the State Administration of Taxation, and the China Securities Regulatory Commission jointly issued the Several Opinions on Establishing a Venture Investment Mechanism [关于建立风险投资机制的若干意见], No. 105 [1999] of the General Office of the State Council. Such as the Technical Innovation Fund for SMEs 1999. See ‘私募股权投资业十年华丽 飞跃, 2014年开起中国股权投资时代’ (The Glorious Growth of the Private Equity Investment Industry over 10 Years, 2014 Marks the start of a New Era), PE Daily, 24 April 2015, online: https://m.pedaily.cn/news/381787. The very first VC firm in China, Zhongchuang, went into liquidation because of its massive failures in various real estate investments. Supra note 105, at p. 19. Beijing Zhongguancun Technology VC Company was the first private venture capital firm in China. In 1992, the first foreign VC (IDG Capital) entered into China. In 1995, the Procedures for the Management of China’s Industrial Investment Funds Abroad [设立 境外中国产业投资基金管理办法] (Order No. 1 [1995] of the President of the People’s Bank of China) was promulgated by the PBOC. The 1st Sino Foreign Joint Venture in the venture capital sector, Kezhao High Tech Co. Foreign PE, invested in Sohu, Sina, 163, and so on and eventually got them listed on NASDAQ. See Steve Blank, ‘The Rise of Chinese Venture Capital (Part 3 of 5)’ (12 April 2013), Steve Blank (blog), online: http:// steveblank.com/2013/04/12/the-rise-of-chinese-venture-capital/. The business form of limited partnership was not available in this period.

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Meanwhile, many of these firms deviated from their original purpose, and expanded their investments into mature companies and industries. Some even entered the booming real estate and securities markets.113

1.4.3 Decline and Subsequent Growth (2002–2005) Venture capital investment declined substantially in China after the bursting of the ‘dot-com bubble’ in 2001 and the global economic slowdown in 2002.114 Thereafter, in order to provide a business-friendly regulatory environment and a coherent legal framework to VC participants, clear guidance and regulations were issued on matters pertaining to the establishment, management, supervision, taxation, and foreign investment115 of VC.116 To facilitate the exit of VC-backed companies, the SME Board117 was launched in 2004. In 2005, the CSRC issued a notice announcing a split share structure reform of the securities market. The historical differentiation between tradeable shares and those held by the firm’s founders ended. This reform revived market activity, resulting in a bull market between 2005 and 2008, and facilitated the exit of domestic VC-backed companies via IPOs carried out on China’s stock exchanges.118 As a result of these policy incentives, VC 113 114 115

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Supra note 105. Refer to Figure 1.2 in this chapter for a timeline of key developments since 2002. ‘外商投资创业投资企业管理规定’ (Regulations on the Administration of Foreign Invested Venture Capital Enterprises) (No. 2 [2003] of the Ministry of Foreign Trade and Economic Cooperation, Ministry of Science and Technology, State Administration for Industry and Commerce, State Administration of Taxation, State Administration of Foreign Exchange) allowed foreigners intending to invest in the Chinese VC market to do so through setting up a Foreign-Invested Venture Capital Investment Enterprise (FIVCIE), which can take the form of an incorporated entity or a non-legal person entity. State Development & Reform Commission, Ministry of Science and Technology, Ministry of Finance, Ministry of Commerce, PBOC, State Administration of Taxation, State Administration for Industry and Commerce, China Banking Regulatory Commission, China Securities Regulatory Commission, and State Administration for Foreign Exchange, 15 November 2005, ‘创业投资企业管理暂行办法’ (Interim Measures for Administration of Startup Investment Enterprises) (Order No. 39 of the National Development and Reform Commission, Ministry of Science and Technology, Ministry of Finance, Ministry of Commerce, PBOC, State Administration of Taxation, State Administration for Industry and Commerce, China Banking Regulatory Commission, China Securities Regulatory Commission, and State Administration for Foreign Exchange, 3 January 2006) (China). In 2004, the SME Board was launched at Shenzhen, China. In 2005, the CSRC issued ‘关于上市公司股权分置改革试点有关问题的通知’ (Notice on the Pilot Reform of the Share-trading of Listed Companies) (No. 32 [2005] of the CSRC).

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funds raised more than USD 4 billion in 2005, exceeding the cumulative amounts raised in the previous three years.119

1.4.4 Deepening Structural Reforms (2006–2013) The adoption of the limited partnership in 2006 was essential to the Chinese VC market as it provided a new business vehicle for venture capitalists and investors to raise funds.120 The introduction of the limited partnership was part of the government’s strategy to develop scientific innovation as articulated in its 11th Five-Year Plan (2006–2010),121 which identified the promotion of VC investment as a critical element for achieving ‘independent innovation’ and sustainable economic progress in China.122 The number and volume of VC funds raised dipped in 2009, due to the global financial crisis, while the number of newly established venture funds, and the amounts raised increased two-fold in 2011 as compared to the previous year (Figure 1.1). The major contributors to this VC boom included as follows: (1) the launch of a new NASDAQ-like123 secondary board, ChiNext (chuangyeban), in 2009, (2) new measures allowing insurance funds to make equity 119 120

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123

Supra note 105, at pp. 3–4. State Council, 25 November 2009, ‘外国企业或者个人在中国境内设立合伙企业管理 办法’ (Administrative Measures relating to the Establishment of Partnerships in China by Foreign Enterprises or Individuals) (Order No. 567 [2009] of the State Council, 3 January 2010) (China). In 2001, ‘关于设立外商投资创业企业的暂行规定’(Interim Measure on the Establishment of Foreign-Invested Venture Capital Enterprises) (Order No. 4 [2001] of the Ministry of Foreign Trade and Economic Cooperation, the Ministry of Science and Technology, the State Administration for Industry and Commerce) was issued. In 2002, ‘指导外商投资方向规定’ (Foreign Investment Industry Guidance Catalogue) (No. 17 [2002] of the General Office of the State Council) was issued to attract more foreign investment. In 2005, the State Administration of Foreign Exchange issued the Circular 75 (No. 75 [2005] of the State Administration of Foreign Exchange), which greatly improved the foreign equity investment environment in China. See Central Committee of the China Communist Party, ‘中华人民共和国国民经济和 社会发展第十一个五年规划纲要’ (The Eleventh Five Year Plan), passed on 11 October 2005, at the Fifth Meeting of the Sixteenth Central Committee of the China Communist Party. See National People’s Congress, News Release, ‘Reasons for Revising Partnership Enterprise Law’ (May 2006). Before the introduction of LPs, the only major legal structures generally available for VC firms in PRC were the Limited Liability Company, Joint Stock Company, and General Partnership, but all of them were unattractive because of their inherent features. National Association of Securities Dealers Automated Quotations.

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investments in 2010,124 (3) the launch of several Qualified Foreign Limited Partner (QFLP) schemes in Shanghai, Beijing, Tianjin, and Chongqing, which permitted foreign qualified institutional investors to make equity investments in Chinese markets, and (4) the substantial increase in investments by the National Social Securities Fund (NSSF) in PE and VC.125 In particular, the launch of ChiNext provided a new exit option to VC-backed companies, which greatly accelerated the development of VC in China. As such, although the suspension of the IPO process by the CSRC from November 2012 to January 2014 negatively affected fundraising in both 2012 and 2013, the reforms discussed in the previous paragraph accelerated the revival of the VC market in 2014. This was further reinforced by the 2013 nationwide expansion of the National Equities Exchange and Quotation (NEEQ) system (also known as the New Third Board), which has now become an important exit vehicle for VC-backed start-up firms.126 In addition, there has been a rapid emergence of private firms and investors in the VC market since 2006. In terms of numbers, individuals and families form the majority of investors in VC fundraising.127 The majority of leading VC firms in China are now composed of private firms and foreign firms.128

1.4.5 Venture Capital for Everyone (2014–2017) Since May 2013, the central government has issued at least twenty-two documents and policies to encourage the development of VC, such as the Several Opinions of the State Council on Promoting the Sustainable and Sound Development of Venture Capital129 and the Opinions of the State 124

125 126

127

128

129

‘保险资金投资股权暂行办法’ (Interim Measures for Equity Investment with Insurance Funds) (No. 79 [2010] of the China Insurance Regulatory Commission) allowed insurance funds to make equity investments. See L. Lin, supra note 9, at Appendix 2. According to Zero2IPO statistics, in the year 2015 alone, 929 VC-backed companies were listed on the NEEQ, accounting for 51.2 per cent of the total exit vehicles in 2015. See further information on the correlation between the stock market and the venture capital market in L. Lin, supra note 76. See Table 2.4 and Table 2.5 in this book noting that government guidance funds only account for a small portion of all investors on average. See ‘2015中国股权投资年度VC机构评选排名’ (The Top 50 VC Firms of the Year 2015), PE Daily, 4 December 2015, online: http://pe.PEdaily.cn/201512/20151204391023 .shtml. State Council, 16 September 2016, ‘国务院关于促进创业投资持续健康发展的若干意 见’ (Several Opinions of the State Council on Promoting the Sustainable and Sound

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Council on Promoting the High-Quality Development of Innovation and Entrepreneurship and Creating an Upgraded Version of ‘Entrepreneurship and Innovation among All the People’.130 In particular, State Council embarked on the Mass Entrepreneurship and Innovation (dazhong chuangye, wanzhong chuangxin) reform in 2015.131 This policy was followed by several specific measures that aimed to improve institutional mechanisms to facilitate entrepreneurship and innovation, such as deepening business system reforms, strengthening intellectual property protection, and establishing a mechanism for training and hiring talented professionals.132 Since 2014, the Chinese central government seems to be moving towards a ‘Government Led plus Market Operation’ model in providing public funding,133 instead of directly participating in the allocation of capital. The State Council announced in 2015 that China would be setting up the RMB 40 billion (USD 6.5 billion) State Venture Capital Investment Guidance Fund (SVCIGF) (guojia xinxingchanye chuangyetouzi yindao jijin) to support start-ups in emerging industries, foster innovation, and upgrade the industry.134 Public tenders would be made to select qualified professional firms to manage the fund. Rather than setting up and directing the government-backed funds, the central government stated that it would instead be a limited participant by only providing funding.135 However, whether the new SVCIGF will be effective and whether local governments136 will strictly follow the central

130

131

132 133

134 135 136

Development of Venture Capital) (No. 53 [2016] of the State Council, 16 September 2016) (China), effective from 16 September 2016. State Council, 18 September 2018, ‘国务院关于推动创新创业高质量发展打造‘ 双创’ 升级版的意见’ (Opinions of the State Council on Promoting the High-Quality Development of Innovation and Entrepreneurship and Creating an Upgraded Version of ‘Entrepreneurship and Innovation among All the People’) (No. 32 [2018] of the State Council, 18 September 2018) (China), effective from 18 September 2018. State Council, 11 June 2015, ‘国务院关于大力推进大众创业万众创新若干政策措施 的意见’ (Views of the State Council on Policy Measures Relating to Mass Entrepreneurship) (No. 32 [2015] of the State Council, 16 June 2015) (China), online: http://bit.ly/2t1Q9Oh. Ibid. Zero2IPO Research Center, ‘2015 年中国政府引导基金发展报告简版’ (Report of the China Government Guidance Fund 2015), (Zero2IPO Publisher, 2015). Ibid. Ibid. In China, provincial and sub-provincial leaders on the local level have a significant amount of autonomy. There are five practical (de facto) levels of local government: the provincial (province, autonomous region, municipality, and special administrative region), prefecture, county, township, and village.

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government’s approach towards government funds remain open questions. From 2016 to 2017, the capital in China which local and foreign VC firms can invest in has grown rapidly. This can mainly be attributed to the development of a relatively more conducive environment for VC fundraising.

1.4.6 Strengthened Regulation (2018–Present) Rapid market development prior to 2018 has led to the participation of undesirable agents and the emergence of unethical, and often illegal, practices. A group of fund managers, as well as some VC/PE firms, have engaged in practices such as illegal fundraising and insider trading, despite this being in clear violation of the law.137 In the face of these issues, the authorities have had to successively introduce a series of laws, regulations and rules to refine the framework governing fundraising and the duties imposed upon fund managers and venture capitalists. In particular, following the promulgation of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (also known as the New Regulations on Asset Management, in pinyin: ziguan xingui) in 2018,138 both PE and VC fundraising activities have been subject to greater supervision. The next part will continue to discuss the evolving regulatory framework governing VC and its implications on the VC market.

1.5 The Evolving Regulatory Framework China’s VC regulatory regime is evolving rapidly. The timeline of VC regulation in China is illustrated in Figure 1.2. The major stages and changes are discussed here in sequence. A key difference between the Chinese and the American regimes139 is that the former has long been based on the type of financial institutions and their products. For example, funds organised as trust companies are 137

138

139

See Lin Lin, ‘Private Equity Investor Protection: Conceptualizing Duties of General Partners In China’, Berkeley Business Law Journal, 15(1) (2018) 43–91, at pp. 43–44. Issuance of the Guidelines on Regulating Financial Institutions’ Asset Management Business [关于规范金融机构资产管理业务的指导意见发布], Caixin Global, 27 April 2018, online: http://finance.caixin.com/2018-04-27/101240366.html. In the US, various legislations played a positive role in the development of VC market, including the 1933 Securities Act, 1940 Investment Company Act, 1958 Small Enterprise Act, and the Uniform Limited Partnership Act.

Pre-2014 PE/VC funds regulated by CSRC, NDRC and Ministry of Science and Technology simultaneously

2016 AMAC Guidelines on Internal Control AMAC Measures on Information Disclosure AMAC Guidelines on Contracts AMAC Measures on Fundraising

2014 CSRC became the regulator of PE/VC funds

Figure 1.2

Timeline of PE and VC regulation in China

2017 CSRC Measures for the Suitability Management of Securities and Futures Investors; AMAC Measures for the Administration of Privately Offered Investment Fund Services

2018 PBOC, CBIRC, CSRC, and SAFE issued Guiding Opinions on Regulating Asset Management Business of Financial Institutions (New Regulations on Asset Management)

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regulated by the China Banking Regulatory Commission (CBRC), while securities companies and fund management companies, and their financial products, are regulated by the CSRC. Pertinently, the NDRC and CSRC have been competing to take charge of supervising the PE and VC industries in China.140 This fragmented regulatory regime has hampered the development of the VC industry and enabled regulatory arbitrage by market participants. Moreover, up until 2014, the Chinese PE and VC sectors operated in a regulatory vacuum without a clear governing regulatory and legal framework.141 As a result of the explosive growth of the Chinese PE and VC market, as well as the absence of regulatory oversight in the sector, a large number of frauds and scandals emerged from 2011 onwards. To clarify the regulatory responsibilities of different government agencies, and to tackle the perceived market concerns, Chinese regulators are in the process of amending the relevant laws that govern VC activities.142 As shown in Figure 1.2, since 2014, more robust regulations and special inspections on private funds have been made. A notable improvement is the promulgation of the Interim Measures for Supervision and Administration of Private Investment Funds (CSRC Interim Measures) by the CSRC in 2014143 and the Measures for the

140

141 142

143

See further in Dean Collins, Qingjian Wang and Hailin Cui, ‘A New Era for Private Funds in China?’, online: Dechert LLP, https://info.dechert.com/10/3730/landing-pages /a-new-era-for-private-funds-in-china.asp. Ibid. See National Development and Reform Commission, 31 January 2011, Circular on Further Regulating the Development and the Administration on Filings of Equity Investment Enterprises in Pilot Regions [关于进一步规范试点地区股权投资企业发展 和备案管理工作的通知] (No. 253 [2011] of the General Office of the National Development and Reform Commission, 31 January 2011) (China); see also National Development and Reform Commission, 23 November 2011, Notice for Promoting the Development of Equity Investment Enterprises, [关于促进股权投资企业规范发展的通 知] (No. 2864 [2011) of the General Office of the National Development and Reform Commission, 7 February 2012) (China). On 21 August 2014, the CSRC officially released this Interim (No. 105 [2014] of the CSRC), which became effective on the same date. China Securities Regulatory Commission, 30 June 2014, Interim Measures for the Supervision and Administration of Privately Offered Investment Funds [私募投资基金监督管理暂行办法] (No. 105 [2014] of the CSRC, 21 August 2014) (China), effective from 21 August 2014. The CSRC Interim Measures set forth the regulatory regime for private funds under five key topics: (i) registration and filing; (ii) qualified investors; (iii) fundraising; (iv) fund operation; and (v) special rules for venture capital funds.

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Registration of Private Investment Fund Managers and Filing of Private Funds by AMAC.144 Under the new regulatory framework, the CSRC is the key regulator of the PE/VC sector,145 but certain regulatory powers of the CSRC are delegated to a self-disciplinary association – the AMAC (See Figure 1.3 for the regulatory framework).146 All privately raised funds (including PE/VC funds) have to be registered with the AMAC and must comply with the rules or measures made by CSRC.147 All fund managers operating in China, including foreign private fund management institutions, have to comply with the requirements implemented by the AMAC. Since 2016, AMAC has issued a whole series of self-disciplinary regulatory measures, directives, and Q&A explanations on private funds dealing with registration, fundraising, internal control, and information disclosure, as well as contracting guidelines to improve risk management and market compliance. Specifically, the AMAC imposed substantive entry requirements, sought to deregister dormant shell entities, imposed severe sanctions on institutions that failed to provide timely information disclosure, referred non-compliant entities to the relevant bureaus for investigation, and increased qualification requirements for senior management of funds.148 In 2017, China established a Financial Stability and Development Committee under the State Council to oversee financial stability, and related reforms and developments (see Figure 1.3).149 In 2018, the People’s Bank of China (PBOC), the CSRC, China Insurance Regulatory 144

145

146

147 148

149

AMAC, 17 January 2014, Measures for the Registration of Management Institutions of Privately Offered Investment Funds and the Recordation of Funds [私募投资基金管理人 登记和基金备案办法(试行)] (No. 1 [2014] of the AMAC, 7 February 2014) (China). In June 2013, the Central Government issued the Notice on the Division of Responsibilities of Private Equity Fund Management [关于私募基金管理职责分工的 通知] (No. 22 [2013] of the State Commission Office for Public Sector Reform), specifying that CSRC will be responsible for the supervision and administration of PE funds. Since 2013, the NDRC has been empowered to compile policies for the development of the PE and VC industry. Ibid. However, it must be noted that, as AMAC is an ordinary self-regulated organisation, its notices and measures are not formal legal sources and cannot be the direct basis upon which judicial decisions are made. This committee was set up in July 2017. See Yan, ‘China Focus: China establishes financial stability and development committee’, Xinhuanet, 8 November 2017, online: http://news.xinhuanet.com/english/2017-11/08/c_136737949.htm.

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Financial Stability and Development Committee (FSDC)

People's Bank of China (PBOC)

China Securities Regulatory Commission (CSRC)

China Banking and Insurance Regulatory Commission (CBIRC)

Asset Management Association of China (AMAC)

Figure 1.3

Regulatory framework of PE and VC in China

Commission (CIRC), and the Foreign Exchange Bureau issued the New Regulations on Asset Management.150 After these measures, the supervision of the asset management industry in China has been significantly tightened. Nevertheless, these government interventions have increased the difficulty of VC fundraising in China.151 For example, due to the New Regulations on Asset Management, capital supply to the VC market 150

151

PBOC, China Banking and Insurance Regulatory Commission, China Securities Regulatory Commission, and State Administration of Foreign Exchange, 14 August 2018, ‘关于进一步明确规范金融机构资产管理业务指导意见有关事项的 通知’ (Guiding Opinions on Regulating the Asset Management Business) (China), online: CSRC, www.csrc.gov.cn/pub/zjhpublicofbj/tzgg/201808/t20180823_342979.htm. See Figure 1.1 in this chapter. Since the third quarter of 2018, the number of newly registered funds has decreased by 25.89 per cent as compared to the same period in 2017. See Wang Ying and Mo Lin, ‘The VC/PE Market Continues To Be Depressed, More Observation Is Needed To Determine Whether The New Rules For Asset Management Are Effective’ [VC/PE 市场持续低迷 资管新规创投细则成效待观察], China Fund News, 4 November 2019, www.cnfund.cn/news/detail_108727.html.

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from banks has been restricted.152 Meanwhile, excessive administrative supervision has also led to high enforcement costs.153 Since 2016, CSRC and its various local offices have conducted dozens of random on-site inspections on alternative funds. Due to the large number of registered funds, the spot checks on the small proportion of inspected funds have been extremely costly and inefficient. On-site inspection also requires high levels of human and financial resources, which worsens regulatory agencies’ already existent manpower constraints.154 Today, the different stages of the standard VC cycle, namely fundraising, investment, and exit, are regulated by different statutes (See Table 1.1 in this chapter). Legislation and regulations on VC in China include the following types: (1) National laws promulgated by the National People’s Congress and its Standing Committee, such as PRC Company Law, PRC Partnership Enterprise Law,155 PRC Securities and Investment Fund Law, PRC

152

153

154

155

To address the decline of fundraising due to the New Regulations on Asset Management, the State Council issued the amended 中华人民共和国外资银行管理条例 (Regulations of the PRC on the Administration of Foreign Funded Banks) (No. 720 [2019] of the State Council) on 30 September 2019 and the China Banking and Insurance Regulatory Commission (CBIRC) issued the amended 中华人民共和国外资银行管理条例实施 细则 (Implementation Rules of the Regulations of the PRC on the Administration of Foreign Funded Banks) (No. 6 [2019] of the CBIRC) on 29 November 2019. The CBIRC also promulgated the amended 外资银行行政许可事项实施办法 (Implementation Measures on the Administrative Licensing Items of Foreign Funded Banks) (No. 10 [2019] of the CBIRC) on 26 December 2019 to implement and specify the details of the opening-up policies in the banking industry with the aim to optimise the business environment. Interviewed regulators have also indicated the lack of capacity within AMAC to regulate the PE and VC sectors. Interview with Mr D (anonymity required), Director of Private Fund Department, AMAC, on 25 October 2019 in Beijing. Ibid. All of China’s financial regulators have suffered severe manpower loss. Talents recruited from overseas by CSRC’s so-called Hundred Talents Program have mostly left the organisation. On 28 October 2003, Securities Investment Funds Law of the People’s Republic of China [证券投资基金法] (‘2004 PRC Fund Law’) was promulgated, effective as of 1 June 2004. However, the 2004 PRC Fund Law regulated only publicly offered funds, leaving private funds in regulatory limbo. Nine years later, on 8 December 2012, new amendments were finally made to the 2004 PRC Fund Law (Amended Fund Law, effective as of 1 June 2013), and this time, private funds were brought under the regulatory regime. Unfortunately, the Amended Fund Law was designed in such a way that PE and VC funds were excluded from its scope of application.

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Table 1.1 The evolving regulatory framework of PE and VC in China Date

Legislation/policy/milestone

Description and implication

October 1992

The Securities Commission of the State Council (SCSC) and the CSRC were established.

These regulatory bodies oversee China’s capital markets.

November 1997

The SCSC issued the ‘Interim Measures on the Management of Securities Investment Funds’.

This is the first administrative regulation regulating the operation of securities investment funds.

July 2002

The ‘Rules on the Establishment of Foreignshared Fund Management Companies’ came into force.

These rules encouraged foreign investments in fund management companies.

June 2004

The Securities Investment Fund Law came into force.

This is the basic national law regulating securities investment funds.

November 2005

The ‘Interim Measures for the Administration of Start-up Investment Enterprises’ was issued.

VC funds were subject to certain requirements under these measures.

June 2007

The revised Partnership Enterprise Law was enacted.

The limited partnership was introduced as a business form for PE/VC funds.

6 June 2012

The AMAC was established.

The AMAC is in charge of the registration and operation of private funds in China.

1 June 2013

The Securities Investment Fund Law was amended.

The amended legislation subjects private funds to regulatory purview.

June 2013

The ‘Measures for the Pilot Programme of Establishing Fund Management Companies by Insurance Institutions’ was issued.

This programme allowed insurance companies to establish fund management companies.

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Table 1.1 (cont.) Date

Legislation/policy/milestone

Description and implication

June 2013

The State Commission Office of Public Sectors Reform issued the ‘Notice on the Functions for the Management of Privately Offered Investment Funds’.

This notice placed PE funds under the unified supervision of the CSRC.

January 2014

The AMAC issued the ‘Measures for the Registration of Management Institutions of Privately Offered Investment Funds and the Recordation of Funds (for Trial Implementation)’.

This marked the official start to the registrations of PE fund managers and record filing of assets.

7 February 2014

The ‘Measures for the Registration of Private Investment Fund Managers and Filing of Funds’ was implemented.

This is specifically applied to the CSRC’s interim measures section on registration and filing, thereby establishing a national private fund registration and filing system.

May 2014

The State Council issued the ‘Opinions of the State Council on Further Promoting the Sound Development of Capital Markets’.

This opinion specified the future tasks and structure of China’s capital market.

July 2014

The AMAC is officially responsible for the record filing of the private assets of, the risk statistics, of and other responsibilities relating to security companies, fund management companies, and their subsidiaries.

This initiative enhanced the role of the AMAC in administering the registration of private funds in China.

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Table 1.1 (cont.) Date

Legislation/policy/milestone

Description and implication

21 August 2014

The ‘Interim Measures for the Supervision and Administration of Private Investment Funds’ was issued.

This is one of the key regulations relating to private funds. It established the regulatory framework governing private funds (including PE/VC funds).

1 January 2015

The AMAC implemented the use of electronic certification for the registration and filing of private funds.

This initiative made the filing of funds more efficient.

June 2015

The ‘Opinions of the State Council on Several Policies and Measures for Vigorously Advancing the Mass Entrepreneurship and Innovation’ was issued.

These opinions reflect an attempt to encourage ‘mass innovation and entrepreneurship’.

1 February 2016

The ‘Guidelines on the Internal Control of Private Investment Fund Managers’ was issued.

These guidelines attempt to create a self-regulatory framework by focussing on internal control objectives as well as principles, internal environment, risk assessment, control of activities, internal supervision, among others,. within the Chinese VC market.

4 February 2016

The ‘Measures on the Administration of Private Investment Fund Information Disclosure’ was issued.

This established a preliminary industry self-disciplinary framework for the disclosure of information for private funds. It sets forth, inter alia, the extent, content, and manner of information disclosure required when private funds conduct fundraising and operational activities.

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Table 1.1 (cont.) Date

Legislation/policy/milestone

Description and implication

18 April 2016

Guidelines for private investment fund contracts were issued.

This is meant to provide unified, standard contractual terms for all private fund products such as private mutual funds, PE funds, and VC funds.

15 July 2016

The ‘Measures for Administration of Fundraising by Private Investment Funds’ was issued.

This imposed more stringent and detailed rules on private fundraising activities. It sets out the following requirements: specific target confirmation, investor suitability management, risk disclosure and explanation, qualified investor confirmation, cooling-off period, and return visit. It imposed restrictions on marketing and promotion and requires funds and their personnel to satisfy certain qualifications.

November 2016

The CSRC issued the ‘Provisions on the Administration of Subsidiaries of Securities Investment Fund Management Companies’ and the ‘Interim Administrative Provisions on the Risk Control Indicators of Specific Client Asset Management Subsidiaries of Fund Management Companies’.

These regulations enhanced the compliance and disclosure of private funds.

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Table 1.1 (cont.) Date

Legislation/policy/milestone

Description and implication

12 December 2016

The ‘Measures for the Suitability Management of Securities and Futures Investors’ was issued.

This sets out the definition of a ‘professional investor’, which is more stringent than the previous ‘qualified investor’ classification. Funds are also now required to provide suitability matched opinions according to the different risk tolerance capabilities of investors and different risk levels of products.

30 August 2017

The ‘Interim Regulations for Administration of Private Investment Fund (for consultation)’ was issued.

This consolidated present laws and regulations into a single administrative regulation. It imposed comprehensive regulatory requirements on fund managers, fund custodians, fundraising behaviour, investment operations, information disclosure, industry self-discipline, and other aspects of the private fund industry.

1 March 2017

The ‘Administrative Measures for Private Investment Fund Service Business’ was issued.

This included the main provisions of AMAC’s previous ‘Outsourcing Guidelines’, including the legal status of the service organisation, fund manager’s legal responsibilities when outsourcing, and security mechanism for settlement of funds. It also adds the definition of services, separation of powers and duties, exit mechanism, etc.

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Table 1.1 (cont.) Date

Legislation/policy/milestone

Description and implication

June 2017

The AMAC issued the ‘Measures for the Suitability Management of Investors in Fundraising Agencies’.

This specified the requirements which investors must comply with when investing in private funds.

November 2017

The State Council set up the Financial Stability and Development Committee.

The committee was set up for the purpose of strengthening coordination between financial regulators and supplementing regulatory shortcomings.

15 December 2017

The AMAC issued the ‘Compliance Requirements for the Registration of Management Institutions of Privately Offered Funds’.

These requirements enhanced the compliance requirements relating to registration by fund managers.

January 2018

The AMAC issued the ‘Compliance Requirements for the Recordation of Privately Offered Funds’.

These requirements enhanced the compliance requirements relating to the registration of funds.

June 2018

The National Development and Reform Commission and the Ministry of Commerce jointly issued the ‘Special Management Measures (Negative List) for the Access of Foreign Investment in the Pilot Free Trade Zones (2018)’.

This relaxed the requirements pertaining to the proportion of foreign investment in fund management companies. The proportion was changed to 51 per cent, with the restriction as to proportion lifted after three years.

April 2018

The PBOC, the China Banking and Insurance Regulatory Commission (‘CBIRC’), the CSRC, and the SAFE jointly issued the ‘Guiding Opinions on Regulating the Asset Management Business of Financial Institutions’.

These Opinions defined the scope and meaning of asset management businesses and asset management products. The PBOC made clear its determination to punish the promotion of implicit guarantees for asset management products.

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Securities Law, PRC Contract Law, PRC Trust Law, and PRC Foreign Investment Law. (2) Administrative regulations (bumen guizhang) promulgated by the State Council and the ministries under the State Council, such as the Interim Measures for Administration of Start-up Investment Enterprises (‘Start-up Measures’),156 the Provisions Concerning the Administration of Foreign-Funded Venture Investment Enterprises,157 the Interim Measures for the Supervision and Administration of Privately Offered Investment Funds,158 and the Interim Measures for the Administration of Government Investment Funds.159

156

157

158 159

State Council, 15 November 2005, Interim Measures for the Administration of Startup Investment Enterprises [创业投资企业管理暂行办法] (No. 39 of the National Development and Reform Commission, Ministry of Science and Technology, Ministry of Finance, Ministry of Commerce, PBOC, State Administration of Taxation, State Administration for Industry and Commerce, China Banking Regulatory Commission, China Securities Regulatory Commission, and State Administration for Foreign Exchange, 1 March 2006) (China) (‘Startup Measures’). Before the Start-up Measures were issued, local governments such as Beijing, Shanghai, and Shenzhen promulgated various kinds of local regulations to facilitate venture capital investment in their regions. Ministry of Foreign Trade and Economic Cooperation, the Ministry of Science and Technology, the State Administration for Industry and Commerce, the State Administration of Taxation, and the State Administration of Foreign Exchange, 30 January 2003, ‘外商投资创业投资企业管理规定’ (Provisions Concerning the Administration of Foreign-funded Venture Investment Enterprises) (No. 2 [2003] of the Ministry of Foreign Trade and Economic Cooperation, the Ministry of Science and Technology, the State Administration for Industry and Commerce, the State Administration of Taxation, and the State Administration of Foreign Exchange, 1 March 2003) (China) came into force on 1 March 2003. Supra note 144. Ministry of Finance, 12 November 2015, ‘政府投资基金暂行管理办法’ (Interim Measures for the Administration of Government Investment Funds) (No. 210 [2015] of the Ministry of Finance, 12 November 2015), effective 12 November 2015. China Securities Regulatory Commission, 2 June 2017, ‘私募基金监管问答——关于首发企 业中创业投资基金股东的认定标准’ (Q&A on Supervision of Private Equity Funds— Criteria for Determining Venture Capital Fund Shareholders in IPO Enterprises); China Securities Regulatory Commission, 2 June 2017, ‘发行监管问答——关于首发企业中 创业投资基金股东的锁定期安排’ (Q&A on Supervision of Issuance–Requirements for the Lock-up Period of Venture Capital Fund Shareholders in IPO Enterprises); China Securities Regulatory Commission, 1 March 2018, ‘上市公司创业投资基金股东减持 股份的特别规定’ (Special Provisions on Shareholding Reduction by Venture Capital Fund Shareholders of Listed Companies) (No. 4 [2018] of the China Securities Regulatory Commission, 2 June 2018) (China).

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(3) Local regulations promulgated by local legislatures (difang fagui). (4) Self-disciplinary rules made by AMAC.160 At this juncture, it is important to note that the Chinese regulatory framework governing the VC market comprises largely of piecemeal interim regulations. These regulations tend to be introduced in a reactionary fashion for this rapidly developing VC market. Many rules are never formalised and the nature of these rules is interim. The net result is a situation of policy unpredictability, which, when coupled with the rapidly changing nature of the financial market, detrimentally impacts the business environment. The limitations of the Chinese legal system have forced central and local governments to rely on piecemeal regulation. The Chinese legal system follows the civil law legal tradition. Unlike judges of the common law tradition, Chinese judges are unable to create law via the doctrine of stare decisis or the doctrine of equity. Consequently, these constraints prevent judges from developing timely responses catered to the specific circumstances of each case. The alternative response lies in legal reform. However, a comprehensive revision of national laws is time-consuming. As a result, the national laws, such as the partnership law or the securities law, would be unable to keep up with developments in the market. Consequently, the introduction of piecemeal regulations and measures has been the only method by which the Chinese authorities could keep up with the dynamism of the market and correct any problems that arise. It 160

Including ‘私募投资基金管理人登记和基金备案办法 (试行)’ (Measures for the Registration of Private Equity Fund Managers and the Recording of Funds (for Trial Implementation)), 关于进一步规范私募基金管理人登记若干事项的公告 (Announcement on Several Matters concerning Further Regulations of the Registration of Private Equity Fund Managers), and ‘中国基金业协会负责人就落 实《关于进一步规范私募基金管理人登记若干事项的公告》相关问题答记者问’ (Q&A on Relevant Issues regarding the Announcement on Several Matters concerning Further Regulations of the Registration of Private Equity Fund Managers by AMAC Officers). On 12 January 2018, the AMAC issued the 私募投资基金备案须 知 (Requirements for the Recordation of Privately Offered Investment Funds) (the ‘Requirements’). The Requirements provide for stricter rules in three aspects, namely: Regarding the general requirements of the recordation of private equity funds, the scope of PE funds, and the recordation of PE funds that involve special risks. Additionally, on 27 March 2018, the AMAC issued ‘中国证券投资基金业协会 关于进一步加强私募基金行业自律管理的决定’ (Decision regarding the Further Strengthening of the Self-disciplinary Management of the Private Equity Fund Industry) and ‘关于私募基金管理人在异常经营情形下提交专项法律意见书的公 告’ (Announcement on Submitting Special Legal Opinions by Private Fund Managers under Abnormal Operation Circumstance), once again strengthening the standard of the self-regulatory management system of private fund managers, increasing the requirements for registration.

a n i nt r o d u c t i o n

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remains to be seen how further regulatory intervention may ameliorate these issues.

1.6 Significance of the Book The purpose of this book is threefold. First, the book seeks to fill the gap in the literature by examining the Chinese experience of engineering a VC market through law and policies. Although there are books161 and articles discussing the role of the government in boosting entrepreneurship and VC in other countries,162 there are few sophisticated and systematic case studies of China.163 In particular, the special characteristics of the Chinese VC market and the peculiar problems which the Chinese market faces remain largely unexplored. Second, most of the existing textbooks or casebooks on VC are studies from the economic perspective164 or from the comparative 161

162

163

164

J. Lerner, supra note 1. Robyn Klingler-Vidra, The Venture Capital State: The Silicon Valley Model in East Asia (New York: Cornell University Press, 2018), in Douglas Cumming, Michael Firth, Wenxuan Hou, and Edward Lee (eds.), Sustainable Entrepreneurship in China: Ethics, Corporate Governance, and Institutional Reforms (USA: Palgrave Macmillan, 2015). The ground-breaking paper by R. J. Gilson, supra note 1, argues that the development of the VC market in the US could not be attributed to government intervention, but rather to the functioning of private actors. Gilson’s perspectives on the nature of government intervention are particularly helpful due to the uncontroversial premise that a thriving VC market strongly stimulates economic growth. The paper by Christopher J. Gulinello, supra note 7, builds on Gilson’s research in the Taiwanese VC market, and argues that, inter alia, the Taiwanese government’s policy intervention helped to create a successful VC market. See also, the paper by Lin Lin, supra note 9, at pp. 160–220. It seeks to analyse Gilson’s work in the Chinese context and provides insight on the rise of VC in China. It argues that various government programmes and initiatives (such as the introduction of the limited partnership model and easing of regulatory bars for small businesses) have driven the growth of the VC market in China. Haitian Lu, Yi Tan and Gongmeng Chen, supra note 102; Lin Zhang, China’s Venture Capital Market: Current Legal Problems and Reforms (Oxford: Chandos Publishing, 2014); Jonsson Yinya Li, Investing in China: The Emerging Venture Capital Industry (A Guide for Foreign Investors) (UK: GMB Publishing, 2005); L. Lin, ibid (explaining the rise of VC in China based on R. J. Gilson’s seminal work); L. Lin, supra note 63 (discussing the agency problem faced by limited partners in the Chinese PE market); L. Lin, supra note 76 (analysing VC exits through IPOs in China). Douglas J. Cumming, Oxford Handbook of Venture Capital (Oxford: Oxford University Press, 2013); J. Lerner, Felda Hardymon, and Ann Leamon, Venture Capital and Private Equity: A Casebook (US: John Wiley & Sons, 2009).

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perspective165 rather than from the legal perspective. For those books focussing on a comparative analysis of the VC industry, their scope tends to be confined to drawing comparisons between the US and other countries, and there is a lack of in-depth legal study on China’s VC market.166 The difficulty of accessing source materials in Chinese and a general unfamiliarity with Chinese bureaucracy have hindered the development of a body of literature on the Chinese VC industry, and this is further compounded by the fast pace of regulatory change in China. This book therefore fills this gap in the literature by providing a timely and in-depth study of the Chinese VC market from the legal perspective. It discusses the most-updated laws on VC in China, including the applicable corporate law, securities law, partnership law, and bankruptcy law, the latest cases on VC disputes, as well as the latest relevant regulations and rules promulgated by various authorities. It aims to be an authoritative evaluation of the major legal problems and institutional impediments faced by the Chinese VC market and offers legal solutions. Third, while the existing literature discusses the different stages of a VC cycle167 and the role of the government in encouraging 165

166

167

Milford B. Green, Venture Capital: International Comparisons (UK: Routledge, 2011); William Scheela, Venture Capital In Asia: Investing In Emerging Countries (New York: Business Expert Press, 2014). Lin Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies (New York Dordrecht Heidelberg London: Springer, 2012); Jonsson Yinya Li, supra note 163; Robyn Klingler-Vidra, The Venture Capital State: The Silicon Valley Model in East Asia (Ithaca, New York: Cornell Studies in Political Economy, 2018). Some examples are provided later: Milford B. Green, ibid; William Scheela, ibid.; Stephen Barkoczy and Daniel Sandler, Government Venture Capital Incentives: A MultiJurisdiction Comparative Analysis (Australia: Australian Tax Research Foundation, 2007). Some examples of such materials include: Brad Feld and Jason Mendelson, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist (US: John Wiley & Sons, 2016); Alejandro Cremades, The Art of Startup Fundraising; Pitching Investors, Negotiating the Deal, and Everything Else Entrepreneurs Need to Know (US: John Wiley & Sons, 2016). R. J. Gilson, ‘The Legal Infrastructure of High Technology Industrial Districts: Silicon Valley, Route 128, and Covenants not to Compete’, New York University Law Review, 74 (1998), 575–642; R. J. Gilson and David M. Schizer, ‘Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock’, Harvard Law Review, 116(3)(2003), 874–916; R. J. Gilson, supra note 1; R. J. Gilson and Bernard S. Black, ‘Does Venture Capital Require an Active Stock Market?’ Journal of Applied Corporate Finance, 11, 36–48 (1999); R. J. Gilson and Bernard S. Black, ‘Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets’, Journal of Financial Economics, 47 (1998), 243–277. John Armour and Douglas J. Cumming, ‘The Legislative Road to Silicon Valley’, Oxford Economic Papers, 58(4)(2006), 596–635. Douglas J. Cumming and Sofia A. Johan, Venture Capital and Private Equity Contracting: An International Perspective, 2nd Edition (US: Elsevier

an introduction

39

entrepreneurship,168 there is a clear lack of theoretical studies on the key legal and institutional determinants of a viable VC industry as well as sophisticated legal studies of the Chinese VC market. Most of the existing materials are targeted at professionals associated with the VC industry, while the theoretical studies tend to be of limited scope. This book’s contribution is therefore to critically explore the role of law and the government in creating and developing a VC market. Furthermore, there currently exists no theoretical defence of the thesis that legal protection for investors is needed in the Chinese VC industry.169 This book seeks to highlight that the general international convention that VC investors are sophisticated and hence do not require extra legal protection does not really hold in the context of China. To achieve the above purposes, this book uses hand-collected qualitative and quantitative data. The dataset consists of five parts, which are used to support the arguments made throughout the book. The first part of the dataset consists of sixty hand-collected Chinese-based investment agreements and forty limited partnership agreements, all of which concluded between 2010 and 2019.170 The second part comprises interviews with 100 key market participants, including lawyers, venture capitalists, PE managers, founders of start-ups and large technology or e-commerce companies, individual investors, and representatives of institutional

168 169

170

Science Academic Press, 2013); Douglas J. Cumming, Venture Capital: Investment Strategies, Structures and Policies (US: John Wiley & Sons, 2010). J. Lerner, supra note 1. Existing literature on VC is primarily written from an economic perspective and aims to educate the reader on the transactional aspects of the industry. A few examples include: Douglas J. Cumming, supra note 167; J. Lerner, Felda Hardymon, and Ann Leamon, supra note 164; Mike Wright, Harry J. Sapienza, and Lowell W. Busenitz (eds.), Venture Capital, Volume 1 (UK: Elgar, 2003). These agreements are obtained from Chinese law firms and venture capital firms, including, inter alia, Gaorong Capital, October Capital, Jieyi Capital, Han Kun Law Offices (Beijing office and Shanghai office), Fangda Partners (Shanghai office), King & Wood Mallesons (Shanghai office, Guangzhou office, and Shenzhen office), Zhong Lun Law Firm (Shanghai office and Shenzhen office), Grandall Law Firm (Shanghai office), DeHeng Law Offices (Shenzhen office), Global Law Office (Beijing office), China Commercial Law Firm (Shenzhen office), Llinks Law Offices (Shanghai office), Jingtian & Gongcheng Law Firm (Shanghai office), Qi Heng Law Firm (Shanghai office), Gf Law Firm (Shanghai office), T&C Law Firm (Shanghai office).These agreements only include the agreements between Chinese parties and exclude agreements that involved foreign parties.

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venture c apital law in c hi na

investors.171 The third part consists of judgments obtained from the database maintained by the Chinese courts on disputes relating to VC investments.172 The fourth part comprises a study of a wide range of data and reports published by leading law firms and service providers in China and the US.173 The fifth part comprises a study of VC agreements used in 171

172

173

Interviewees consist of: (1) partners, analysts and legal counsels from venture capital or private equity firms: Amadeus Capital Partners (UK), Temasek Holdings, Gaorong Capital, Chengwei Capital, Shenzhen Cedar Fund Management Company, Jieyi Capital, iVision Ventures, Shengda Group, October Capital, Island Peak Innovation, Hualin Securities Company, Bondbridge Asset Management Company, Hainan State Farms Investment Holdings Group, China Investments Corporation (Shenzhen office), GF Securities, iGlobe Partners (Singapore), Jieyi Capital, Golden Concord Holdings Limited, and Tembusu Partners (Singapore); (2) partners and associates from law firms: Orrick, Herrington & Sutcliffe LLP (Shanghai office), Clifford Chance LLP (Singapore office), Allen & Gledhill LLP (Singapore office), WongPartnership LLP (Singapore office), Han Kun Law Offices (Beijing office and Shanghai office), JunHe LLP (Shenzhen office), Fangda Partners (Shanghai office), King & Wood Mallesons (Shanghai office, Shenzhen office, and Hong Kong office), Zhong Lun Law Firm (Beijing office, Shanghai office, and Shenzhen office), Grandall Law Firm (Shanghai office), DeHeng Law Offices (Shenzhen office), Global Law Office (Beijing office), Dentons Law Firm, Jingtian & Gongcheng Law Firm (Shanghai office), Allbright Law Offices (Shanghai office), Broad&Bright Law Firm (Beijing office), China Commercial Law Firm (Shenzhen office), Llinks Law Offices (Shanghai office), Qi Heng Law Firm (Shanghai office), GF Law Firm (Shanghai office), T&C Law Firm (Shanghai office), Guantao Law Firm (Tianjin office), Yingke Law Firm (Guangzhou office), Zhuoxin Law Firm (Guangzhou office), Zhong Hao Law Firm (Chongqing office), and Yingming Law Firm (Shanghai office); (3) founders and entrepreneurs from start-ups or large technology or e-commerce companies: CTO of Qunar.com, CEO of the CXA Group, founders of Yincubator, founder and CEO of ZBMY, founder and CEO of SILOT, and managers of Shenzhen United Property and Share Rights Exchange; (4) legal counsels and managers of institutional investors: Sichuan Development Big Data Industry Investment Co., Ltd, Zhangjiang Hi-Tech Park, and Hainan State Farms Investment Holdings Group. Most of the practitioners are based in Beijing, Shanghai, Tianjin, Shenzhen, Chongqing, and Guangzhou, which are the major venture capital hubs in China. I also interviewed practitioners based in Cambridge, Singapore, Hong Kong, and Silicon Valley; (5) drafters of the VIMA (Venture Capital Investment Model Agreements); and (6) regulators from AMAC. These judgments were obtained from the database maintained by the Chinese courts, online: China Judgments Online, http://wenshu.court.gov.cn, and were issued between 7 November 2012 and 4 October 2019, inclusive. These reports include: (1) the Annual Report of the Venture Capital Market in China published by the Zero2IPO Research Center; (2) the China Venture Capital Yearbook published by China Venture Capital Research Institution; (3) the annual reports on venture capital published by the VentureChina.cn; (4) Data Analysis Report for VC/PE Deals, Han Kun Law Offices, 2017, online: https://hankunlaw.com/downloadfile/ newsAndInsights/9be8ff02c61f5dcf3d49da6711bfffe9.pdf; and (5) the Silicon Valley Venture Capital Survey published by Fenwick & West LLP in 2019.

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other VC markets.174 Relying on the extensive data and the author’s professional experience in China, the US, and Singapore, this book reveals the special characteristics of the Chinese VC market, the peculiar legal problems within the Chinese market and provides in-depth comparative studies of the two largest VC markets in the world – China and the US.

1.7 Structure of This Book A typical VC cycle in China is similar to its international counterpart.175 The cycle consists of three stages: raising a VC fund (fundraising), investing in and adding value to a portfolio company through the VC fund (investment), and realising profits and returning them to the VC investors (exit). A VC project also involves three major parties: (1) investors who provide capital to the VC fund; (2) venture capitalists who manage the VC fund and who identify and give credibility to their portfolio companies by providing management assistance, intensive performance monitoring, and reputational capital; and (3) entrepreneurs within the portfolio companies.176 The core chapters of the book – Chapters 2, 3, and 4 – provide a legal analysis of China’s VC market according to the three stages of a VC cycle scoped out above. Chapter 2 critically examines the legal and regulatory problems relating to VC fundraising and evaluates the role of regulators in facilitating VC fundraising in China. It discusses the major sources of funding and the role that institutional investors play in China’s VC market. The legal structure of the VC fund will also be discussed given that it has a profound impact on the behaviour of investors and managers. In doing so, the chapter compares the different business organisational forms of VC funds under Chinese law and evaluates the advantages and disadvantages within each type of fund. Given that the limited partnership is the most popular form for VC fundraising in China, this chapter focusses on its attributes and specifically discusses the internal governance and compensation of the general partners. This chapter also 174

175

176

These model legal documents include the model legal documents of NVCA, the model legal documents made by the leading Silicon Valley law firm Cooley LLP, and the VIMA. For the international version of the venture capital cycle, see generally Paul Alan Gompers and J. Lerner, supra note 28. Ibid.

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critically evaluates the role of foreign-invested funds, the development of the government guidance funds (GGFs), as well as the problems of GGFs in China. Chapter 3 discusses VC investment in China. Based on empirical data, this chapter studies the core contractual mechanisms used in VC investments in other jurisdiction and the legal obstacles to their use in China. It then evaluates whether these mechanisms are able to incentivise both venture capitalists and entrepreneurs in the VC investment stage. It also discusses the prevalence of a unique contractual design in China’s VC market – the valuation adjustment mechanism (VAM) agreements concluded between the investor and the portfolio company/the company’s shareholders or founders – along with the reasons behind its prevalence in China, the problems in using VAMs, and how the Chinese VC market should develop in respect of VC contracting. Chapter 4 explores exits of VC investments in China. Through empirical studies, this chapter explores the connection between the stock market and the VC market in China, VC-backed IPOs, and mergers and acquisitions (M&As), the role of the government in facilitating VCbacked exits by building a multi-layer capital market, as well as the lack of a personal bankruptcy law for a long period and its implication on the VC market. This chapter identifies the legal problems and institutional impediments faced by practitioners in the stage of VC exit, evaluates the new Science and Technology Innovation Board on the Shanghai Stock Exchange and the newly introduced dual-class stock structure, and makes suggestions for major steps forward. This chapter illustrates that law plays an instrumental role in facilitating VC-backed exits, which in turn is a key determinant of the success of China’s VC market. The last chapter concludes this monograph with a summary of its findings. It takes a second look at the three questions raised at the beginning of this book: First, how did China create the world’s second largest VC market within such a short period of time? Second, what are the lessons of general applicability which may be extracted from China’s VC story? Third, what are the ways forward for China’s VC market? It concludes that China has facilitated the simultaneous availability of VC and the emergence of a class of entrepreneurs through constant legal and policy reforms. One key factor of the rapid development of the Chinese market in recent years has been its increased reliance on market forces in allocating capital. The Chinese experience shows that governments can facilitate the creation of a VC market premised on market forces through appropriately designed governmental interventions, specifically, by

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restricting its own participation in capital allocation and leaving capital allocation decisions to private-sector parties with the right incentives. However, this should be done only after the key market infrastructure has been set up. Failure to do so would prevent the VC market from attaining sustainable growth. This chapter also suggests future law and policy reforms to develop a sustainable VC market.

2 Venture Capital Fundraising

2.1 Introduction This chapter discusses venture capital (VC) fundraising, the very first stage of the VC life cycle, in the Chinese VC market. The general practice of VC fundraising has been discussed in fair detail in the existing literature:1 investors and experienced professionals partake in an investment venture, with the former contributing capital and the latter contributing expertise. In other words, capital that is pooled from investors is entrusted to specialised professionals for investment into specific portfolio companies. This fundraising process creates a number of legal problems, which have been analysed by academics. Most notable among these issues are the potentially divergent interests between investors and professionals and the best methods by which to address resulting conflicts. In developed VC markets such as the United States (US), several legal solutions are available to address this problem, including the use of specialised investment vehicles such as the limited partnership, which demarcates distinct rights and responsibilities of investors (as limited partners (LPs)) and managers (as general partners (GPs)) in order to manage the investor–manager relationship and the imposition of fiduciary duties on managers. This chapter articulates the Chinese narrative on VC fundraising, which is little understood outside China. It starts by identifying the various business organisational forms which Chinese VC funds organise 1

See L. Lin and U. Varottil, ‘Venture Capital in China and India: Does Business Form Matter?’ Vanderbilt Journal of Transnational Law 53(3) (2020), 949; L. Lin, ‘The Private Equity Limited Partnership in China: A Critical Evaluation of Active Limited Partners’, Journal of Corporate Law Studies, 13(1) (2013), 185.

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45

themselves as and specifically examining the Chinese limited partnership along with its special features. It makes a case for the importance of business forms in VC fundraising and offers suggestions to further liberalise the Chinese limited partnership vehicle to meet the evolving needs of the market. The chapter then moves on to identify, in general terms, a few unique features of the Chinese VC fundraising space that predominantly concern the identities and roles of LPs and GPs and the dynamics of the LP–GP relationship. Market participants are depicted as generally lacking in sophistication and the resulting problems which may arise are canvassed. Next, the current legal landscape and regulatory framework for government guidance funds and foreign funds are examined critically. Finally, suggestions for future reforms are made. The current investor protection regime is explored and its deficiencies revealed when considered against the various incidents of market failure and fraudulent fundraising. Specific issues are addressed, such as the fact that the legal framework governing GPs remains highly abstract in terms of the substantive performance standards imposed and regrettably vague in terms of enforcement procedures when contrasted with its Western counterparts. Accordingly, suggestions are proposed to improve the existing legal framework, for example by taking a leaf from the established common law standards and supplying more concrete requirements into GPs’ duties. There are also suggestions for improving market sophistication and reputation, as well as increasing the role of market forces in VC allocation.

2.2 Organisational Forms of Venture Capital Funds Many jurisdictions have introduced various kinds of investment vehicles in order to enhance the attractiveness of their respective VC markets. However, the investment vehicle preferred by venture capitalists and investors varies from one jurisdiction to another. At the fundraising stage, the limited partnership has been the predominant vehicle in the US since the 1970s,2 while the company has been the predominant vehicle in Taiwan’s VC market.3 2

3

See P. Gompers and J. Lerner, The Venture Capital Cycle, 2nd ed. (The MIT Press, 2004), at p. 10 and p. 32. C. Gulinello, ‘Engineering a Venture Capital Market and the Effects of Government Control on Private Ordering: Lessons from the Taiwan Experience’, George Washington International Law Review, 37 (2005), 845.

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In recent years, a number of jurisdictions such as Singapore,4 New Zealand,5 Taiwan,6 Japan,7 and Switzerland8 have introduced the limited partnership onto their business menu to attract more equity investment. Other jurisdictions that already have the limited partnership vehicle, such as the United Kingdom (UK),9 Cayman Islands,10 and Australia,11 have also recently amended their limited partnership regimes in order to encourage the growth of VC investment. As a result of these efforts, the limited partnership has become the dominant business form globally.12

4

5

6

7

8

9

10

11

12

Singapore passed the Limited Partnership Bill on 18 November 2008. The Singapore Limited Partnerships Act 2008 (Cap 163B, Rev. Ed. 2001) came into operation on 4 May 2009. See L. Lin, ‘Venture Capital in Singapore: The Way Forward’, Journal of Business Law, 5 (2019), 363–387. The Limited Partnerships Act 2008 (2008/1) came into force on 2 May 2008 in New Zealand. See New Zealand Companies Office, News Release and Introducing Limited Partnerships (3 December 2008). Taiwan Executive Yuan, News Release, ‘Taiwan Executive Yuan Passed the Limited Partnership Bill’ (12 Feb 2015), www.ey.gov.tw/Page/9277F759E41CCD91/b45e41ab5302-4b59-bdf1-016e48caf3ee. In 1999, the National Diet of Japan passed the Limited Partnership Act for Investment (Act No. 90 of 3 June 1998) (投資事業有限責任組合契約に関する法律) to enable the formation of the Limited Partnership for investment. A special form of limited partnership which was designed for collective investments in the area of alternative investment was introduced into Swiss law in 2007. See R. Bärlocher, ‘The Swiss Limited Partnership – An Attractive Structuring Alternative for Private Equity in Europe’, European Lawyer (December 2007/January 2008), 77. The British Government announced in 2006 that it would reform the Limited Partnership Act 1907 to clarify and modernise the law relating to limited partnerships. Certain changes based on these recommendations were brought forward in a legislative reform order laid before Parliament in June 2009. In 2017, the British government published a legislative reform order to change partnership legislation for private equity investments. See Legislative Reform Order to change partnership legislation for private equity investments (16 January 2017), https://www.gov.uk/government/publications/ legislative-reform-order-to-change-partnership-legislation-for-private-equityinvestments. Cayman Islands revised the Exempted Limited Partnership Law in 2018 to make it possible to form limited partnerships for offshore investors with the minimum of delay. See Cayman Islands, General Registry, www.ciregistry.ky/partnerships-register/types-ofpartnerships/exempted-limited-partnership/. In 2007, the Tax Laws Amendment (2007 Measures No. 2) Bill 2007 was introduced in Australia in order to relax the eligibility requirements for foreign residents investing in VC LPs and Australian VC funds. See Minister for Revenue and the Assistant Treasurer, Media Release, ‘Government to Make Further Improvements to the Tax System’ (29 March 2007), available at www.tax-news.com/news/Australia_To_Make_Further_Improvements_To_ Tax_System____28194.html. L. Lin, ‘Engineering a Venture Capital Market: Lessons from China’, Columbia Journal of Asian Law, 30(1) (2017), 160–220 at pp. 180–181.

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Chinese policymakers thus have strong incentives to introduce efficient legal rules and business vehicles to meet the needs of its emerging VC market and have sought to implement such reforms in the same way as other jurisdictions. Over the years, new business vehicles have been introduced as solutions to the various problems that arise in the VC cycle. Chinese VC funds fall into three major categories depending on their organisational forms: (1) limited partnership-type funds,13 (2) companytype funds, and (3) trust-type funds.14

2.2.1 Limited Partnership 2.2.1.1 A Venture Capital-Oriented Business Vehicle The limited partnership is a new business vehicle created by the revised Partnership Enterprise Law of the People’s Republic of China (PEL) on 1 June 2007.15 The adoption of the limited partnership was part of the government’s strategy to develop scientific innovation as articulated in its 11th Five-Year Plan (2006–2010).16 Enacted in 2005, the Five-Year Plan identified the promotion of VC investment as an element critical to achieving ‘independent innovation’ and sustainable economic progress in China.17 The Chinese legislature, knowing that the limited partnership had already proven to be a popular business form for VC funds in the US and had been introduced by a number of jurisdictions18 to encourage investment, decided to introduce it into China to facilitate the development of VC.19 13 14

15

16

17

18 19

Ibid., at pp. 180–181. The trust-type private equity fund emerged in China in 2008. The trust-type fund is regulated by the PRC Operational Guidelines for Private Equity Investment Trust Business of Trust Companies 2008, the China Banking Regulatory Commission, [2008] No. 45. The law was promulgated in 2006 and came into effect in 2007. Prior to the revision of this particular statute, the general partnership was the only partnership enterprise allowed under PRC law. See Central Committee of the China Communist Party, ‘The Eleventh Five Year Plan’, online: Government of People’s Republic of China, passed on 11 October 2005 at the Fifth Meeting of the Sixteenth Central Committee of the China Communist Party, available at www.gov.cn/english/special/115y_index.htm See Y. Yan, ‘Reasons of Revising the Partnership Enterprise Law’, National People’s Congress, News Release (8 May 2006), online: www.npc.gov.cn/zgrdw/npc/bmzz/caiz heng/2006-05/08/content_1383740.htm. Before the introduction of LPs, the only major legal structures generally available for VC firms in the PRC were the limited liability company, joint stock company, and general partnership, but all of them are unattractive because of their inherent features. See supra text accompanying notes 4 –11. Supra note 17.

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Up until 2006, there was only one type of partnership enterprise under Chinese law, that is the general partnership enterprise (putong hehuo qiye). This type of partnership had not garnered much popularity as a business vehicle for the purpose of raising VC funds primarily because all partners are personally liable for the debts and obligations of the partnership. Immediately following the enactment of the revised PEL on 1 June 2007, the very first Chinese limited partnership (Nanhai Chengzhang Venture Investment Limited Partnership)20 was set up on 27 June 2007.21 By the following year, more than half of the newly raised VC funds were organised as limited partnerships.22 The author’s earlier paper shows that the most popular business form among newly raised VC funds from 2008 to 2017 was the limited partnership, reflecting an overwhelmingly positive response in the business community towards this new business vehicle.23 As shown in Table 2.1, in 2017, 82.3 per cent of the newly raised VC funds were registered as limited partnerships.24 The popularity of the limited partnership in China can be attributed to several factors. First, the adoption of the limited partnership increases the range of business options available to venture capitalists. Prior to the introduction of the limited partnership, the major business forms used by venture capitalists were the limited liability company (LLC), the joint stock company (JSC), and the general partnership. Each of these business vehicles had their own limitations. LLCs and JSCs faced double taxation, substantial formation costs, and substantial financial disclosure requirements,25 while general partnerships gave rise to unlimited liability for all partners and used to face a similarly harsh tax burden.26 The limited partnership faced none of these problems. 20

21 22

23 24

25

26

Shanghai Securities News, ‘The First Venture Capital Limited Partnership was Established’ (29 June 2007). ‘The First Limited Partnership in China’, First Financial Daily (17 March 2009). China Venture Capital Yearbook 2009, (中国风险投资年鉴) (Beijing, China: Democracy and Construction Press, 2009), at p. 252. L. Lin and U. Varottil, supra note 1, at table 1. PE Daily (2017年中国股权投资市场募资策略专题研究报告) ‘The 2017 Special Report on Fundraising Strategies in the Chinese Equity Investment Market’ (30 May 2018), online: PE Daily https://m.pedaily.cn/news/431823. Before the revision of the Company Law of the PRC 2005, it was not easy to incorporate a company in China as the minimum capital required for the LLC and the JSC was RMB 30k and RMB 5 million, respectively. Before 2000, the PRC partnership enterprise was subject to taxation both at the enterprise level and upon distribution. Since 2000, the partnership enterprise has become tax transparent.

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Table 2.1 Different types of business forms used for newly raised VC funds in China (2012–2017)a

2017b 2013 2012

Limited partnership (%)

Company (%)

82.3 68.96 57.50

6.1 24.14 35.00

Trust (%) 11.6 0.00 5.00

Others (%)

Total (%)

6.90 2.50

100 100 100

a

Source: China Venture Capital Yearbook, published by Democracy and Construction Press. The sample size for the years from 2012 to 2013 is 40 and 29, respectively. The figures are collected from Zero2IPO Research Center, China Venture Capital Annual Report, Zero2IPO Publisher (2012–2013), online: www .pedata.cn/report_do/index.html. Data of 2017 from PE Daily, 2017年中国股权 投资市场募资策略专题研究报告, ‘The 2017 Special Report on Fundraising Strategies in the Chinese Equity Investment Market’ (30 May 2018), online: PE Daily https://m.pedaily.cn/news/431823. b PE Daily, ibid.

Second, the contractual nature of the limited partnership was also appealing. Like partnerships in most parts of the world, the Chinese limited partnership is governed by the partnership agreement. This flexibility meant that partners can design and enter into covenants that best align the interests of the investors and the venture capitalists, particularly in the areas of compensation and management. Moreover, as compared to companies, partnerships enjoy a greater degree of confidentiality in their financial information – an attractive feature for investors (such as wealthy families and individuals) who do not wish to disclose their investment in such funds. Partnerships also enjoy considerably lower formality costs as compared to companies. Further, the combination of limited liability and personal liability meets the needs of the key players in a VC market, especially those of the investors, who prefer to entrust their capital to experienced venture capitalists and would not want to bear unlimited liability for the debts of the partnership. Additionally, partnerships enjoy tax transparency at the entity level in China. In China, the standard corporate income tax rate is

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25 per cent.27 The personal income tax rate is generally categorised into three types: (1) a progressive tax rate of 3 per cent up to 45 per cent is applied for the taxation of the comprehensive income; (2) a progressive tax rate of 5 per cent up to 35 per cent is applied for the taxation of the operating income; and (3) a proportional tax rate of 20 per cent is applied for the taxation of any income from interest, dividends and bonuses, lease of property, transfer of property, and other sources. Many local Chinese governments have implemented preferential tax policies for VC firms that serve as GPs and for their investors who serve as the LPs in VC funds. For example, in the city of Tianjin, a considerably low tax rate of 20 per cent on individual income is applicable to GPs and LPs who are natural persons, and a 100 per cent subsidy is granted for any tax above this 20 per cent threshold.28 China’s Ministry of Finance and State Administration of Taxation (SAT) issued a Circular 8 on 10 January 2019 setting out the individual income tax rules for individual partners of VC enterprises taking limited partnership form. Such a drop in the tax rate can have a substantial effect on the willingness of corporate employees to become entrepreneurs, thereby increasing the need for VC. This increase in demand caused by greater entrepreneurial activity could also lead to more VC fundraising.29 In the Chinese market, a typical VC fund is a fixed-life fund organised as a limited partnership, raised and managed by a professional VC firm comprising investment professionals. The limited partnership agreement clearly sets out the rules governing matters such as the rights and obligations of partners, governance, and compensation. The VC firm typically serves as the GP and carries out the day-to-day operations of the fund’s business, such as raising new funds, selecting portfolio companies, and managing and monitoring the fund’s investments. Investors usually act as LPs and provide capital to the fund. Figure 2.1 shows the typical structure of a limited partnership-type VC fund in China.

27

28

29

But eligible enterprises in state-encouraged industries (e.g. high-tech companies and certain integrated circuit manufacturers) can enjoy a lower tax rate of 15 per cent. Enterprises engaging in state-encouraged projects can also enjoy regular tax exemptions and reductions. For the tax treatments of limited partnership-type funds in China, see L. Lin, supra note 12, at 178. See P. Gompers and J. Lerner, supra note 2, at 25.

v e n t u r e c a p i t a l f u n d r a i si n g

Venture Capital Firm (General Partner)

51

Investors (Limited Partners)

Capital contribution

Management Venture Capital Fund (Limited Partnership)

Make investments in

Portfolio Company A

Portfolio Company B

Portfolio Company C

Figure 2.1 Typical structure of a limited partnership-type VC fund in China. Source: Lin Lin and Umakanth Varottil, “Venture Capital in China and India: Does Business Form Matter?” Vanderbilt Journal of Transnational Law, 53(3) (2020), 949–987, figure 1.

2.2.1.2 Special Features of the Chinese Limited Partnership As indicated in the drafting materials of the PEL, the Chinese limited partnership was not intended to model any specific foreign limited partnership regime. Instead, it adopted various legal institutions and provisions from existing limited partnership regimes or similar business forms around the world, including the US and Germany.30 In China, partnerships, including limited partnerships, are not considered ‘legal persons’ (fa ren). Under the PRC Civil Code, a ‘legal person is an organisation with capacity for civil rights and capacity for civil conduct, and enjoys civil rights and assumes civil obligations 30

See generally S. Zhu and Y. Ge (朱少平,葛毅), (《中华人民共和国合伙企业法》的修 订：立法进程资料汇编) [Collection Of Materials Relating to the Amendment of the Partnership Enterprise Law] 4 (2004). For discussion on the nature of limited partnership in China, see further in L. Lin and U. Varottil, supra note 1.

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independently in accordance with the law’.31 ‘A legal person shall have its own name, organs, domicile, and property or funding.’32 Partnership enterprises are considered non-legal-person organisations (fei faren zuzhi), which refer to organisations without legal personality but with the capacity to conduct civil actions in their own names.33 Although Chinese partnerships do not have a separate legal personality, the general impression is that they appear to possess certain attributes that are consistent with the entity approach – for example, it is able to hold assets in its own name34 and sue and be sued in its own name;35 furthermore, during insolvency, recourse against the partners is withheld until a creditor has exhausted its remedies against partnership assets;36 and lastly, the partnership is not automatically dissolved upon the dissociation of partners.37 The Chinese limited partnership model possesses the basic features of a modern limited partnership regime.38 The Chinese limited partnership is deemed to be valid from the date of issue of the partnership enterprise business license.39 With regard to the parties, there are two types of partners: (1) GPs who are jointly and severally liable for the debts and liabilities of the firm, and (2) LPs who are only liable to the extent of their capital contributions.40 At least one GP must be expressly identified as 31 32 33 34 35 36

37

38 39 40

Civil Code 2020 (PRC), Art. 57. Civil Code 2020 (PRC), Art. 58. Civil Code 2020 (PRC), Art. 102. Partnership Enterprise Law 2006 (PRC), Arts. 20, 21, and 22. See Civil Procedural Law 2007 (PRC), Art. 49. L. Lin and H. Y. Yeo, ‘Limited Partnership: A New Business Vehicle in People’s Republic of China’, Butterworths Journal of International Banking and Financial Law, 25(2) (2010), 104. Partnership Enterprise Law 2006 (PRC), Art. 48 provides that where any partner is under any of the following circumstances, the said partner shall be deemed to have withdrawn naturally from the partnership: (1) a natural person partner is deceased or declared deceased according to law; (2) it (he) is insolvent; (3) a partner as a legal person or any other organisation whose business license is revoked, or who is ordered to close up for revocation, or who is declared bankrupt; (4) a partner loses the relevant qualifications as required by law or as stipulated in the partnership agreement; or (5) a partner’s entire property share in the partnership business has been executed by the people’s court. Ibid. Partnership Enterprise Law 2006 (PRC), Art. 11. Partnership Enterprise Law 2006 (PRC), Art. 2.

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the partner who would bear unlimited liability for the debts of the firm.41 Furthermore, partners can be individuals and legal persons.42 The Chinese limited partnership also incorporates the fundamental default rule on the management of the firm – an LP shall not ‘carry out partnership affairs’, while GPs have the right to conduct the day-to-day management of the firm.43 Beyond the similarities discussed in the previous paragraph, the Chinese limited partnership also possesses some special features that distinguish it from its US counterpart. These deserve critical examination. First, the PEL does not allow wholly state-owned companies, stateowned enterprises (SOEs),44 listed companies,45 charitable institutions,46 and social organisations to serve as GPs in a limited partnership.47 The legislative concern is that GPs assume unlimited liability for the debts of the partnership, and allowing such entities to serve as GPs may expose national assets and public funds to an unacceptable degree of risk.48 There is also a great degree of uncertainty here as the PEL is silent on whether subsidiaries or branches of the listed companies or SOEs can

41 42 43 44

45

46

47 48

Partnership Enterprise Law 2006 (PRC), Art. 61. Partnership Enterprise Law 2006 (PRC), Art. 2. Partnership Enterprise Law 2006 (PRC), Arts. 2, 67, and 68. The National People’s Congress has defended this proposition on the basis that allowing state-owned companies to be GPs may trigger the stripping of state-owned assets and that allowing listed companies to be GPs may also unduly prejudice the interests of shareholders. The latter’s investment in the company may then be exposed to ‘double risks’ in that the company will have to bear unlimited liability not only for the debts incurred by the limited partnership but also for its own corporate debts. See Partnership Enterprise Law 2006 (PRC) Art. 24; See also F. Li, Interpretation of Partnership Enterprise Law of the People’s Republic of China (Beijing: Law Press China, 2006), at p. 4. However, it is arguable that the PRC Company and Securities Laws have already provided sufficient mechanisms to protect shareholder interests. Moreover, the requirement that partners must be registered will, in principle, provide the means for any third party who deals with (or proposes to deal with) the LP to easily identify whether the listed company is a GP in the firm. There is, hence, arguably no need to prevent the listed company from being a GP. The preclusion of charitable institutions and social organisations from being GPs has been justified by the National People’s Congress on the ground of protection of ‘public interest’. As many activities of these organisations involve the public and publicly donated funds, it may be inappropriate to expose such organisations to potential unlimited liability. Partnership Enterprise Law 2006 (PRC), Art. 4. F. Li, supra note 44, at 6.

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serve as GPs,49 and there are different regulations on which types of companies are considered to be ‘SOEs’50 and consequently barred from becoming GPs. Second, unlike other jurisdictions such as the State of Delaware,51 the UK,52 and Singapore53 that do not impose an upper limit on the number of partners in the limited partnership, the Chinese limited partnership can only have a total of a minimum of two and a maximum of fifty partners.54 The major concern of the drafters underlying this rule is that investors may engage in illegal fundraising if there is no upper limit on the number of investor partners.55 However, in practice, partners are able to get around this upper limit by emplacing a company as the GP and having additional LPs subscribe as shareholders of that company.56 Setting aside any innovations in structure, prescribing a maximum number of partners may unduly constrain the number of investors and the size of the fund and is inconsistent with international practice. As such, it is suggested that the restriction on the number of partners be removed from the PEL. Third, in contrast to the law in Delaware57 that allows LPs to contribute in kind by rendering services, LPs of a Chinese limited partnership can only contribute in cash, tangible goods, intellectual property, land use rights, or other property rights.58 The drafters of the PEL assert that, 49

50

51 52

53 54 55 56

57 58

The practical view is that subsidiaries of a listed company can serve as GP of a limited partnership as the listed company is only liable for the contribution in its subsidiary but does not need to bear unlimited liability for the debts of the partnership. These relevant regulations include Notice on Issuing the Interim Provisions on the Administration of the Marks of Listed Companies’ State-owned Shareholders 2008 [关于 实施上市公司国有股东标志管理暂行规定有关问题的函], [2008] No. 80; Provisions for the Classification of Types of Enterprise Registration 2011 [关于划分企业注册类型的 有关规定], [2011] No. 86. See Delaware Revised Uniform Limited Partnership Act, § 17-101. Although the UK used to impose an upper limit on the number of partners, there is no longer such a limit for all types of partnerships since 2001. Singapore Limited Partneship Act, section 3(2). Partnership Enterprise Law 2006 (PRC), Art. 61. See F. Li, supra note 44, at 100. Some interviewees said that this restriction was not an obstacle in fundraising, especially when the investor is an institutional investor. Given that the national pension fund has been given approval by the State Council to engage in VC/PE investment, it is assumed that the limitation on the number of LPs will not have a considerable side effect in fundraising. Delaware Revised Uniform Limited Partnership Act, §17-501. Partnership Enterprise Law 2006 (PRC) Art. 64 read with Art.16.

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first, LPs do not participate in the management of the fund, and hence there is no need for LPs to contribute in services. Moreover, allowing LPs to make contributions in kind may create difficulties in valuing their partnership shares.59 However, the expertise and industrial experience of the LPs can also be invaluable assets to the success of the fund. Indeed, valuing a service is not much more difficult (and, in fact, could be easier) than valuing an intangible asset like intellectual property. Therefore, practical difficulties provide an unsatisfactory rationale for a blanket rule against contributions in kind from LPs. It is therefore recommended that the PEL should be amended to allow LPs to make contributions in the form of services.60 Fourth, under the Chinese limited partnership, partners are allowed to transfer their partnership shares to an assignee of a GP, with such an assignee becoming a GP himself and thus being subject to rights and obligations in accordance with the amended agreement and the PEL.61 This allows the new GP to completely take over the management of the fund.62 Arguably, any change in GP is likely to result in serious consequences for a limited partnership-type VC fund, particularly with regard to the LPs’ interests since they rely on the personal skills of the GP to invest in the fund. Therefore, it is submitted that the PEL should not entitle the assignee, during the continuance of the partnership, to participate in the management of the fund. Fifth, the law of Delaware does not require newly admitted GPs or LPs to be personally liable for the prior obligations of the partnership.63 Logically, the newly-admitted partner ought not to bear 59 60

61 62

63

See F. Li, supra note 44, at 105–106. Where capital contribution that takes the form of in-kind benefits, intellectual property, land use rights, or any other form of property rights requires valuation, the Partnership Enterprise Law 2006 (PRC) Art.16 additionally provides that all the partners may determine the value of the contribution or appoint a statutory organisation to conduct the valuation. It is submitted that allowing the partners to determine the value of their own contributions is inappropriate, since such practices would invariably prejudice the interests of any third party dealing with the VC fund. In particular, the venture capitalist’s contribution in a VC fund is usually in terms of non-monetary property, and it is suggested that the partners should appoint a neutral party to perform the appraisal instead. Partnership Enterprise Law 2006, (PRC) Art. 24. See also F. Li, supra note 44, at 37. This stands in stark contrast to the assignee’s position under the Uniform Partnership Act, whereby a transfer in whole or in part of a GP’s transferable interest in the partnership does not entitle the transferee to participate in the management of the partnership business. See Uniform Partnership Act of 1997 (US), §503. https://users.wfu.edu/palmi tar/ICBCorporations-Companion/Conexus/UniformActs/RUPA1997.pdf See Delaware Revised Uniform Partnership Act, §15-306 (b); Uniform Partnership Act of 1997 (US), §306.

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any liability for the prior debts of the firm since he was not a partner then and was not involved in any form of management of the firm. However, similar to the position adopted in Germany64 and Japan,65 a GP in a Chinese limited partnership assumes joint liability with the existing partners for the debts incurred by the firm before he joined the firm. Correspondingly, a new LP will bear liability to the extent of his capital contribution even if the partnership’s debts were incurred before he joined the firm.66 Arguably, this imposition of liability is inconsistent with principle and would reduce the attractiveness of the limited partnership vehicle to venture capitalists and investors. Sixth, unlike the Delaware code, the PEL does not provide any rules specifying how an existing company or partnership may convert into a limited partnership or vice versa. There is a real practical need for VC limited partnerships to be able to convert into companies as portfolio companies backed by limited partnership-type funds are not allowed to list on the stock exchange under current Chinese law.67 Consequently, funds must deregister as limited partnerships and re-establish themselves as companies in order to realise their exits. This introduces additional monetary and time costs that can be avoided by introducing a more streamlined conversion procedure. It is therefore suggested that the Chinese legislature should provide a seamless process for the conversion of limited partnerships to companies.68 Finally, another distinctive feature of the PEL is the requirement that a limited partnership must be dissolved and converted into a general 64

65

66 67

68

Handelsgesetzbuch, Commercial Code (Germany), §130 provides that a new partner is equally liable as the other partners for partnership obligations incurred before he joined. Handelsgesetzbuch, Commercial Code (Germany), §173 also provides that a new limited partner shall be liable for partnership obligations incurred before he joined. Commercial Code (Japan) (Act No. 48 of 9 March, 1899), Art. 82 provides that in a corporate partnership (Gomei Kaisha), ‘a corporate member which joined the corporation after its establishment is also liable for the obligations of the corporation arising before the corporate member joined the corporation’. Partnership Enterprise Law 2006 (PRC), Arts. 44 and 77. G. Yang, ‘RMB Funds Change Face: A Trend to Convert Back to Companies through Increasing Capital Contribution by GP’, (2 June 2009) Chinese Venture. It is suggested that the draftsman may consider Delaware’s rules for the conversion process: before a certificate for ‘conversion’ to limited partnership can be filed with the Secretary of State, the proposal for conversion should be approved internally by the company or partnership and there should be a partnership agreement that includes seeking the approval of those who have agreed to be the general partners of the limited partnership after the conversion process. See Delaware Revised Uniform Limited Partnership Act, §17-217.

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partnership in the event that the firm is left with only LPs after the departure of all GPs.69 Equivalent provisions are not found in its German, French, and Delaware counterparts.70 In view of this, it is suggested that a Chinese limited partnership with only LPs should be allowed to continue operating as a limited partnership over a grace period so as to explore possible options and attract incoming GPs. Furthermore, as a typical VC fund usually lasts for ten years and makes long-term investments in a number of portfolio companies, forcing a limited partnership to be dissolved would create unnecessary costs and adversely affect the operation of the investee portfolio companies, which largely rely on the provision of funding and management by the VC fund. Table 2.2 Limited partnerships in China and Delaware: a comparison Characteristics

China

Delaware

Legal personality

Not a separate legal person 2–50 partners; Exclude wholly SOEs, listed companies, charitable, and social organisations LPs shall not participate in the management of the firm

Entity with legal personality No maximum limit

Constituents

Control rule

Contributions by LPs GPs’ fiduciary duties

69 70

Exclude services

If the LP does participate in the control of the business, the LP is liable only to persons who transact business with the firm reasonably believing, based upon the LP’s conduct, that the LP is a GP. Include services

Partnership Enterprise Law (PRC) 2006, Arts. 24 & 75; See also F. Li, supra note 44, at 122. For example, under the Delaware Revised Uniform Limited Partnership Act, § 17-801, the firm will not be automatically dissolved if the sole remaining partner is either a limited partner or a general partner; instead, the Delaware limited partnership is allowed to appoint another limited or general partner within a grace period of ninety days (or such other period as provided for in the partnership agreement).

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Table 2.2 (cont.) Characteristics

Transferable interest

China

Delaware

No equitable fiduciary duties, but a few statutory duties under the PEL An assignee will become a partner

Duties under common law and the Delaware Code

Incoming partner’s liability

Liable for the debts incurred by the limited partnership before he joined the firm

Dissolution

The limited partnership must be dissolved if left with only LPs after the departure of all GPs The limited partnership must be converted to a general partnership if left with only GPs The limited partnership must be dissolved if left with only one GP Lack of detailed procedure

Derivative actions by LPs

An assignment of a partnership interest does not entitle the assignee to become a partner, but a partner ceases to be a partner if he assigns all partnership interests Not personally liable for any obligation of the limited partnership incurred before the person’s admission as a partner A limited partnership will not be automatically dissolved if the sole remaining partner is either an LP or a GP; instead, the limited partnership is allowed to appoint another LP or GP within a grace period of 90 days Detailed procedure

2.2.2 The Company as an Alternative to the Limited Partnership Another major business vehicle used by VC funds in China is the company. Domestic VC funds can choose to be set up as an LLC or a JSC.71 71

Foreign-invested VC funds may choose another business form specially designed for foreign-related investments – the VC investment enterprise (VCIE). As compared to a domestic company-type VC fund which is subject to double taxation, the VCIE enjoys

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One advantage of the company-type fund as compared to the limited partnership-type fund is that the liability of all shareholders in the former is limited, whereas the GPs in the latter have to bear unlimited liability. Second, shareholders in company-type funds are entitled to participate in the management of the funds by exercising their shareholder rights, which include the right to vote and appoint directors. The company structure is presumably more attractive to individual investors,72 who will find it easier to participate in the management of the funds, as compared to the limited partnership which, under the default rule, does not allow investors to take part in the control of the fund. Third, directors on the board, supervisors on the supervisory board, and senior management in the corporate form are subject to stricter legal regulations under Chinese law, as compared to those found in the PEL. The relevant statutes include the PRC Company Law, the PRC Securities Law, and the Listing Manual of the Stock Exchanges. For example, the PRC Company Law stipulates that directors, supervisors, and senior management are subject to duties of integrity and sound management.73 They are also subject to statutory duties of loyalty, diligence, and restrictions against personal gains.74 This provides stronger protection to fund investors than the Chinese partnership law, PEL, which does not impose any statutory duties of loyalty or diligence on partners.

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substantial tax incentives in the form of a 70 per cent tax deduction of its total investment in target enterprises from the VC enterprise’s taxable income if it makes equity investments in private high-tech and new technology SMEs for more than two years. This type of fund is regulated under the 2005 Interim Measures on Administrative Rules on FIVCIE. See Minister of Finance and State Administration of Taxation Circular on Tax Policies Promoting Development of Venture Capital Enterprises 2007 Cai Shui. No. 31 (PRC), Art. 1. The main criteria include the following: (1) The VC enterprise itself must be properly registered in China and be operating in compliance with the Provisional Measures on Administration of Venture Capital Enterprises issued in 2005, (2) The size of the investee is restricted to no more than 500 employees, and neither gross sales nor total assets can exceed RMB 200 million (about USD 32 million), and (3) When the VC enterprise files the application for the special tax deduction, the investee must be certified as a ‘high-technology enterprise’ in accordance with the relevant high-technology enterprise certification rules. These rules require that the investee’s annual high-technology R&D expenditures represent at least 5 per cent of the investee’s gross annual sales, and that the aggregate income derived from technical services and sale of high-technology products represent at least 60 per cent of the investee’s annual gross revenues. Individual investors are most prone to intervention that doing so best protects their rights and monitors the management. Company Law 2005 (PRC), Art. 6. Company Law 2005 (PRC), Art. 147.

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Nonetheless, in terms of internal governance, company-type funds are less flexible than partnership-type funds. The PRC Company Law has various mandatory requirements regarding the corporate governance of a company. In particular, China has a two-tier board system for companies, i.e. the board of directors and the supervisory board. An LLC has to establish a board of three to thirteen directors as well as a supervisory board comprising either at least three members, or one to two supervisors if the company is small in scale with a small number of shareholders.75 This may be contrasted with the limited partnership where the relationship between the GPs and LPs is mainly based on the partnership agreement. One issue with the mandatory organisational structure of a company is that it may cause practical problems in the rapidly changing business world. In particular, when the number of shareholders increases, the composition of the boards of the company will have to be adjusted accordingly in order to meet the statutory requirements.76 For example, an LLC may have to set up a supervisory board instead of simply having an individual supervisor when the size of the company increases to a certain threshold.

2.2.3 Trust-Type VC Funds Trust-type funds began to emerge in China in 2007.77 In a typical trust-type fund, a trust company acts as the trustee of a fund and is responsible for fundraising and investments. Capital is pooled from investors via a trust plan. A trust company would either employ a professional investment company (normally a private equity (PE) firm or an investment bank) as the investment consultant of the fund, or conduct investments on its own. It is also common for a trust company to set up an investment committee to select portfolio companies and make investments. Investors participate in the management of the trust plan through beneficiary meetings and share in profits according to the trust plan. There is no taxation of trust

75 76

77

Company Law 2005 (PRC), Arts. 44 and 51. See J. Zou, Fundraising and Operation of Private Equity Fund (Beijing: Law Press China, 2014), at p. 64. This type of fund is regulated by the PRC Trust Law, the Operational Guidelines for the Private Equity Investment Trust Business of Trust Companies 2008, the China Banking Regulatory Commission (Yinjianfa), 2008 No.45 (PRC).

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profits; instead, individual income tax or enterprise income tax is levied on the beneficiaries. Nonetheless, the trust-type fund has not been a popular business form for fundraising in China (Table 2.1). This can be traced to the structure’s complexity, insufficient protection to investors and beneficiaries, as well as the lack of a registration regime. The trust form suffers from its complex structure and insufficient protection of investors and beneficiaries, which are major obstacles to large-scale adoption.78 Under current regulations, the highest decision-making authority reposes in the investment committee of the trust-type fund, which decides on important investment issues.79 The investment committee is not strictly required by law, and its composition may vary. Typically, its members are primarily drawn from investment consultants, one of whom will also serve as the committee’s chair, and supplemented by members from the trustee company. These investment consultants play a key role in the investment process by shortlisting potential portfolio companies and carry out processes such as due diligence and negotiations. It is then for the investment committee as a whole to decide on the selection of investment projects and investment strategies. The beneficiaries’ meeting has no power to interfere with project selection and investment decision-making. Investment consultants are restricted to the provision of advisory services, and are not permitted by law to make or implement investment decisions. In practice, however, investment consultants play a role similar to that of GPs in a limited partnership-type fund. The heavy involvement of investment consultants in the investment-making process is problematic when viewed through the lens of investor protection. Since the investment consultants are not the agents of the investors but are instead appointed by the trust company, they do not owe duties to nor are they

78

79

For example, in contrast with GPs, trustee companies do not bear unlimited liability. Such companies only bear unlimited liability in specific situations, such as illegal activities or breach of the trust agreement, while bearing no liability for any failures under ordinary operating situations. As such, the accountability of the trustee company towards the fund is limited. See Jianbo Lou, ‘An Overview of PRC Trust Law and Trust Business’, at p. 6–7 (unpublished manuscript), online: http://shintakuhogakkai.jp/activity/pdf/vol40_China2 .pdf. Guideline of the Trust Company Collective Funds Trust Scheme Management 2009 [信托 公司集合资金信托计划管理办法], CBRC 2009, No. 1, effective on 2 February 2009 (PRC).

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otherwise accountable to the investors. Furthermore, unlike the GPs in a limited partnership-type fund, they do not bear unlimited liability for their investment decisions and are not disincentivised against making poor decisions. As a result, they may not serve in the best interests of the investors when advising the fund on investment prospects. Furthermore, the trustee company also does not bear unlimited liability except in specific situations, such as when it commits illegal acts or breaches the trust agreement; beyond that, the trustee company bears no liability for any failures under ordinary operating situations. As such, the accountability of the trustee company towards the fund is also limited. Another problem for the trust-type fund is the lack of a registration regime. Currently, the trustee company has a legal duty towards the beneficiaries to ‘keep all other trust matters and documentation confidential, except when it is otherwise agreed upon’.80 As a result, the trustee company, in ensuring that the identities of the beneficiary investors are kept confidential, does not need to register the trust. From a legal viewpoint, the lack of registration means that trust assets and properties cannot be fully ascertained. This has adverse effects on the ability of the law to safeguard the rights of transacting parties, particularly with regard to the transfer and determination of assets. More importantly, the fact that the identity of the beneficiaries cannot be determined becomes an obstacle when the portfolio company that the trust has invested in wants to conduct an IPO.81

80

81

Management Measures on the Trust Investment Company 2007 [信托投资公司管理办 法] CBRC 2007 NO. 2, Art. 27, effective on 1 March 2007 (PRC). According to the requirements of the Securities and Futures Commission (SFC) of Hong Kong, a business seeking an IPO must reveal the identities of its actual shareholders to prevent problems such as cross shareholding. As the SFC does not recognise the trustee company as a legitimate shareholder in an IPO, it means that a trust-type VC fund is likely to face problems should it attempt to exit the investment via an IPO. For example, China Pacific Insurance Group was unable to list its shares until they were no longer indirectly held by trustee companies. This necessitated a pre-listing sale by the beneficiaries of the trust or a direct purchase by the trustee companies themselves, leading to a huge cut in the profits of the VC business. As the trust regime lacks a compulsory public registry, the identity of the beneficiaries cannot be determined, and this becomes an obstacle when the portfolio company of the trust-type VC fund wants to conduct an IPO in China. CSRC requires pre-listed companies to retire any shares held by trustee companies. See Industry Development Report on Products: Private Equity Investment Trust 2016 [行业发展报告之 产品篇：私人股权投资信托], China Trust Industry Association (中国信托业协会), Sina Finance (新浪财经), 10 November, 2016, http://bit.ly/2tvgk2z.

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2.2.4 Does Business Form Matter? Scholars have advocated the limited partnership as an appropriate vehicle for VC funds, referring to it as ‘venerable’82 and as ‘the single most important organisational innovation of the modern VC system’.83 The limited partnership structure first became visible in the American VC sector in the 1960s,84 and turned into the dominant organisational form in the 1970s,85 mainly due to the legal and tax incentives available to it.86 Some have called for a widespread application of the US-style limited partnership in other countries, especially in Europe.87 Further, legislatures in some jurisdictions have hastened the introduction of the limited partnership, while in others they have sought to modernise existing limited partnership structures to suit evolving business needs.88 The earlier discussion on China shows that the adoption of the limited partnership in China and the revisions to the PRC Company Law have contributed to a more favourable regulatory environment for VC fundraising in China. However, as will be discussed further, there are some special features within the Chinese limited partnership,

82

83

84 85

86

87 88

Joseph A. McCahery and Erik P.M. Vermeulen, ‘Limited Partnership Reform in the United Kingdom: A Competitive, Venture Capital Oriented Business Form’, European Business Organization Law Review, 62(5) (2004), at p. 65. Martin Kenney and Richard Florida, ‘Venture Capital in Silicon Valley: Fueling New Firm Formation’, in Martin Kenney (ed.), Understanding Silicon Valley: The Anatomy of an Entrepreneurial Region (1st ed.) (United States: Stanford Business Books, 2000), cited in David Rosenberg, ‘Venture Capital Limited Partnerships: A Study in Freedom of Contract’, Columbia Business Law Review, 363 (2002), at p. 365. Rosenberg, ibid., at 365. J. Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed – And What To Do About It (United States: Princeton University Press, 2009). William A. Sahlman, ‘The Structure and Governance of Venture-Capital Organisations’, Journal of Financial Economics, 27 (1990), 473 at p. 473; P. Gompers and J. Lerner, ‘The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements’, Journal of Law and Economics, 39 (1996), 463, at p. 469; Curtis J. Milhaupt, ‘Market for Innovation in the United States and Japan: Venture Capital and the Comparative Corporate Governance Debate’, 91 (1997), 865 at p. 885; Michael Klausner and Kate Litvak, ‘What Economists Have Taught Us About Venture Capital Contracting’, in Michael J. Whincop (ed.), Bridging the Entrepreneurial Financing Gap: Linking Governance with Regulatory Policy (United Kingdom, Ashgate Publishing Limited, 2001) at p. 54 and p. 69. Joseph A. McCahery and Erik P.M. Vermeulen, supra note 82, at p. 65. L. Lin and U. Varottil, supra note 1.

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venture c apital law in c hina

Table 2.3 Different types of VC funds in China: a comparison Business forms

Company

Trust

Limited Partnership

Liability of investors

Limited liability

Limited liability

Limited liability for limited partners

Liability of fund managers

Limited liability

Pursuant to the trust agreement

Unlimited liability for general partners

Internal governance

Board of directors, supervisory board, shareholders meeting

Trust company beneficiary meeting

GPs manage the fund

Tax

Double Taxation (tax on the entity level and on individual shareholder level)

No taxation on trust profits, but income tax or corporate tax levied on beneficiaries

No tax on entity level, but income tax or corporate tax on partners

Governing law

PRC Company Law

PRC Trust Law; Guidelines for Trust Companies on the Operation of PE Investment Trust

PRC Partnership Enterprise Law

which require further legislative reforms, such as introduction of the fiduciary duties of partners and more detailed procedural rules on LP derivative actions.89 Nevertheless, the theoretical optimality of the business form as it pertains to the degree by which the practical needs of fund managers and investors are met in each jurisdiction is only one consideration amongst others.90 Ultimately, fundraising is only one stage in the VC

89 90

See infra text accompanying notes 390–445. L. Lin and U. Varottil, supra note 30.

v en t ur e cap i t al f un dr aising

65

cycle. In order to develop a robust VC market, improving the regulatory environment for the purposes of investments and exits, such as by encouraging capital supply and boosting entrepreneurship, is also important.

2.3 Unique Features of Chinese Limited Partnership-Type Funds Apart from the special features that distinguish the Chinese limited partnership discussed earlier,91 there are three attributes regarding the manner in which the Chinese limited partnership-type fund is run that set it apart from the US limited partnership: (1) the high degree of activism among LPs; (2) the double-GP regime, and (3) the presence of an alternative method of calculating GP compensation. Before exploring these matters in the following sub-sections in this chapter, we need to understand who the LPs in the Chinese VC market are.

2.3.1 Who Are the LPs? Various supply and demand factors affect the level of capital commitments to a VC market.92 LPs are the ones who supply capital to VC funds. Unlike the current US market where LPs are primarily institutional investors, wealthy individuals and families make up the majority of LPs in China by number, although the value of their actual investment is in the minority (Table 2.4).93 The rapid growth of China has made it the country with the second largest number of high-net-worth households in the world, after the US.94 Correspondingly, the number of individuals participating in the VC market as LPs has risen. Moreover, institutional investors such as commercial banks, insurance companies, trust companies, and

91 92 93 94

See Table 2.2 in this chapter. See P. Gompers and J. Lerner, supra note 2, at 25. L. Lin, supra note 12, at 175. As shown by the 2018 China High-Net-Worth Wealth White Paper. See Wu Wei, ‘Release of the 2018 White Paper on China’s High Net-Worth Individuals; Emerging economy breaks down class divide.’ (《2018中国高净值人群财富白皮书》发布 新兴经济打破 阶层固化), Phoenix New Media, 29 March 2018, online: http://ifinance.ifeng.com /16051923/news.shtml?&back.

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pension funds have long been prohibited from making equity investments due to policy constraints under previous regulations; the result is a predominance of wealthy individuals and families in the VC market.95 In China, only ‘accredited investors’ are allowed to make VC investments under China Securities Regulatory Commission (CSRC) rules.96 In reality, however, these accredited investors do not have a level of sophistication comparable to their US counterparts.97 While these individuals have substantial wealth, they remain financially unsophisticated98 and do not have the requisite ability and experience to screen and invest in high-risk VC funds. A large number of these individual investors belong to the first generation of wealthy individuals whose fortunes were made during China’s rapid economic development following the

95 96

97

98

L. Lin, supra note 12, at 173-176. Under the new ‘qualified investor’ (合格投资者) classification, an institution needs to possess net assets of RMB 20 million or net financial assets of RMB 10 million in the past year. In addition, the institution needs to have at least two years of investment experience in securities, funds, futures, gold, or foreign exchange. An individual is required to possess net financial assets of RMB 5 million or have an annual income of at least RMB 500,000 during the past three years. The individual must also have at least two years of relevant investment experience, or two years of working experience relating to financial product design, investment, and risk management, or have experience as a senior manager of a professional investment entity, or a certified public accountant or lawyer providing finance-related services. See Measures for the Suitability Management of Securities and Futures Investors 2016, CSRC, No. 130 [2016], Arts 8 & 12, effective 1 July 2017 (PRC). The Guiding Opinions on Regulating the Asset Management Business of Financial Institutions 2018, 关于规范金融机构资产管理业务的指导意见, People’s Bank of China, No.106 [2018] stipulates that a ‘Qualified Investor’ refers to a person, either natural or legal, or an organisation correspondingly capable of identifying and assuming risks, who makes an investment not less than a certain amount in an asset management product and meets the following conditions: (1) A natural person shall have an investment experience of not less than two years and satisfy any of the following conditions: (a) family financial net assets are not less than RMB 3 million; (b) family financial assets are not less than RMB 5 million; or (c) the average annual income of the person in the immediate preceding three years is not less than RMB 400,000; (2) A corporate entity shall have net assets no less than RMB 10 million at the end of the immediate preceding year; and (3) Other investors otherwise deemed qualified by financial authorities. L. Lin, ‘Private Equity Investor Protection: Conceptualizing Duties of General Partners in China’, Berkeley Business Law Journal, 15(1) (2018), 43. Gordon Orr, ‘A Pocket Guide to Doing Business in China’ (October 2014), online: McKinsey & Co., www.mckinsey.com/business-functions/strategy-and-corporatefinance/our-insights/a-pocket-guide-to-doing-business-in-china.

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economic reforms of 1978. They are, generally, inexperienced in the high-risk, long-term nature of VC investments99 and are instead interested in short-term, pre-IPO projects with the aim of obtaining quick returns.100 Nevertheless, regulators in China have recognised the importance of institutional investors as a source of capital in long-term and high-risk investments and have made efforts to encourage capital supply from institutional investors and foreign investors. Regulators – comprising the State Council,101 CSRC, the then China Insurance Regulatory Commission (CIRC), and China Banking Regulatory Commission (CBRC),102 among other agencies – have since 2008 begun to remove restrictions preventing the National Social Security Fund (NSSF), insurance companies, commercial banks, investment funds, and trust companies from making equity investments.103 As shown in Table 2.4 and Table 2.5, institutional investors have increased by number and by investment amount. This is arguably a good sign, given that the available literature has proved that institutional investors are generally more sophisticated and risk-tolerant as compared to individual investors in investments.104 It must be noted that the LPs in Table 2.4 include LPs in both RMB funds and US dollar (USD) funds. The following parts of this section explore the involvement of major institutional investors in the context of the Chinese VC market. 99

100 101

102

103

104

Interview with Mr Xu Kaixi, Investment Manager, October Capital, 25 April 2019, Shanghai; interview with Mr Ma Lingjun, Partner, Fangda Partners, 17 April 2019, Shanghai. Ibid. The State Council also issued the ‘Several Opinions of the State Council on Promoting the Sustainable and Sound Development of Venture Capital’ (No. 53 [2016] of the State Council) (国务院关于促进创业投资持续健康发展的若干意见) in 2016, clearly proposing multiple channels to expand the sources of VC. Since then, large enterprises, listed companies, government guidance funds, insurance funds, and banks have become the primary sources of funding for VC funds. The China Insurance Regulatory Commission (CIRC), and the banking regulator, the China Banking Regulatory Commission (CBRC), merged into the China Banking Insurance Regulatory Commission (CBIRC) in 2018. Since 2008, the NSSF has been permitted to make equity investments in certain funds. Since 2010, insurance companies have been allowed to make equity investments. Since 2014, insurance companies have been permitted to make investments in VC funds. See L. Lin, supra note 12, at Appendix 2. See generally John R. Nofsinger, and H. Kent Baker eds., Behavioral Finance: Investors, Corporations, and Markets (Wiley, 2010).

Table 2.4 Percentage of capital raised by LPs in China’s VC and PE market (by investable amount) (2011–2017) 2011 (%)105

2012 (%)106

2013 (%)107

2014 (%)108

2015 (%)109

2016 (%)110

2017 (%)111

Listed companies

28.7

26.3

26.3

25.0

24.5

24.7

19

Public pension funds

20.4

20.7

20.3

19.2

17.8

17.5

—

Sovereign wealth funds

19.0

19.1

18.7

17.5

16.0

14.8

—

105

106

107

108

109

110

111

PE Daily, ‘Summary of Private Equity Market LP Yearly Research Report 2011’ 2011年中国私募股权投资市场LP年度研究报告简版)) (2012), online: PE Daily, http://bit.ly/2uCGxtV. PE Daily, ‘Summary of Private Equity Market LP Yearly Research Report 2012” 2012 年中国私募股权投资市场LP年度研究报告简版)) (2013), online: PE Daily, http://bit.ly/2sZlejV. PE Daily, ‘Summary of Private Equity Market LP Yearly Research Report 2013’ 2013年中国私募股权投资市场LP年度研究报告简版)) (2014), online: PE Daily, http://bit.ly/2sShJ3Q. PE Daily, ‘Summary of Private Equity Market LP Yearly Research Report 2014’ 2015年中国私募股权投资市场LP年度研究报告简版)) (2015), online: PE Daily, http://bit.ly/2sZwGfH. Zero2IPO, ‘Year 2015:Zero2IPO Annual Report: PE LPs increase to 15,849, Government Guidance Funds, Listed Companies, Insurance Institutions are the most popular institutional LPs” (清科年报：私募通收录LP增至15,849家，政府引导基金、上市公司、险资成2015最 热机构LP) (1 February 2016), online: PE Daily, http://bit.ly/2tBwQf9. Zero2IPO, ‘In 2016, Half of LPs were institutions, 60 per cent of Surveyed GPs have applied or are preparing to apply for guidance funds’ (2016年 机构LP占比超半数，六成被调研GP已申请或准备申请引导基金) (8 August 2016), online: Zero2IPO Private Equity (清科私募通), www .mingin.com/column/8206-1.html. Zero2IPO, ‘Qingke Report: How to break the cycle of “funding difficulties”? – 2017 China Equity Investment Market Fundraising Strategy Research Report released’ (清科报告: “募资难” 困局如何破？——《2017年中国股权投资市场募资策略专题研究报告》重磅发布), (30 May, 2018), online: Gelonway (格隆汇), https://gelonghui.com/p/183057. For data of 2017, investment companies and asset management companies are counted together. Governmental agencies and government-guided funds are counted together.

Enterprises112

3.5

3.4

3.6

4.5

4.5

5.2

8

Fund of funds

5.9

6.4

6.3

6.1

5.6

5.2

4

Investment companies

2.8

4.0

4.1

4.5

4.7

5.5

18

Asset management companies

1.7

2.3

2.3

2.3

2.4

2.7

VC/PE institutions

3.7

3.2

3.3

3.8

3.8

5.4

10

Enterprise annuity fund

4.3

4.1

4.0

3.7

3.4

3.1

—

Governmental agencies

0.4

0.9

1.0

3.4

5.9

4.6

7

Governmentguided funds

1.8

2.1

2.1

2.0

2.0

2.1

Wealthy families and individuals

0.7

1.1

1.3

1.5

1.6

1.5

112

In this table, enterprises exclude listed companies.

1

Table 2.4 (cont.) 2011 (%)

2012 (%)

2013 (%)

2014 (%)

2015 (%)

2016 (%)

Private family funds

1.4

1.4

1.3

1.2

1.1

1.1

Trusts113

3.8

0.2

0.3

0.4

0.5

0.7

3.0

2.9

2.8

4.0

4.0

1.0

1.1

1.1

1.1

1.1

0.1

0.1

0.1

0.1

0.1

—

0.7

0.7

0.7

0.6

0.6

—

0.2

0.2

0.2

0.3

0.3

25

100.0

100.0

100.0

100.0

100.0

Banks Insurance institutions Endowment funds University endowment funds Others Total

113

1.1 — 0.8

— 100.0

2017 (%)

8

100.0

In 2011, trusts and banks were counted together. Summary of Private Equity Market LP Yearly Research Report 2011, supra note 105.

Table 2.5 Percentage of types of limited partners in China’s VC and PE market (by number) (2011–2017) 2011 (%)114 Wealthy families and individuals Enterprises121 VC/PE institutions Investment companies Asset management companies Government-guided funds Governmental agencies Listed companies

114 115 116 117 118 119

120

121

46.1 19.5 7.0 4.7 3.1 3.7 3.0 3.0

2012 (%)115 2013 (%)116 2014 (%)117 2015 (%)118 2016 (%)119 2017 (%)120 50.2 17.2 6.3 5.9 2.3 2.8 3.2 4.3

50.8 16.6 6.3 6.1 2.1 2.7 3.9 4.2

54.4 14.9 6.2 8.5 1.7 2.0 3.1 3.9

53.0 14.6 6.2 9.4 1.7 2.1 3.0 4.7

46.7 14.8 7.0 9.9 1.8 8.9

40.7 15.3 8.3 13.4

5.7

6.5

10.5

Summary of Private Equity Investment Market LP Yearly Research Report 2011, ibid. Summary of Private Equity Investment Market LP Yearly Research Report 2012, supra note 106. Summary of Private Equity Investment Market LP Yearly Research Report 2013, supra note 107. Summary of Private Equity Investment Market LP Yearly Research Report 2014, supra note 111. Zero2IPO, supra note 109. Zero2IPO, ‘2017 Ranking of Limited Partners of China Private Equity Investment Market to be announced soon, interpreting the diversified development pattern of the LP market in the era of Great Change’ (清科2017年中国私募股权投资市场有限合伙人排名揭晓在即，解读“大 变革”时代下LP市场的多元化发展格局) (14 June 2017), online: PE Daily, https://m.pedaily.cn/news/415323. Noah Group (诺亚(中国)财富管理中心), ‘Research Report on LP Institutional Trends in the Equity Market’ (股权市场LP机构化趋势研究报 告 [核心观点]) (24 August 2018), 3 (Zero2IPO figure). In this table, the category ‘Enterprises’ excludes listed companies.

Table 2.5 (cont.) 2011 (%) Trusts Banks Insurance institutions Public pension funds Fund of funds University endowment funds Private family funds Sovereign wealth funds Enterprise annuity fund Endowment funds Others Total

122

3.6122 0.6 1.9 1.8 1.0 0.5 0.4 0.1 0.0 − 100.0

2012 (%)

2013 (%)

2014 (%)

2015 (%)

2016 (%)

0.6 1.3 0.6 1.3 1.5 0.5 0.3 0.3 0.1 0.3 1.0 100.0

0.7 1.1 0.6 1.1 1.5 0.4 0.3 0.3 0.1 0.3 1.0 100.0

0.5 0.8 0.4 0.8 1.3 0.3 0.2 0.2 0.1 0.2 0.9 100.0

0.5 0.7 0.4 0.7 1.5 0.3 0.2 0.1 0.1 0.2 0.8 100.0

0.5 0.7 0.4 0.6 1.6 0.3 0.1 0.1 0.0 0.1 0.8 100.0

2017 (%) 1.8

− 1.5 − − − − − 2.0 100.0

In the data of 2011, trusts and banks were counted together. See Summary of Private Equity Investment Market LP Yearly Research Report 2011, supra note 105.

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The NSSF123 used to be prohibited from investing in VC sectors. While the NSSF has, since 2008, increased its investment in PE and VC, this amount remains much smaller than its permitted capacity to invest.124 The proportion of the NSSF that may be invested in the PE and VC sectors is limited at 10 per cent of its total assets, but the actual proportion invested in those sectors by September 2017 was a mere 2 per cent, far lower than the upper limit.125 As depicted in Table 2.4 and Table 2.5, the NSSF accounts for a much smaller proportion of the Chinese market than its counterpart in the US – the public pension fund.126 Arguably, the NSSF should provide more long-term capital to the VC market. Unlike the US where university endowment funds are a major contributor to VC,127 the size of university endowments funds in China is much smaller, resulting in a correspondingly lower level of participation in the Chinese VC market. From 1980 till December 2018, total donations to Chinese universities reached renminbi (RMB) 32 billion, with Peking University having received the highest amount of RMB 3 billion.128 In comparison, the Yale endowment fund, which manages USD 29.4 billion in capital, increased its venture allocation to 19 per cent as of June 2018.129 This is perhaps not surprising as the history of endowments in Chinese universities is much shorter as compared to their US counterparts. It was not until 1994 that China’s first 123

124

125

126

127

128

129

Founded in August 2000, the assets of the NSSF are managed and operated by the National Council for Social Security Fund. These assets come from funding sources such as funds allocated from the central government’s budget, capital, and equity assets derived from state-owned enterprise share sales, investment returns, and other means approved by the State Council. Lu Yuebing and Yang Xingxin, LPs in Private Equity (私募股权LP) (China: CITIC Press Group, 2016), at p. 200. Wang Zhongmin, ‘Higher-than-Expected Returns for NSSF from Direct Investments and Private Equity Investments’ (27 September 2019), online: Sohu Finance, www .sohu.com/a/194942949_481792. For the US figure, see L. Lin, supra note 12, at 177, Table 2.3 (stating that public pension funds accounts for 31 per cent of capital raised in the US venture capital market). Vance H. Fried, ‘Venture Capital and the University: The Endowment’s Role’ The Journal of Private Equity, 6(2) (2003), 79–85. Chinese Universities Alumni Association, ‘2019 Chinese University Alumni Donations Ranking, Peking University ranks first with alumni donating more than 3 billion RMB’ (2019中国大学校友捐赠排行榜，北京大学捐赠超30亿全国第一) (6 December 2019), online: Cuaa.Net, www.sohu.com/a/283994483_356902. ‘Yale Boosts Venture Capital to Almost a 5th of Its Endowment’, Business Times, 9 March 2019, online: Business Times, www.businesstimes.com.sg/consumer/yaleboosts-venture-capital-to-almost-a-5th-of-its-endowment

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university foundation, the Tsinghua University Education Foundation, was established,130 and not until 2007 that this foundation started to make VC investments in Qidi VC (now THG Ventures).131 In these circumstances, Chinese endowment funds have a long way to go as they develop both in size and expertise. Listed companies also make up a significant component of LPs by number in China (see Tables 2.4 and 2.5). This is different from the US where listed companies are not major participants as LPs in the VC market.132 One of the possible reasons why Chinese listed companies actively invest in VC is that these companies seek to find new avenues to achieve strategic business development. Another reason relates to the fact that many Chinese GPs were investment bankers prior to joining the PE and VC sectors.133 These GPs leverage on existing relationships with the listed companies they had previously worked with during their IPO process to persuade them to invest in their new funds.134 It is clear that this is not ideal, since investment in the high-risk sector is very likely to affect the main business of listed companies. Potential conflicts of interests may also arise if listed companies utilise these funds to invest in their own projects. Insurance companies in China were not permitted to make equity investments in unlisted companies, including VC, till 2010.135 In 2015, 130

131

132

133

134

135

Wang Longjuang and Zhang Ying, ‘The Alumni of Tsinghua University, the Winners Behind VC/PE, Boosted the Value of the University Education Fund by More Than RMB 100 Billion, Increasing Its Value by Twenty Times in Thirty Years. China Is Beginning Its Development.’ (校友撑起千亿清华大学教育基金会规模，30年翻20倍，他们是VC/ PE背后大赢家，中国才刚起步) (16 June 2017), online: PE Daily, https://news .pedaily.cn/201706/20170616415495.shtml. Wen Fei Cheung, ‘The Development of China’s University Funds: How Far Is It From Mature Capital Operation?’ (中国大学基金的发展之路: 离成熟资本运作还有多远) (May 17, 2019), online: Huxiu.com, www.huxiu.com/article/299760.html Laura Kreutzer, ‘Private Equity Analyst: Pensions Are Still LP Top Dogs, but Wealthy Investors Gain Ground’ (May 2015), p. 18, online: Mercury Capital Advisors, http://bit .ly/2vcOHtl. 21st Century Business Herald, ‘Hu Zuliu’s New Trend Prediction: Ex-foreign Investment Bankers “Overseas Returnee GP” Gradually Increasing, (胡祖六新动向:外资投行系“海 归GP”渐成气候) (22 March 2010), online: Sohu Business, http://business.sohu.com /20100322/n271002782.shtml. Interview with Mr Xu Kaixi, Investment Manager, October Capital, 25 April 2019, Shanghai. See Interim Measures for Equity Investment with Insurance Funds 2010 (保险资金投资 股权暂行办法), CIRC, No.79 [2010] (PRC). On April 1, 2018, the Measures for the Administration of the Utilization of Insurance Funds 2018 (保险资金运用管理办法), CIRC, No. 1 [2018] (PRC) promulgated by the CBIRC was formally implemented. Article 16 clearly stipulates that insurance funds can be invested in VC funds and private

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insurance companies were officially allowed to establish PE funds as GPs.136 Where the insurance company satisfies certain conditions and receives the approval of the CIRC, it may also establish VC funds. The Chinese regulatory authorities have also, to a certain extent, imposed criteria pertaining to the selection of fund managers.137 Where insurance companies invest in an equity investment fund, the investment institution launching, establishing, and managing such funds must meet ten major conditions, including the requirement that the balance of assets under the institution’s management is not less than RMB 3 billion, that the institution must have accomplished at least three projects, and that its registered capital is not less than RMB 100 million, amongst others.138 However, as illustrated in Tables 2.4 and 2.5, insurance funds in China still account for a smaller proportion of LPs than those in the US. In these

136

137

138

equity funds. According to the CIRC’s previous regulations, 10 per cent of the total assets of insurance institutions may be used to invest in shares of unlisted companies, equity investment funds, and other related financial products. In the future, there will be a large amount of insurance assets being allocated to unlisted shares and equity investment funds. With the CIRC issuing the Notice of the China Insurance Regulatory Commission on Matters concerning the Formation of Insurance Privately Offered Funds 2015 (中国保监 会关于设立保险私募基金有关事项的通知), CIRC, No. 89 [2015]. The Interim Measures for Equity Investment with Insurance Funds 2010 (保险资金投资 股权暂行办法), CIRC, No.79 [2010], Art. 12. In December 2014, The Notice of the China Insurance Regulatory Commission on Matters concerning the Investment of Insurance Funds in Venture Capital Funds (中国保监会关 于保险资金投资创业投资基金有关事项的通知), CIRC, No. 101 [2014] was issued, stipulating that insurance funds may invest as LPs if they meet the required conditions: (1) the VC fund being invested into must have over five years of experience in VC management, with outstanding historical performance and the cumulative size of the VC assets under management being no less than RMB 1 billion; (2) the VC fund must be equipped with a stable management team exclusive to the fund, comprising at least five investment professionals and which must have successfully exited from no less than a total of ten VC projects. Further, there must be at least three investment professionals who have been working together for five years, and investment decision-makers with more than five years of experience in VC management, including at least two people with more than three years of experience in enterprise management and operation; (3) the VC fund should not be the first VC fund managed by the fund management institution, and the scale of fundraising for a single fund should not exceed RMB 500 million; and (4) the insurance company should also place greater emphasis on the principle of diversifying investments. The total amount of outstanding investment that the insurance company has in VC funds should not exceed 2 per cent of its total assets as at the end of the last quarter, and the outstanding amount of investment in a single VC fund should not exceed 20 per cent of the amount raised by such fund.

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circumstances, the government should reduce restrictions on insurance funds and permit them greater involvement in VC investments. Commercial banks are allowed to make VC investments through direct investment by overseas subsidiaries, wealth management funds (such as mutual funds), and investment and loan linkage mechanisms.139 The wealth management funds of banks may not invest in VC unless this is accomplished through a private banking service with relevant investment experience.140 As such, the proportion of wealth management funds being used to invest in the relatively high-risk equity investment market is still small (Table 2.4 and Table 2.5).141 Market-Oriented Parent Funds (Fund of Funds (FOF)) is another major LP in China’s VC market. It emerged in China in the 1990s.142 The sources of the FOFs generally fall into four main categories in China: (1) government funds with state capital; (2) funds from financial institutions; (3) funds from private enterprises; and (4) funds from wealthy individuals and families.143 China’s FOFs may also be divided, according to the level of government participation, into government-guided FOFs

139

140

141

142 143

According to Section 2 of the Guiding Opinions of the China Banking Regulatory Commission, the Ministry of Science and Technology and the People’s Bank of China on Supporting Banking Financial Institutions to Intensify Innovation and Implement the Pilot Program of Debt-Equity Combination of Scientific and Technological Innovative Enterprises 2016 (中国银监会、科技部、中国人民银行关于支持银行业金融机构加 大创新力度开展科创企业投贷联动试点的指导意见), CBRC, No. 14 [2016], debtequity combination refers to the financing mode in which banking financial institutions provide sustained financial support for scientific and technological innovative enterprises, by means of combining ‘credit granting’ and ‘equity investment’ of the subsidiaries established by the Group with investment functions, through the relevant institutional arrangements, offsetting credit risk with investment revenue, and achieving matching of credit risk and revenue of scientific and technological innovative enterprises. Han Kun Law Office, Private Equity Regulations in China (中国私募基金监管蓝皮书), 2nd version, at p. 19. According to the Banking Wealth Management and Registration Center (银行业理财登 记托管中心), among the wealth management products released in 2017, those sold with risk levels 4 and 5 only accounted for 0.16 per cent of the total funds raised by such products in the entire year. Hexun News, ‘2017 China Banking Wealth Management Market Report’ (2017 年中国银行业理财市场报告) (2 February 2018), online: Hexun Finance, http://bank.hexun.com/2018-02-22/192483164.html. Ibid. Everyday Finance News, ‘Source of Funds: Four sources of funds for the parent fund’ (钱 从哪里来：四类募资主体为母基金资金来源) (19 April 2018), online: Sina Finance, http://finance.sina.com.cn/money/fund/jjyj/2018-04-20/doc-ifzihneq1844281.shtml? cre=tianyi&mod=pcpager_fintoutiao&loc=31&r=9&doct=0&rfunc=100&tj=none&tr=9.

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established by the government,144 and private FOFs. The advantages of government-guided FOFs are their large scale and ability to utilise government resources. However, government-guided FOFs are constrained by government restrictions in the selection of investment projects and do not operate purely based on market force.145

2.3.2 LP Activism 146

While LPs in the US are generally passive and do not participate in the control of VC funds, LPs in Chinese VC funds are more active and eager to take part in management, including in key decisions pertaining to the selection of portfolio companies.147 Chinese LPs participate in management through various kinds of internal committees, in marked contrast to the typical US fund where GPs generally have sole control over daily operations.148 Such internal committees, typically referred to as ‘investment strategy committees’ (touzi juece weiyuanhui), generally comprise LPs, GPs, and external advisers, and are formed to review and approve investment proposals.149 For instance, Richlink Capital Fund had an investment strategy committee of seven comprising two GPs, three LP representatives, and two external experts, with the LPs having veto power over all investment proposals.150 This internal governance model is commonly found in small-sized domestic funds, especially in Zhejiang province, and also normally features LPs having majority control of the investment committee.151 A number of LPs that were interviewed held the view that they are the ‘parents’ of the funds because the funds would not have been set up without their capital, revealing the persistent attitude among LPs underlying their refusal to cede full control to GPs.152 144 145 146

147 148

149

150

151 152

For example, Technology Financial Group FOF (Yueke mujijin). See infra text accompanying notes 248-249. In this book, the abbreviations ‘LP’ and ‘GP’ are used in the discussion of VC context; while the full term of ‘limited partner’ and ‘general partner’ is generally used in the discussion of the partnership law. See L. Lin, supra note 1, at 185. See Chen Wei, ‘The Opportunity and Evolution of PE after the Financial Crisis’ (2010) China Venture Capital Yearbook, at p. 61. Zero2IPO Research, ‘Report for China Venture Capital and Private Equity Management Mechanism and Compensation Scheme 2011’ (2012), at p. 13. Yang Yongxiang and Xu Xiaocheng, ‘Limited Partners in China’, Top Capital, 8 (2008), 1. Interview with Ms Kang, Partner, Global Law Office, 23 October 2015, Beijing. L. Lin, supra note 1, at 187.

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One extreme case of LP activism was the case of East Ocean Venture Capital Limited Partnership (Wenzhou Donghai Chuangye Touzi Youxian Hehuo Qiye).153 This was one of the earliest limited partnerships set up after the enactment of the revised PEL on 1 June 2007,154 comprising nine LPs (all private companies) and one individual GP. The partners’ meeting, consisting of all the partners, including the nine LPs, was the highest decision-making body in the firm.155 Every investment proposal had to be put to a vote and approved by a two-third majority in voting share,156 with each partner having voting rights in accordance with their respective share in paid contributions (a paid-up contribution of RMB 5 million (equivalent to USD 73,000) entitled the contributor to one vote).157 As the GP’s capital contribution was less than 1 per cent of the total committed contribution, he had no controlling power over the fund; instead, de facto control was reposed in the LPs. Due to severe internal conflict over choice of investments, this partnership was eventually dissolved.158 Article 68 of the PEL states generally that ‘a limited partner shall neither carry out partnership affairs nor represent the limited partnership when dealing with other parties’. However, in contrast to jurisdictions such as US-Delaware,159 New Zealand,160 and Singapore,161 which make an LP personally liable for the obligations of the firm if he does take part in the control of the partnership’s affairs, the PEL is silent on whether personal liability is attributable to the LP in the event that he contravenes Article 68.162 Furthermore, the meaning of ‘management’ has not yet been authoritatively determined in China. The ‘safe-harbour’ list in the PEL merely lists out the activities under which LPs are not deemed to be ‘carrying out the partnership affairs’163 and it is hard to tell if Article 68 has been breached in the first place. 153

154 155 156 157 158 159 160 161 162

163

Shanghai Securities News, The First Venture Capital Limited Partnership was Established (29 June 2007). L. Lin and U. Varottil, supra note 30. L. Lin, supra note 1, at 194. Ibid. Ibid. Ibid. Delaware Revised Uniform Limited Partnership Act, Del. Code Ann. Tit. 6, § 17-303. Limited Partnerships Act. 2008 (NZ), s 30. Limited Partnerships Act. 2008 (Cap 163B, 2010 Rev Ed Sing), s 6. Article 68 does not provide the liability of limited partner if he participates in the management of the firm. This is different from Article 98, which deals with the limited partner’s specific liability in the case of losses caused to the partnership. Partnership Enterprise Law of the People’s Republic of China (2006 Revision) (No. 55) (中华人民共和国合伙企业法) (2006修订) (PRC), Art. 68. These activities include: ‘(1)

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Nevertheless, if a third party reasonably believed that the contracting party was a GP and conducted transactions on that basis, the LP would bear the same liability as a GP in the partnership.164 However, to establish liability under this rule, the third party bears the burden of proving that he reasonably believed that an LP was a GP, and that he accordingly proceeded to conclude a transaction with that LP. Given that such third parties typically do not have information about the decision-making process of the funds, it is generally difficult to prove that they were aware that the LPs had exercised control in the management of the fund as if he was a GP. In any case the prominent activism of LPs may only be a temporary phenomenon. Firstly, China’s limited partnership is a relatively new business vehicle. When coupled with the fact that the Chinese VC market is still young and therefore does not possess the rich entrepreneurial experience that the US market has, it seems reasonable that development in various aspects would take more time. Other salient factors include the facts that many Chinese venture capitalists or fund managers in domestic VC firms come from investment banking backgrounds with no experience in the VC industry165 and the shortage of experienced venture capitalists with good track records.166 Seen in this light, it is likely that the activism shown by Chinese LPs thus far is merely a manifestation of their unfamiliarity with the business vehicle and their attempt to protect themselves when entrusting capital to relatively inexperienced and unproven venture capitalists. Second, as shown in Tables 2.4 and 2.5, institutional investors have over the years been forming a greater proportion of LPs in China. Unlike individual investors, institutional

164 165

166

participation in a collective decision to admit or remove a general partner, (2) making a proposal relating to the business management of the limited partnership firm, (3) participation in the selection of an accounting firm to audit the limited partnership firm, (4) receiving an audited financial report of the limited partnership firm, (5) inspection of accounting books and other financial information of the limited partnership business which involves self-interest, (6) commencement of legal proceedings against an accountable partner when the limited partnership’s interests have been infringed, (7) initiation of legal action in one’s own name to safeguard the limited partnership’s interests where the partner responsible for the conduct of partnership affairs has neglected the exercise of his rights, and (8) providing guarantee for the limited partnership.’ Partnership Enterprise Law 2006 (PRC), Art. 76. Interview with Ms Kang, Partner, Global Law Office, 23 October 2015, Beijing; see also Yang Yong Xiang and Xu Xiaocheng, Investment and Cooperation, [投资与合作] ‘China LP’ (6 August 2008). Interview with Ms Kang, Partner, Global Law Office, 23 October 2015, Beijing; interview with Ms Shao, Legal Counsel, Gaorong Capital, 23 October 2015, Beijing.

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investors are more sophisticated and less risk-averse, and, accordingly, less likely or willing to participate in the management of the fund. Recent reforms are also likely to limit activism. These developments in practice include allowing only GPs to form the investment strategy committee, limiting the LPs to an advisory role in an advisory committee,167 and explicitly restricting and limiting LPs’ interference with the investment decisions of the GPs.168 Furthermore, the increase in the number of angel investors and institutional investors means that a promising entrepreneurial firm can more easily choose from a larger pool of investors, giving it free rein to manage the enterprise.169 These reforms, when considered in conjunction with other developments such as the increased sophistication of investors and the increasing number of experienced professionals who are able to advise on the negotiation of agreements, will help to further align VC practice in China with global standards.

2.3.3 Dual GPs Unlike the typical American VC fund in which only one GP manages the business of the firm, a number of Chinese funds have recently engaged in the practice of designating two GPs to take on the managerial role – the so-called dual GP structure.170 Before it can raise VC funds in China under the current CSRC regulations and AMAC rules, a VC firm must register as a member and fund manager with the AMAC.171 However, the VC firm needs not manage the fund itself, since AMAC rules allow a VC firm to serve as the GP in the fund while appointing another firm to manage the fund.172 In such a case, the GP and the actual fund manager would be different entities. Under this model, the fund manager will sign a commission management 167 168 169 170

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Ibid. Ibid. Interview with Mr He Weiping, CTO of qunar.com, 29 October 2018, Beijing. Insight Capital (洞见资本), ‘The practice of “Double GP” Private Placement Model’ (私 募‘双GP’模式实务详解) (5 June 2018), online: Dong Jian 360 (洞见知行) https:// dy.163.com/article/F83SV3AM05399RAW.html?referFrom=google Measures for the Registration of Management Institutions of Privately Offered Investment Funds and the Recordation of Funds (for Trial Implementation) 2014 (私募投资基金管 理人登记和基金备案办法(试行)), AMAC, No. 1 [2014] (PRC). Regulations in Privately Offered Investment Fund Contract Guide No. 3 (Guide on Essential Contractual Terms) of Asset Management Association of China (私募投资基 金合同指引3号(合伙协议必备条款指引)).

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agreement with the fund. The GP and the fund manager will then assume different sets of rights and obligations which the law imposes depending on their respective roles – the GP’s right and obligations are regulated by the PEL while the fund manager’s rights and obligations are regulated under the PRC Securities Investment Fund Law.173 Due to the lack of a comprehensive regulatory framework governing private funds (including VC funds and PE funds) prior to 2012,174 there have been a large number of fraudulent fundraising and sham projects in China’s private fund markets.175 These incidents have resulted in stricter regulations and closer supervision over the registration of private funds.176 In particular, the threshold experience required to register as a fund manager has been raised over the years since 2016, and the time required to obtain the licence as a registered fund manager has been increased as well.177 Such changes have made it extremely difficult for PE or VC firms to get licences from AMAC, prompting these firms to appoint registered GPs as fund managers. Making use of this ‘back door’ to proceed with fundraising gives rise to three types of ‘dual GP’ in practice. As illustrated in Figure 2.2, the first model is the so-called dual GPs + single licence model. In this model, there are two GPs. One of them is a licensed fund manager serving as the managing partner of the fund while the other GP is not licensed. The second model also has two GPs. In this model, management of the fund falls to the non-licensed GP rather 173

174

175 176 177

This piece of legislation was passed on 28 October 2003, during the fifth session of the Tenth National People’s Congress Standing Committee. It was amended on 28 December 2012 on the thirtieth session of the Eleventh National People’s Congress Standing Committee. It was published through Order of the President of the People’s Republic of China (No.71) (中华人民共和国主席令(第七十一号) and has been in force since 1 June 2013. It was amended again on 24 April 2015 on the fourteenth session of the Twelfth National People’s Congress Standing Committee according to the National People’s Congress Standing Committee’s Decision on amending the Law of People’s Republic of China on Ports and Seven Other Laws (Order No. 23) (全国人大常委会关 于修改《中华人民共和国港口法》等七部法律的决定(含税收征收管理法、固体 废物污染环境防治法、枪支管理法、防洪法、证券投资基金法、城乡规划法)). As explained in Chapter 1 of this book, the regulatory framework governing private equity and VC in China was gradually established after 2012. The sectors were largely unregulated before that. The regulatory body of private funds – AMAC – was established in 2012. L. Lin, supra note 97, at pp. 43–44. See further discussion on this issue in Part 1.5 of Chapter 1 in this book. Ibid.

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GP 2 (not licensed)

LPs

VC fund

Model 2 GP 1 (licensed manager)

GP 2 (not licensed manager being the managing partner)

LPs

VC fund

Model 3 GP 1 (licensed manager being the managing partner)

GP 2 (licensed manager)

LPs

VC fund

Figure 2.2

Examples of dual GP structures

than the licensed GP. In the third model, both GPs are licensed fund managers and both serve as managing partners. The ‘dual GP’ model is problematic. Although these models meet the business needs for fundraising, they enable non-qualified firms to engage in fund-raising exercises and the management of these funds. They may

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also be a source of internal conflict should the managers of the fund have conflicting opinions regarding investment decisions, which would in turn affect the efficiency of the fund. Furthermore, where multiple GPs are concerned, there is a greater chance of some GPs ‘sacrificing’ their decision-making power to LPs, making them the de facto fund managers. In this situation, some LPs may even engage in fund management in contravention of Article 68 of the PEL. The emergence of the practice of engaging ‘dual GP’ reflects the conflict between the high market demand for fund raising and the overregulation of fundraising in China. To protect the right of the investor, the AMAC’s solution was to suspend the recording of filing of funds by dual fund managers.178 Non-licensed firms have also been banned by regulatory authorities from making use of the ‘dual GP’ model as a channel to issue private fund products. To build on this, it is suggested that the regulatory authorities should expressly forbid non-licensed firms from conducting fundraising.

2.3.4 Compensation in VC funds GP’s compensation is critical for aligning the incentives of GPs (venture capitalists) with those of LPs (investors).179 China’s VC market has unique practices regarding the compensation of fund managers.

2.3.4.1 Variation of GP Management Fees GPs are generally compensated in accordance with the so-called 2/20 rule.180 This consists of an annual management fee181 amounting to 2 per cent of the committed capital and a carried interest of 20 per cent of the profits realised by the fund.182 As an industry-wide practice, the 2/ 20 rule has long been accepted as providing an effective mechanism to 178

179 180

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Financial Times (证券时报), ‘What Are the Impacts of Tightening of Dual GP Registration’ (‘双GP’备案收紧，有啥影响？ ‘借通道’模式恐难以为继) 17 August 2018, online: www.sohu.com/a/247646785_99897610. p. Gompers and J. Lerner, supra note 29, at 29. Victor Fleischer, ‘Two and Twenty: Taxing Partnership Profits in Private Equity Funds’, New York University Law Review, 83(1) (2008), at p. 3. Management fee, as the basic income of GPs, serves as the main source of funding for the basic salaries of employees and the day-to-day operational costs of the firm and the fund. Kate Litvak, ‘Venture Capital Partnership Agreements: Understanding Compensation Arrangements’, University of Chicago Law Review, 76 (2009), 161.

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align the interests of the LP and the GP. While the 2 per cent management fee provides for an adequate level of basic compensation, the presence of payment based on carried interest, which is dependent on the success of the fund, is a powerful performance incentive. Nevertheless, many differences between Chinese and international practice may be identified. First, a CSRC rule affecting the compensation of GPs is that GPs are required to contribute at least RMB 1 million to the funds.183 Furthermore, despite the payment structures put in place, the actual compensation paid can vary, sometimes considerably, from the 2/20 rule.184 A total of 22.2 per cent of the surveyed PE and VC firms charge management fees at a rate lower than 2 per cent while firms with a rate higher than 2 per cent are in the minority (11.4 per cent).185 Some GPs with weak bargaining power receive 1 per cent to 1.5 per cent management fee.186 Relative to the US, the interests of the GP and the fund can be considered to be less aligned. Some funds even waive management fees if the rate of return for the investment is 300 per cent or below. GPs are entitled to 2 per cent in

183

184 185

186

Interim Measures for the Supervision and Administration of Privately Offered Investment Funds (No. 105 of the CSRC) (私募投资基金监督管理暂行办法), CSRC, No. 105, Arts 12 & 13, effective on 21 August 2014. Article 12 states that a qualified investor of a private fund shall be an entity or individual that has the corresponding risk identification ability and risk tolerance, invests not less than RMB 1 million in a single private fund, and meets the following relevant criteria: (1) An entity with net assets of not less than RMB 10 million; (2) An individual with financial assets of not less than RMB 3 million or with average annual income in the last three years of not less than RMB 500,000; the term ‘financial assets’ as mentioned in the preceding paragraph includes but is not limited to bank deposits, stocks, bonds, fund shares, asset management plans, financial products of banks, trust plans, insurance products, and futures equity. Article 13 states that the following investors shall be deemed qualified investors: (1) The Social Security Fund, enterprise annuities, and other pension funds; and charity funds and other social welfare funds. (2) Investment plans legally created and granted recordation with the AMAC. (3) Private fund managers and their employees that invest in private funds under their management. (4) Other investors as specified by the CSRC. Where investment is made directly or indirectly in a private fund by pooling the funds of multiple investors in a non-corporate form such as a partnership, the private fund manager or distributor shall, in a look-through manner, check whether the end investors are qualified investors, and include them in the total number of investors, except investment in private funds by investors as mentioned in subparagraphs (1), (2), and (4). L. Lin, supra note 1, 185 -217. Zero2IPO Research, ‘China Venture Capital & Private Equity Firm Compensation and Operation Mechanism Research Report 2016’ (2017), 19. Interview with Ms Ding, Partner, Yincubator, 2 October 2018, Singapore.

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management fees and a correspondingly higher carried interest if the rate of return for the investment exceeds 300 per cent.187 There are also firms which choose not to adopt a fixed 2 per cent rate but to adjust the rate based on the prevailing circumstances of the fund. For example, some firms adopt a flexible floating rate based on the scale of fundraising and investment of LPs. Also, the marginal revenue from management fees generally decreases with an increase in the size of the fund.188 Some firms adjust the management fee depending on the stage of the VC cycle. During the investment period, the firm charges a fixed management fee rate based on the committed or invested capital contributed by LPs.189 Other funds even waive the management fees when the fund is insolvent, to penalise the GPs.190 Another method of adjustment is to vary management fees according to the remaining duration of the fund. This is done by including specific provisions to the effect that before the dissolution of the fund, management fees shall be charged at a fixed rate as per normal; when the fund comes to term but before dissolution, there shall not be any chargeable management fees; when the term of the fund has been extended by agreement, the rate of management fees shall be reduced thereafter.191 187

188 189 190 191

Zhao Na, ‘Crazy Year-end Bonus: How much PE investors earn’ (疯狂的年终奖: PE从 业者薪酬揭秘)(January 7, 2017), online: 21st Century Business Herald, www .21jingji.com/2017/1-7/xMMDEzNjFfMTQwMTUxMw.html. Zero2IPO, infra note 194, at 19. Telephone interview with Ms Shao, Legal Counsel, Gaorong Capital, 22 August 2019. Zero2IPO, infra note 194, at 19. Ibid. There are three major types of management fees based on my empirical studies. First, management fees are charged at different rates in periods of investment and liquidity, but the calculation base is always the invested capital of the fund. For instance, the LPA of an RMB fund stipulates that ‘from the year in which such capital is fully paid up, for a period of three years, basic management fee shall be charged at 2 per cent of the invested capital of the fund; from the fourth year to the seventh year, basic management fee shall be charged at 1 per cent of the total invested capital for projects that have not been liquidated at the relevant time; if the term of the fund is extended, no management fee shall be chargeable for the extended period.’ Second, the proportion at which management fees are charged remains the same for periods of investment and liquidity, and the calculation base of management fee is the total committed capital of the fund. For instance, the LPA of a fund stipulates that ‘for the entire investment period (excluding any extended term), the annual management fee payable by partner firms shall be 2.5 per cent of the total committed capital. From the day on which the investment period (excluding any extended term) ends onwards, the annual management fee payable by partner firms shall be 2.5 per cent of the partner firms’ investment amount which has not been recovered or offset as of the day, before the date, on which

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In addition, the 80/20 rule is generally applied in the VC sector. Under this arrangement, investment returns earned by the fund beyond a basic hurdle rate are distributed in the proportion of 80 per cent (to LPs) and 20 per cent (to GPs).192 A total of 60.1 per cent of the Chinese firms surveyed adopt the 80/20 rule. Other variations also exist; about 20.9 per cent adopt a proportion of 75/25 or 70/30 while another 12.0 per cent adopt a proportion of 90/10.193 As a whole, most Chinese funds adopt GP compensation structures that are in line with international practice. However, there is some variance in the sense that the amount of carried interests can vary widely, from as low as 10 per cent of the profits of the fund to as high as 30 per cent.194 Finally, another aspect of the GPs’ compensation is the project bonus, which includes the ‘fundraising bonus’. This bonus ranges progressively from 3 per cent to 5 per cent of the total amount raised, depending on the size of the fund.195 GPs thus have an incentive to expand the size of the fund.

192

193

194

195

such management fee becomes due.’ Third, management fees are charged at a relatively low rate irrespective of whether the fund is at the investment period or the liquidation period. For instance, the LPA for a VC fund sized at RMB 0.901 billion stipulates that ‘management fee shall be charged at 0.5 per cent of the invested capital from all limited partners each year. For as long as the manager is in charge of the management of the partnership, the manager shall be entitled to such management fees payable by the partnership for the applicable duration at the relevant due date after the partnership has been set up and limited partners have paid up their respective capital contributions.’ The relatively low rate of management fees charged in case 3 gives rise to certain problems, insofar as the GP may be unable to cover the daily operational costs of the fund. The GP may therefore attempt to earn more management fees by expediting the investment process or constantly setting up new funds, or to cover its costs by tapping on other sources of income, eventually compromising the performance of the fund and the interests of LPs. According to ‘China Venture Capital & Private Equity Firm Compensation and Operation Mechanism Research Report 2016’ produced by Zero2IPO Research, the rate at which management fee is charged for the vast majority of Chinese VC/PE firms (specifically, 60.8 per cent) is 2 per cent of the total committed capital, a figure consistent with international trends. See Zero2IPO Research, ‘China Venture Capital & Private Equity Firm Compensation and Operation Mechanism Research Report 2016’ (2017), at 18. Zero2IPO Research, ‘China Venture Capital & Private Equity Firm Compensation and Operation Mechanism Research Report 2016’ (2017). Zero2IPO, ‘2016 Report on the Compensation and Operational Mechanisms of VC/PE Institutions in China’ (2016中国VC/PE机构薪酬与运营机制调研报告) (2017), 23; For VC, the biggest incentive is still carried interests; Most VC firms such as Banyan Capital still earn 20 per cent from carried interests. Zero2IPO, ibid., at 26.

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2.3.4.2 Distribution Waterfalls Another aspect of compensation relates to the priority of GP compensation relative to all other payments to be made by the fund upon its dissolution. There are generally two models in this regard; the first model of distribution prioritises the return of capital contributions (‘All Capital First’): the fund carries out profit distribution not on the basis of individual projects, but the aggregate amount of proceeds earned from all projects. Such a distribution is carried out as follows:196 (1) Proceeds will first be applied to return all capital contributions made by LPs (including investment in all projects, management fee contributions, and all other miscellaneous fees); (2) If the internal rate of return (IRR)197 does not exceed the preferred return,198 GPs will not receive any carried interest. After LPs get back all their capital contributions, the remainder of the proceeds will be distributed to all partners based on the relative proportions of their capital distributions.199 (3) After investors receive their preferred returns, GPs will receive 20 per cent of LPs’ preferred returns as carried interests through the GP catch-up clause.200 (4) All remaining proceeds will then be distributed among GPs and LPs at the proportions of 20 per cent and 80 per cent, respectively. The second model of distribution is the ‘Deal-by-Deal’ Model, that is proceeds obtained from each project of the fund will be distributed among GPs and LPs upon the liquidation of that project. Such a model is more beneficial to GPs as compared to the All Capital First model, as GPs will receive carried interests earlier. Moreover, depending on the profitability of each investment project, this model might result in GPs receiving more carried interests than what they would have earned 196

197

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199

200

Touzi.com, ‘What is the income distribution model of private equity fund?’ (私募基金 的收益分配方式是怎样的?) (27 January 2016), online: www.touzi.com/news/ 021023070-53141.html. The IRR is a metric used in capital budgeting to estimate the profitability of potential investments. See ‘Preferred Return’, divestopedia, online:www.divestopedia.com/defin ition/887/preferred-return The preferred return, or hurdle rate, is a minimum annual return that the limited partners are entitled to before the general partners may begin receiving carried interest. For the preferred return fund, the rate of return promised to investors by the GP will be made clear right when the fund is established. The norm in the US private equity funding industry is usually a compound annual rate of 8 per cent. However, it is worth noting that, unlike China, the US has a very low base rate. If the fund’s IRR is higher than the preferred rate of return, the investor will receive a preferred return based on his or her total principal amount. This clause is meant to make the manager whole so that their incentive fee is a function of the total return and not solely on the return in excess of the preferred return.

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according to the originally agreed proportions. Therefore, to ascertain whether GPs’ actual carried interests exceed the prescribed amount, calculations have to be made to determine the overall profit level of all investment projects within a fund upon the dissolution of that fund. For investors, the Deal-by-Deal model carries a risk that GPs may be unwilling to, or due to various reasons unable to, return their extra carried interests to the fund. While investors can sometimes rely on a GP clawback mechanism provided in the legal documents of the fund to impose obligations on GPs to return these extra fees, such a mechanism is complicated, costly, and time-consuming, and usually involves the concurrent use of escrow accounts and back-to-back guarantees by fund managers. The Deal-by-Deal model can be implemented in various ways. A strict implementation would involve GPs carrying out independent calculations of profits and losses of each project. As soon as LPs get back their capital contributions and preferred returns for one project, GPs can receive their carried interests for that project. Assuming that a fund simultaneously invests in five projects, GPs can receive carried interests with respect to any project as soon as it starts to profit, regardless of whether the other projects are incurring losses. As may be expected, this model incentivises GPs to channel their attention to profitable projects, while possibly requiring less attention and effort to managing lossmaking projects (since GPs would derive less compensation from these).201 American funds generally adopt the latter Deal-by-Deal model, which has led to it being christened the ‘American Waterfall’.202 However, due in part to the recent deterioration in the investment climate, the Deal-byDeal model has been facing many challenges. The PE principles released by the Institutional Limited Partners Association (ILPA) opined that the optimal model for profit distribution as practised by investment funds is the All Capital First model. This set of principles provides strong support for LPs (institutional investors) in their negotiations with GPs over the choice of profit distribution model. The bargaining power of LPs is

201

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Interview with Mr Xu Kaixi, Investment Manager, October Capital, 25 April 2019, Shanghai. ‘We pre-allocate based on the project (because the final overall profits from the fund is not confirmed).’ Jiang Yan, ‘ChinaVenture Opinion: Interpretation of key terms in LPA for private equity investment funds’ (投中观点: 私募股权投资基金LPA关键条款解读) (15 March 2017), online: https://www.sohu.com/a/129049318_323328.

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further strengthened relative to fund managers due to poor market conditions, which makes fundraising increasingly difficult. In many cases, fund managers may have no choice but to adopt wholesale the LPs’ positions on many commercial terms, such as the profit distribution model.203 Both of the above-mentioned models can be observed in the Chinese VC market, and the choice is made based on the commercial needs of the two parties and their relative bargaining power. According to recent research,204 the vast majority of Chinese funds adopt the American model of Deal-by-Deal distribution (57.6 per cent), with the second most popular choice being the European model of All Capital First distribution (20.3 per cent). A small minority distribute their proceeds depending on the stage of investment or based on a combination of both the American and the European models.205 According to the author’s empirical study, RMB funds (funds raised in RMB) generally adopt the All Capital First model,206 which can be attributed to the relatively strong bargaining power of Chinese LPs.

2.3.4.3 Employee Compensation in VC Firms Compensation paid to employees of VC firms consists of base salary and performance-related bonus. Performance-related bonus comprises annual bonus, project-based bonus, project-based carried interests, coinvestment returns, and employee benefits. According to Zero2IPO Research,207 base salary and bonuses constitute the bulk of employee compensation in Chinese firms, whereas project-based carried interests and employee co-investment returns account for a relatively small proportion. This can largely be attributed to the youth of the Chinese market relative to the US, and also the fact that the majority of funds in the Chinese market have not entered liquidation yet.208 Managers of some Chinese firms would receive the project-based bonus (a certain proportion of the investment amount in the project) 203

204

205 206 207 208

Touzi.Com, ‘What is the income distribution model of private equity fund?’ (私募基金 的收益分配方式是怎样的?) (27 January 2016), online: www.touzi.com/news/ 021023070-53141.html. Zero2IPO Research, ‘China Venture Capital & Private Equity Firm Compensation and Operation Mechanism Research Report 2016’ (2017). Zero2IPO, supra note 194, at 24. Telephone interview with Ms Shao, Legal Counsel, Gaorong Capital, 22 October 2019. Supra note 194. Zero2IPO, supra note 194, at 26.

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once an investment proposal is approved.209 Nevertheless, the projectbased bonus takes up only a small portion of employee compensation in Chinese firms. For about 30 per cent of the employees surveyed, their project-based bonuses constituted 10 per cent to 30 per cent of their total compensation. Only 4 per cent of the employees surveyed receive project bonuses that amounted to more than 30 per cent of their total compensation.210 Co-investment returns are also payable to investment managers when they co-invest together with the fund on the same project.211 There are two types of co-investment: compulsory co-investment and voluntary coinvestment.212 Research shows that more than 70 per cent of the Chinese firms surveyed allowed their employees to make co-investments, as an incentive to align the interests of the investment managers and the firm.213

2.3.4.4 Employee Compensation in State-owned Firms This part discusses the compensation of fund managers within a special type of VC firm – state-owned VC firms, which are set up or backed by the government. Compensation paid to fund managers in these VC firms generally consists of four components: (1) basic salary; (2) performancerelated pay (jixiao gongzi); (3) return on co-investment (xiangmu gentou shouyi); and (4) carried interest.214 Performance-related pay is derived from the management fees, after deducting operation costs and expenses, and the final amount of bonuses distributable is calculated based on net profits and the performance of the firm.215 Empirical evidence shows that the performance ratio (i.e. performance-related pay/total pay) is directly correlated to the designation of the manager.216 For example, 60 per cent of the total pay to chief managers/partners is performance-related, whereas the equivalent figure for junior investment managers is only 20 per cent.217 Given the special nature of the state-owned VC firms, a hierarchical system exists in these firms, under which the promotion of professionals 209 210 211 212 213 214 215 216 217

Ibid. Ibid. Ibid. Ibid. Ibid. Infra note 226. Zero2IPO, supra note 194, at 26. Ibid. Infra note 226.

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is not based on performance, but on seniority and employment position.218 For example, the appointment of the executives is made by the respective state asset supervision authority.219 In order for a vice president of the firm to be promoted to a partner, he has to serve for a certain period of time. The promotion is also subject to a substantial change in the organisational structure as well as the overall performance of the fund.220 In the case of Shenzhen Capital Group Co. Ltd (SCGC), senior management does not own any shares of the firm and the appointment of its executives is made by the State-owned Assets Supervision and Administration Commission (SASAC) of the Shenzhen Government.221 Substantial profits of SCGC are distributed to the largest shareholder, i.e. the SASAC of the Shenzhen Government.222 Only 8 per cent of profits are paid to the employees and a mere 2 per cent of profits from specific funds are awarded to the investment team as performance bonus.223 Arguably, this form of structure may not sufficiently incentivise fund managers because compensation is not closely tied to performance; total compensation is relatively low since most of it is paid out to shareholders. Consequently, this has been regarded as one of the major reasons for the high turnover rate of the management of SCGC.224 Moreover, state-owned VC firms generally do not allow co-investment due to legal restrictions.225 Under current law, an executive of a stateowned enterprise shall not ‘hold equity interests in firms with a similar scope of business as the firm in question, related firms or firms with which the firm in question has business relations’.226 However, recent 218

219 220 221 222 223

224 225

226

W. Pan, ‘Deep Ventures Behind Li Wanshou’s Departure’ (李万寿离职背后：跌宕前 行的深创投) (13 May 2013), Sina Finance, online, http://finance.sina.com.cn/stock/ newstock/pedt/20130513/005915433787.shtml. Ibid. Ibid. Ibid. Ibid. X. Yao, ‘Revealing the Secrets Behind PE Compensation; Partners Make Tens of Millions Annually’ (揭秘PE薪酬机制 合伙人年薪达千万） (18 May 2013), China Securities Journal (中国证券报). Infra note 228. Opinions of the State Council on Promoting the Sustainable and Healthy Development of Venture Capital 2016 [国务院关于促进创业投资持续健康发展的若干意见], State Council, No. 53 [2016], online: www.gov.cn/zhengce/content/2016-09/20/con tent_5109936.htm. Article 5 of the Regulations on the Executives of State-owned Enterprises for Performing Management Duties with Integrity [国有企业领导人员廉洁从业若干规定], jointly issued by Organization Department of the Communist Party of China, Ministry of

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regulations provide that efforts shall be made to ‘explore the possibility of interest-holding and co-investment by core teams in state-owned VC investment firms and other VC investment firms’.227 An increasing number of such firms have accordingly come to allow coinvestment.228 The earlier discussions show that the operation of state-owned firms are not purely based on market forces but are subject to various regulations and governmental intervention, especially as regards compensation structure. There is still a long way to go in giving market forces a greater role in state-owned VC firms and aligning mismatched employee incentives. The next part will continue to discuss the government intervention in VC funds, and such an example is the Government Guidance Funds (GGFs).

2.4 Government Guidance Funds 2.4.1 The Rise of Government Guidance Fund Another special type of fund existing and playing a crucial role in China’s VC market is the GGF, which refers to the policy fund set up by the central government or local governments. In China, GGFs include the government-oriented industry guidance fund, State VC Investment Guidance Fund, and SME Technology Innovation Fund. These GGFs are usually organised as a company, partnership, or via contractual agreement. GGFs exist at both the central and local levels. National GGFs are set up by the central government, while local GGFs are set up by local governments at different levels (i.e. at the provincial, city, and county levels). Local governments generally set up a management committee (or investment committee) to serve as the fund’s highest investment decision-making body and staff these committees with heads of local government. The result is a body filled with officials who may not be properly qualified, or who take advantage of this opportunity to engage in corruption. GGFs also commonly set up

227 228

Supervision and State-owned Assets Supervision and Administration Commission of the State Council in 2004. Supra note 225. Telephone interview with Mr Wu, Hainan State Farms Investment Holdings Group, 23 August 2019.

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a separate management office to manage the daily operation of the fund.229 Another option is for management of the fund to be entrusted to professional institutions.230 In 2002, the establishment of the Zhongguancun VC Guidance Fund marked the beginning of the development of GGFs in China. Since 2008,231 the regulatory authority began to publish regulations232 to guide the management of GGFs (see Table 2.6). Under the current regulatory framework, the finance department, either by itself or in conjunction with the department in charge of the relevant industry, has to submit a request to the local government of the corresponding level for the approval of governmentsponsored investment funds. GGF oversight (pertaining to preinvestment as well as post-investment business activities of GGFs) is undertaken by two government agencies: the National Development

229

230

231

232

For one, the operations of the Zhejiang Venture Capital Investment Guidance Fund are managed by the Zhejiang Provincial Venture Capital Investment Fund Management Co. Ltd. The Shenzhen Capital Group Co. Ltd. has been entrusted with the management of numerous Shenzhen GGFs, with the trustee receiving management fees in accordance with a fixed proportion: Qianzhan Industry Research Institute (前瞻产业研究院), ‘Analysis of the current situation and development trends of the government guiding funds industry’ (政府引导基金行业现状与发展趋势分析 放宽限制条件引导行业联 合), (25 January 2018), online: https://bg.qianzhan.com/report/detail/300/180125b684b418.html. In 2008, the National Development and Reform Commission, Ministry of Finance, and Ministry of Commerce jointly issued the Guideline of Standardised Establishment and Operation of Venture Capital Guidance Fund 2008 [关于创业投资引导基金规范设立 与运作的指导意见], State Council, No. 116 [2008], providing a detailed definition of the concept of the guidance fund for the first time. Since then, the development of GGFs has been regulated by measures such as the 2010 Interim Measures for the Administration of Governmental Funds [政府性基金管理暂行办法], Ministry of Finance, No. 80 [2010] and 2015 Interim Measures for the Administration of Government Investment Funds [政 府投资基金暂行管理办法], Ministry of Finance, No. 210 [2015]. As stipulated by the Interim Measures for the Administration of Guidance Funds 2007 [科技型中小企业创业 投资引导基金管理暂行办法], Ministry of Finance, No. 128 [2007], the guidance fund should give a risk subsidy of up to 5 per cent of the amount actually invested by the VC institution, with the amount of subsidy not exceeding RMB 5 million. The main purpose of the risk subsidy is to make up for the loss of VC. It also stipulates that the guidance fund may grant pre-investment funding to these ‘mentee enterprises’ of not more than RMB 1 million, with the funding mainly being for the purpose of subsidising the expenses they incur by undertaking high-tech research and development. Such as the Interim Measures for the Administration of Government-Sponsored Industry Investment Funds 2016 [政府出资产业投资基金管理暂行办法], National Development and Reform Commission, No. 2800 [2016].

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and Reform Commission (NDRC) and the local development and reform department. As shown in Figure 2.3, from 2012 to 2017, with the aid of guiding and regulating policies as well as the increased demand of capital, the number of GGFs has increased rapidly. In particular, after the launch of China’s national strategy of ‘Mass Entrepreneurship and Innovation’ in 2015, the number of GGFs increased dramatically. In 2016 alone, 547 new GGFs were established, with the total target size exceeding RMB 3.5 trillion. The number of GGFs set up and the overall target size in 2016 surpassed that in the three-year period of 2013–2015 combined.233 However, the VC industry experienced a lack of capital in the three consecutive years following 2016. In 2018, a total of 151 new GGFs were established, 41.5 per cent lower than in 2017. In the first half of 2019, only fifty new GGFs were established, 49.5 per cent lower than the first half of 2018. After the period of rapid growth from 2015 to 2016, the pace of establishing GGFs slowed, with some of the earlier established GGFs either in their peak investment cycle or their exit period. At the same time, despite the sheer number of large-scale GGFs established in recent years, the actual amount of capital invested by them constituted only a small portion of the total value of GGFs. A significant portion of such GFFs remained in a ‘sleeping state’ – uninvested and idle. Starting from 2017, AMAC issued strict requirements for administrative procedures linked to the establishment of GGFs such as, inter alia, the registration of fund managers, record filing of funds, and disclosure of important matters and major changes. This resulted in a situation whereby the guidance fund is approved and established long before the completion of registration and record filing. These delays also impacted the investment timeline of sub-funds such that they were no longer invested as planned.234

233

234

Economic Daily, ‘1171 government guidance funds in China, with a total target value of RMB 5.85 trillion’ (国内共成立1171只政府引导基金 总目标规模达5.85万亿元), 21 August 2018, online: Xinhua Net, www.xinhuanet.com/fortune/2018-08/21/ c_1123299570.htm. Y. P. Huang, ‘Few industrial policies have been successful in history’ (历史上成功的产 业政策很少), Chinese Economists 50 Forum, September 13, 2016, www.50forum.org.cn /home/article/detail/id/6639.html.

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600 500 400 300 200 100 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Number of Funds

Figure 2.3

Government Guidance Funds in China (2006–July 2019)235

Table 2.6 The development and evolving regulatory framework of GGFs in China Year

Legislation/Policy/Milestone

2002

The Zhongguancun VC Guiding Fund was established.

2005

The Interim Measures for the Administration of Startup Investment Enterprises236 (Chuangyetouzi Qiyeguanli Zanxingbanfa) was promulgated by the State Council on 1 March 2006. These measures feature three main forms of policy supports for VC enterprises, namely: (1) the establishment of policy-based VC guidance funds; (2) tax policy support; and (3) the improvement of exit mechanisms.

235

236

Q. Y. Guan, ‘Where can the Chinese government guidance fund go after a trillion-yuan surge?’ (中国式政府引导基金 万亿狂飙之后向何处去？), Sina Column Thought Leaders, 18 July 2019, http://finance.sina.com.cn/zl/2019-07-18/zl-ihytcerm4417875.shtml. State Council, 15 November 2005, ‘创业投资企业管理暂行办法’ (Interim Measures for the Administration of Startup Investment Enterprises) (No. 39 of the National Development and Reform Commission, Ministry of Science and Technology, Ministry of Finance, Ministry of Commerce, People’s Bank of China, State Administration of Taxation, State Administration for Industry and Commerce, China Banking Regulatory Commission, China Securities Regulatory Commission, and State Administration for Foreign Exchange, 1 March 2006).

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Table 2.6 (cont.) Year

Legislation/Policy/Milestone

2007

Interim Measures for the Administration of Guidance Funds for Promoting VC Investments in Small and Medium-sized Technology Enterprises237 (Kejixing Zhongxiaoqiye Chuangyetouzi Yindaojijinguanli Zanxingbanfa)

2008

The Guiding Opinions on the Standardised Establishment and Operation of Venture Capital Guiding Funds238 (Guanyu Chuangyetouzi Yindaojijin Guifansheliyuyunzuode Zhidaoyijian) was jointly formulated by the National Development and Reform Commission, the Ministry of Finance, and the Ministry of Commerce. The Opinions made clear the guiding principles and methods for the general and risk management of such funds.

2009

Interim Measures for the Administration of Equity Participation Venture Capital Investment Funds for VC Plans for Emerging Industries239 (Xinxingchanye Chuangtoujihua Canguchuangye Touzijijin Guanli Zanxingbanfa)

2015

The Standing Committee of the State Council decided to set up two government VC funds, one worth RMB 40 billion to support start-ups in emerging industries and another worth RMB 60 billion to support SMEs.

2015

The Finance departments at every level of government made use of government guidance funds to support entrepreneurship. However, there were problems. For example, the investment and operation of

237

238

239

Ministry of Finance and Ministry of Science and Technology, 6 July 2007, ‘科技型中小 企业创业投资引导基金管理暂行办法’ (Interim Measures for the Administration of Guidance Funds for Promoting Venture Capital Investments in Small and Mediumsized Technology Enterprises) (No. 128 [2007] of Ministry of Finance, 6 July 2007). National Development and Reform Commission, the Ministry of Finance and the Ministry of Commerce, 18 October 2008, ‘关于创业投资引导基金规范设立与运作 的指导意见’ (Guiding Opinions on the Standardised Establishment and Operation of Venture Capital Guiding Funds) (No. 116 [2008] of the National Development and Reform Commission, 18 October 2008). National Development and Reform Commission, 17 August 2011, ‘新兴产业创投计划 参股创业投资基金管理暂行办法’ (Interim Measures for the Administration of Equity Participation Venture Capital Investment Funds for Venture Capital Plans for Emerging Industries) (No. 668 [2011] of the National Development and Reform Commission).

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Table 2.6 (cont.) Year

Legislation/Policy/Milestone these funds were dispersed, unstandardised, and lacked proper fund supervision. In order to regulate government guidance funds, the Ministry of Finance issued the Interim Measure for the Administration of Government Investment Funds240 (Zhengfu Touzijijin Zanxingguanlibanfa) on 12 November 2015.

2015

The Ministry of Finance issued the Guiding Opinions on Injecting Financial Funds into Government Investment Funds to Support Industry Development241 (Guanyu Caizhengzijinzhuzi Zhengfutouzijijinzhichichanye Fazhande Zhidaoyijian). These measures further improved the administration of government investment funds by improving the efficiency of their usage, regulating their establishment, operation, risk management and budget management, etc., and promoting their sustainable operation.

2016

The Interim Measures for the Administration of Government-Sponsored Industry Investment Funds242 (Zhengfuchuzichanye Touzijijin Guanli Zanxingbanfa) promulgated by the National Development and Reform Commission on 1 April 2017 was formulated in order to improve the way government funds were invested. It optimises the guiding and magnification effect of government funds, allows for greater efficiency of the usage of such funds, and attracts nongovernment capital investments in government-sponsored fields and industries.

240

241

242

Ministry of Finance, 12 November 2015, ‘政府投资基金暂行管理办法’ (Interim Measure for the Administration of Government Investment Funds) (No. 210 [2015] of Ministry of Finance, 12 November 2015). Ministry of Finance, 25 December 2015, ‘关于财政资金注资政府投资基金支持产业 发展的指导意见’ (Guiding Opinions on Injecting Financial Funds into Government Investment Funds to Support Industry Development) (No. 1062 [2015] of the Ministry of Finance, 25 December 2015). Ministry of Finance and the National Development and Reform Commission, 17 August 2011, ‘政府出资产业投资基金管理暂行办法’ (Interim Measures for the Administration of Government-Sponsored Industry Investment Funds) (No. 668 [2011] of the Ministry of Finance, 17 August 2011).

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Table 2.6 (cont.) Year

Legislation/Policy/Milestone

2017

Guidelines for the Registration of Credit Information of Government Investment Assets Investment Funds (For Trial Implementation)243 (Zhengfuchuzi Chanyetouzijijin Xinyongxinxidengji Zhiyin (Shixing))

2018

The Notice of the Ministry of Finance on Issues concerning Regulating the Investment and Financing Behaviours of Financial Enterprises for Local Governments and SOEs244 (Guanyu Guifanjinrongqiye Duidifangzhengfuheguoyouqiye Tourongzixingwei Youguanwentide Tongzhi) aims to regulate the investment and financing behaviours of financial enterprises of local government and SOEs.

2.4.2 Problems with GGFs Even though GGFs have only been around for a short period of time, many problems have become evident. While most of these GGFs are recently established and it is still too early to test their roles in the VC market empirically, there are several obvious flaws in the structure of the local GGFs and the rules by which they operate. First, local government intervention is prevalent within local GGFs, as can be seen from the mandatory funding of certain sectors, companies, or locations.245 In particular, it is common for a local government to require a VC firm to inject GGF funding into certain companies within the

243

244

245

National Development and Reform Commission, 8 November 2017, ‘政府出资产业投 资基金信用信息登记指引(试行)’ (Guidelines for the Registration of Credit Information of Government Investment Assets Investment Funds (For Trial Implementation) (No. 1834 [2017] of the National Development and Reform Commission, 8 November 2017). Ministry of Finance, 28 March 2018, ‘关于规范金融企业对地方政府和国有企业投融 资行为有关问题的通知’ (Notice of the Ministry of Finance on Issues concerning Regulating the Investment and Financing Behaviours of Financial Enterprises for Local Governments and State-owned Enterprises) (No. 23 [2018] of the Ministry of Finance, 28 March 2018). For example, Article 6(5) of the Implementation Rules for Shanghai Angel Investments Guidance Fund states that the investor is to invest mainly in companies within Shanghai. Implementation Rules of the Shanghai Angel Investment Guidance Fund 2014 [上海市天 使投资引导基金管理实施细则], Shanghai Municipal Development and Reform Commission, No. 49 [2014], Art. 6(5).

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region, so as to boost the local economy.246 This could lead to conflicts between the GGF and the VC firm which manages the GGF, resulting in undue curbs on GPs. There are also problematic local regulations that unduly restrict the duration of investments and size of the portfolio companies. For example, Jiangsu province specifies that the maximum duration of the GGF investment is five years,247 which is inconsistent with the international practice of between seven and ten years.248 Restricting the duration of investments and size of the portfolio companies ignores market forces in the selection of portfolio companies. Such restrictions may result in market distortions as investment managers choose permitted investment options over companies with greater growth potential and accordingly greater need of VC. Shortening the investment duration also encourages investment managers to choose mature or pre-IPO projects instead of early-stage start-ups. Second, the selection of managers in some local GGFs is flawed. For instance, the manager of the Shanghai Angel Investment Guidance Fund (Shanghai AIGF) is not selected from the private sector, but statutorily appointed. The manager currently appointed is a subsidiary249 of another government-backed fund, the Shanghai Technology Entrepreneurship Foundation for Graduates (EFG),250 that ‘shall exercise the rights as the investors of the Shanghai AIGF’.251 Two questions naturally follow: First, how would EFG ‘exercise the rights as an investor’ and operate the fund effectively since it does not hold any equity interests in the fund? Second, how would the EFG monitor the fund effectively when the fund is being

246

247

248 249 250

251

Article 8 of the Implementation Rules of the Shanghai Angel Investment Guidance Fund [上海市天使投资引导基金管理实施细则], ibid, states that investments by the Shanghai Angel Investments Guidance Fund into each portfolio company shall be between RMB 5 million and RMB 30 million and that this amount shall not exceed 50 per cent of the total subscribed capital of the portfolio company. Article 41 of the Measures of the Jiangsu Emerging Industry Venture Capital Investment Guidance Fund 2010, [江苏省新兴产业创业投资引导基金管理办法], Jiangsu Local Government, No. 153 [2010] states that the duration of investments made by the Jiangsu Emerging Industry VC Investment Guidance Fund shall not exceed five years unless approval is sought from the fund’s management committee. Supra note 2. Shanghai Venture Capital Jieli Technology Financing Group (上海创业接力金融集团). This Foundation was established by the Shanghai government as a not-for-profit organisation in 2006. Implementation Rules of the Shanghai Angel Investment Guidance Fund (上海市天使 投资引导基金管理实施细则), supra note 245, at Art. 3.

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operated by EFG’s subsidiary? Unlike the ordinary VC limited partnership model where a professional VC firm serves as the GP and is subject to various legal and contractual constraints (e.g. unlimited liability for the debts of the fund, fiduciary duties, and the LPs’ derivative action mechanism), there is no effective mechanism to constrain the behaviour of the Shanghai AIGF’s statutorily mandated fund manager, due partly to the lack of duties imposed by law and partly to the specific manner in which this fund is set up. Moreover, under the Shanghai AIGF Measures,252 a steering committee comprising the deputy mayor of Shanghai city and other government bureaucrats is in charge of the policymaking and supervision of the fund.253 The lack of open selection mechanisms for local cadres in charge of the GGFs may lead to problems including bureaucratic red tape and a lack of expertise and professionalism within the GGFs. Further, the Shanghai AIGF Measures mandate the establishment of a separate investment committee comprising external experts and government representatives, whose role is to review and vote on investment proposals.254 These officials may pressure the selectors to put up less viable options, thus causing internal conflicts. Also, while the GP of a limited partnership-type VC fund in the US and the UK is constrained by fiduciary duties and potential personal liability,255 there are only a few piecemeal duties imposed on the GP under PRC law. Consequently, ensuring that these officials do not misuse resources of the fund to obtain personal benefits remains an issue. The lack of proper checks and

252

253 254

255

Article 3 states that the steering committee is the highest management institution for the Shanghai AIGF and is responsible for the policymaking and supervision of the fund. Ibid. Public information reveals that the steering committee is led by the deputy mayor of Shanghai and includes bureaucrats from twelve departments of the Shanghai government. See J. L. Liang, ‘Looking for ‘small Ali’, Shanghai set up the First Domestic Government Angel Guide Fund’ (寻找’小阿里’,上海成立国内首个政府天使引导基 金), Economic Observer (经济观察网), 24 December 2014, online: http://bit.ly/2siFqlz. Ibid. Article 12 of the Implementation Rules of the Shanghai Angel Investment Guidance Fund (上海市天使投资引导基金管理实施细则), supra note 245, states that the fund must set up an independent investment review committee to review investment proposals. The committee will comprise experts and representatives from relevant government agencies. Ibid. K. M. Jacobson, ‘Fiduciary Duty Considerations in Choosing between Limited Partnerships and Limited Liability Companies’ Real Property, Probate and Trust Journal, 36 (2006), 1, 6; L. E. Ribstein, ‘Fiduciary Duties and Limited Partnership Agreements’ Suffolk University Law Review, 37 (2004), 927, at p. 939.

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balances on these officials and the lack of due process open up the door to abuse. Third, local governments or GGFs often provide guarantees for investment losses suffered by VC firms, thereby encouraging excessive risk taking. Examples include the GGFs of Beijing city,256 Jiangsu province,257 Guangzhou city,258 and Shanghai city.259 For example, the Shanghai government guarantees and compensates VC firms for up to 60 per cent of their actual losses caused by investments in scientific and technological enterprises at the seed stage or up to 30 per cent at the startup stage,260 as well as RMB 3 million of their actual losses for each investment project and RMB 6 million for annual investments by each investment firm.261 As a consequence, VC firms are less incentivised to perform effectively and work in the best interests of the funds. Guarantee schemes that are 256

257

258

259

260 261

Special subsidies exist for VC investments in Zhongguancun, an area in Beijing with a high concentration of technology firms. Measures on the Zhongguancun Talent Attraction Investment Fund 2013, [中关村国家自主创新示范区优秀人才支持资金管 理办法], Zhongguancun Science and Technology Park Management Committee, No. 40 [2013]. See The Measures on the Jiangsu Emerging Industrial Venture Capital Investments Guidance Fund, where Jiangsu Development and Reform Commission states that angel investment firms would be compensated for up to 50 per cent of the losses they incur from investments into seed or early-stage technology-based enterprises, provided that these losses were incurred within three years from the time the relevant investments were made, up to a limit of RMB 3 million. Measures on the Jiangsu Emerging Industrial Venture Capital Investments Guidance Fund 2013 [江苏省新兴产业创业投资引导基金 管理办法], (promulgated by the Jiangsu Development and Reform Commission, 20 May 2013, effective 20 May 2013), available at www.jsstb.gov.cn/flfg/201301/ t20130104_3511800.htm. The Trial Measures for the Technology Enterprises Incubator VC and Credit Risk Compensation Fund of Guangdong Province states that VC firms will be compensated for up to 50 per cent of the losses they incur from investments made into early-stage enterprises in the Guangdong Province Technology Enterprises Incubator, up to a limit of RMB 2 million. Trial Measures for the Technology Enterprises Incubator Venture Capital and Credit Risk Compensation Fund of Guangdong Province 2015 [广东省科学 技术厅广东省财政厅关于科技企业孵化器创业投资及信贷风险补偿资金试行细 则] (jointly promulgated by the Guangdong Provincial Office of Science and Technology and the Guangdong Provincial Department of Finance, 15 February 2015, effective 1 April 2015), available at www.gd.gov.cn/zwgk/lsgb/content/post_129368.html. Shanghai Angel Investment Risk Compensation Interim Measures 2016 [上海市天使投 资风险补偿管理暂行办法] (promulgated by Shanghai Municipal Science and Technology Commission, Shanghai Municipal Finance Bureau, and Shanghai Municipal Development and Reform Commission, 29 December 2015, effective 1 February 2016). Ibid., Art. 9. Ibid., Art. 10.

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funded by taxpayers’ money may also create public grievances towards the GGFs, as the very nature of VC investments is high-risk. Another issue is that these guarantee schemes are usually implemented by officials who may not possess sufficient expertise in calculating the losses suffered and who may prefer to compensate VC firms that are government-backed. For example, the Shanghai AIGF Measures state that a steering group comprising government officials is responsible for the implementation of the compensation scheme.262 Statistics show that many of the VC firms that received compensation for their investment losses were indeed government-backed firms.263 Fourth, GGFs often negotiate for smaller compensation packages for GGF-backed VC firms relative to private VC firms, resulting in a suboptimal alignment of interests between investors and GPs of GGFbacked VC firms. As discussed earlier, the most popular distribution of the GP’s compensation is the ‘2/20 Rule’,264 which is, however, not always followed in China. Local governments are often overly protective of the taxpayers’ money while negotiating profit allocation, resulting in the VC firm being paid less than a 20 per cent carried interest,265 or in the GGFs being given priority in the distribution of profits over the VC firm.266 Meanwhile, there is a lack of clear and detailed guidelines on the evaluation of the fund and the appraisal system of the GP in some local GGFs.267 262 263

264

265

266

267

Ibid., Art. 11. Ibid., Art. 8 (specifying that applicants for compensation shall make a filing with the relevant registrar in charge of VC investments). Statistics show that out of more than 110 VC firms which had made filings for compensation as of January 2016, most were stateowned VC firms. See In Touch Today (今日话题), ‘‘Why Should the Government Be Subsidizing Venture Capital Investment Failures’’ (风险投资失败，凭什么政府来贴 钱), 27 January, 2016, online: Teng Xun Ping Lun (腾讯评论) http://bit.ly/2tq6PC8. Under this rule, the venture capitalists are entitled to a flat 2 per cent of total asset value as a management fee and an additional 20 per cent of any profits earned as carried interest. See P. Gompers and J. Lerner, supra note 2, 91–126. Zero2IPO Research Center [清科研究中心], ‘‘Zero2IPO Ranking: 2016 Government Guided Fund Ranking About to Launch, Decipher The Market Structure of Thousandbillion Level Guided Fund 清科排名：2016政府引导基金排名启动在即，解密万亿 规模引导基金市场格局’’, PE Daily [投资界] (28 January 2015), online: https://m .pedaily.cn/news/393065. Investment World, ‘Uncover Government Guide Fund: Four Problems VS Four Trends’ (起底政府引导基金：四大问题拦路VS四大趋势‘观风’), PE Daily.cn, (12 May 2016), online: www.briankreed.com/pe/201605/20160512397136.shtml. Article 23 of the Implementation Rules for Shanghai Angel Investments Guidance Fund (上海市天使投资引导基金管理实施细则), supra note 245, states generally that the steering committee and its office are responsible for the supervision and evaluation of

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Fifth, a minority of guidance funds have special incentive mechanisms designed to encourage the fund to invest locally. For example, the VC guidance fund regulations in Shenzhen, in accordance with market rules and based on the premise that each investor regains his paid contribution to the sub-fund, stipulate that 20 per cent of the net income from the subfund’s investment be awarded to its management organisation, and that the remaining 80 per cent be distributed according to the proportion of each funder’s capital contribution. In order to encourage the sub-fund to increase its investment in more Shenzhen-based projects, when the subfund is due to be liquidated, the guidance fund’s incentive rate for the sub-fund’s management organisation is raised from 20 per cent to 50 per cent in respect of the net income from Shenzhen-based projects in their start-up phase. As for the net income for such projects in their early or middle phases, the incentive rate is raised from 20 per cent to 30 per cent.268 Finally, there are institutional obstacles that prevent local governments from permitting local GGFs to operate purely based on market forces. The most important one is the problematic cadre appointment system in China. Since the early years of the Chinese Communist Party, China’s cadres have always been appointed by higher-level supervisors.269 Under the cadre responsibility system, appointed cadres are personally held responsible for achieving certain targets and policies laid down by higher-ups.270 In the context of GGFs, these systems have led to the inevitable intervention of local governments in the selection of the portfolio companies. In order to make sure that public capital is properly

268

269

270

government guidance funds but provides no specific evaluation criteria. Article 30 of the Interim Measures of the Government Investment Fund simply specifies that the GGF should set up an evaluation system for the fund, but provides no detailed rules on how the assessment should be made. See Interim Measures on Government Investment Funds 2015 [政府投资基金暂行管理办法], Ministry of Finance, No. 210 [2015], Art. 30, available at http://bit.ly/2tm19J1. Qianhai Municipal Administration Bureau (前海管理局), ‘Official promulgation of the Measures for the Administration of Qianhai Industrial Investment Guidance Fund’ (前 海产业投资引导基金管理办法正式发布), Shenzhen Government, 19 July 2018, online:, www.sz.gov.cn/qhglj/qt/gzdt/201807/t20180719_13699232.htm; Luohu district Finance Bureau, ‘Luohu district Finance Bureau issued the Trial Measures for the Management of Government Guidance Funds for government investment in the Luohu district, Shenzhen’ (罗湖区财政局出台《深圳市罗湖区政府投资引导基金管 理办法(试行)》), Luohu district Finance Bureau, 4 March 2016. W. Hu, Z. Lan, and S. Liu, ‘Innovations in Cadres Selection and Promotion in China: The Case of Mudanjiang City’ (2014) 8 Business and Public Administration Studies 48. M. Edin, ‘Remaking the Communist Party-State: The Cadre Responsibility System at the Local Level in China’ China: an International Journal, 1 (2003), 1.

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used and that the officials in charge are subject to some form of personal responsibility, municipal governments typically install the mayor of the city as chairman of the steering committee of the GGF.271 But there does not appear to be any penalty for bad performance, aside from loss of face/ reputation.272

2.5 Foreign Funds The previous sections have focussed on local funds raised in PRC’s local currency – RMB funds. This part will discuss the operation and regulation of foreign funds (waizi jijin) in the context of China.

2.5.1 RMB Funds and USD Funds Foreign funds refer to the funds that possess certain foreign elements (such as source of funding, type of currency, and location of establishment).273 They play an important role in providing funding for the ongoing early-stage development of the Chinese market, and in contributing a wealth of experience in fund management which may be lacking in the domestic context. In China, foreign funds are dominated by funds denominated in USD – USD funds. There are many differences between RMB funds and USD funds, in terms of the sources of funds, the legal basis, regulations, exits, and tax treatments.274 First, the sources of RMB funds and USD funds are different. RMB funds include foreign RMB funds and domestic RMB funds. Foreign RMB funds refer to the funds partially funded by foreign investors, but their investments in China are in RMB. The sources

271

272 273

274

See text accompanying supra note 252. See also Implementation Rules of the Shanghai Angel Investments Guidance Fund (上海市天使投资引导基金管理实施细则), supra note 245. I discussed the problems of GGFs in this paper: L. Lin, supra note 12, at 192–201. Purely foreign funds generally refer to funds which are set up abroad according to foreign laws. The main source of funding of these funds comes from overseas and the fund’s currency is foreign currency. See further in L. Lin, ‘Venture Capital, Angel Capital & Other Finance, IPOs and acquisition’ (2019) chapter 4.4 in Fu Xiaolan, Bruce Mckern, and Chen Jin, eds., Handbook of Innovation in China (United Kingdom: Oxford University Press, 2020). Telephone interview with Ms Ding, Partner, Yincubator, 2 May 2020; and telephone Interview with Mr Tian, Partner, iVision Ventures, 2 May 2020.

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of domestic RMB funds and USD funds are what their names suggest. Second, the legal bases for RMB funds and USD funds are different. The establishment of a RMB fund is governed by Chinese laws; the establishment of a USD fund is governed by the laws of popular jurisdictions for fundraising, such as the United States, the Cayman Islands, and the British Virgin Islands. Third, the investment restrictions placed on RMB funds and USD funds are different. The investment of USD funds in Chinese companies is subject to limitations in the PRC Negative List for the Access of Foreign Investment, and the USD funds are not allowed to have controlling rights or even invest in certain sectors under PRC law. The investment direction of foreign RMB funds is still restricted by the PRC Foreign Investment law. In contrast, there are fewer restrictions and more flexibility for domestic RMB funds. Fourth, RMB funds and USD funds have different exits. Offshore holding structures are usually set up by USD funds for the purpose of their investments, and they will exit by listing the investment enterprises on overseas stock exchanges or transfer their equity interests in the overseas holding companies. In contrast, RMB funds generally seek to list on Chinese stock markets or transfer their equity interests or assets in the domestic market. Fifth, RMB funds and USD funds enjoy different tax incentives. The biggest problem RMB funds face at present is that they cannot enjoy as many tax incentives as the USD funds. Due to inconsistency in the Chinese law, some RMB funds are still troubled by double taxation.

2.5.2 The Development of Foreign Funds China’s history with foreign VC began in the early 1990s. In 1993, IDG Capital275 and the Shanghai Science and Technology Committee founded the Pacific Technology VC (China) Fund, which was the very first foreign VC firm to enter China. During the 1990s, when the dot.com bubble was growing, an immense number of foreign VC funds began investing in Chinese internet companies, including the three major web

275

Founded in 1992, IDG was the first firm to bring foreign VC into China.

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portals - Sina, Sohu, and NetEase.276 After 2000, China’s supervisory controls on foreign funds were relaxed to some extent and corresponding laws and regulations were promulgated to facilitate the development of VC in China.277 The rapid development of domestic VC firms after 2006 coincided with a slew of other developments including the rise of RMB internationalisation, the development of regulations facilitating greater use of foreign facilities,278 and greater amounts of foreign capital flowing into China.279 It is in this context that a greater number of foreign firms started to raise RMB funds in China.280 As shown in Table 2.7, these RMB funds eclipsed foreign currency funds in China for the first time in 2009, both in scale and quantity.281 Since then, the RMB funds have dominated fundraising in China’s VC market. In 2005, China introduced a new business vehicle – the Foreigninvested VC Companies – to facilitate foreign fundraising in China’s

276

277 278

279

280

281

X. Fu, B. Mckern, and J. Chen, eds., Handbook of Innovation in China (Oxford University Press, 2020). Ibid. The current administration for the approval and management of domestic investments mainly abide by the rules set out in regulations such as The Notice of the State Administration of Foreign Exchange on Reforming the Mode of Management of Settlement of Foreign Exchange Capital of Foreign-Funded Enterprises 2015 [国家外汇管理局关于改革外商投 资企业外汇资本金结汇管理方式的通知], State Administration of Foreign Exchange, No. 19 [2015], The Notice of the State Administration of Foreign Exchange on Further Simplifying and Improving Policies for the Foreign Exchange Administration of Direct Investment 2015 [国家外汇管理局关于进一步简化和改进直接投资外汇管理政策的 通知], SAFE, No. 13 [2015], and The Notice of the State Administration of Foreign Exchange on Reforming and Regulating the Policies for the Administration of Foreign Exchange Settlement under the Capital Account 2016, [国家外汇管理局关于改革和规范资本项 目结汇管理政策的通知], SAFE, No. 16 [2016]. Ibid. The main contents of these regulations include the registration of foreign exchange and the management of foreign exchange settlement. On 9 June 2016, the SAFE issued The Notice of the State Administration of Foreign Exchange on Reforming and Regulating the Policies for the Administration of Foreign Exchange Settlement under the Capital Account 2016 [国家外汇管理局关于改革和规范资本 项目结汇管理政策的通知], SAFE, No. 16 [2016]. SAFE No. 16 [2016], built upon the foundations of SAFE No. 19 [2015] by expanding on the main body of institutions, sources, and scope of funds applicable to willing settlements of foreign exchange capital and by clarifying the management of the usage of foreign exchange settlement funds. X. Fu, B. Mckern, and J. Chen, eds., Handbook of Innovation in China (Oxford University Press, 2020). Ibid.

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Table 2.7 Amount of foreign and domestic VC funding: number of foreign VC funds and RMB funds, as well as the annual amount raised by the respective types of funds (2008–2018)282

Year

Annual number of foreign funds raised

Annual amount raised by foreign funds (in RMB millions)

Annual number of RMB funds raised

Annual amount raised by RMB funds (in RMB millions)

2018

41

1,054.64

692

1,970.32

2017

36

468.41

859

3,008.28

2016

40

693.89

596

2,888.05

2015

45

599.95

552

1,396.42

2014

30

503.01

228

666.84

2013

10

32.87

189

387.12

2012

16

149.32

226

436.40

2011

31

491.99

351

1,287.56

2010

12

284.79

145

454.60

2009

10

156.34

84

243.63

2008

28

339.38

88

159.89

VC market.283 However, these regulations governing the Foreigninvested VC Companies limited the areas which VC companies could invest in, imposed strict requirements regarding the establishment of VC

282

283

Data from Annual Research Reports on Venture Capital in China, published by Zero2IPO. This table only includes VC funds but not PE funds. The Provisions Concerning the Administration of Foreign-funded Business-starting Investment Enterprises (2015 Amendment) [外商投资创业投资企业管理规定(2015修 正)] (Order No. 2 [2003] of the Ministry of Foreign Trade and Economic Cooperation, the Ministry of Science & Technology, the State Administration for Industry and Commerce, the State Administration of Taxation, and the State Administration of Foreign Exchange; and Amended according to the Ministry of Commerce of the Decision of the Ministry of Commerce on Amending Some Rules and Regulatory Documents on 28 October 2015 [外经贸部、科技部、工商总局、税务总局、外汇 局令2003年第2号，根据2015年10月28日《商务部关于修改部分规章和规范性文 件的决定》修正].

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companies, and were inflexible as to the business models that such companies could adopt.284 As a result, this business vehicle was not fit for the purposes of the VC industry and was rarely adopted. The National People’s Congress Standing Committee’s response was to enact the Partnership Act in 2006, which introduced a new business vehicle – the limited partnership – to facilitate fundraising in China’s VC market. The promulgation of the PEL and the introduction of Administrative Measures for the Establishment of Partnership Enterprises within China by Foreign Enterprises or Individuals 2010285 provide the legal basis for foreign investors to establish partnership-type VC funds in China. The limited partnership is far more flexible in terms of operation of funds as compared to the foreign-invested VC company.286 284

285

286

The conditions for the establishment of a foreign-funded business-starting investment enterprise (‘FBIE’) include: (1) Business-starting investment shall be the main business of the indispensable investor; (2) The accumulative total capital managed by the indispensable investor in the three years before the application shall not be less than 100,000,000 US dollars, and of which no less than 50,000,000 US dollars have been used in business-starting investment. If the indispensable investor is a Chinese investor, the accumulative total capital managed thereby in the three years before the application is submitted shall not be less than RMB 100 million and of which no less than RMB 50 million have been used in business-starting investment; (3) The indispensable investor shall have at least three professional managerial persons who have practical experience in business-starting investment; (4) If the affiliated entity of an investor meets the above-mentioned requirements, the investor may apply for the status of an indispensable investor. The term ‘affiliated entity’ in this paragraph refers to an entity controlled by the investor, or an entity that controls the investor, or another entity under the control of the same entity that controls the investor. The term ‘control’ in this paragraph means that the controlling party has a voting power of more than 50 per cent over the controlled party; (5) Neither the above-mentioned indispensable investor nor its affiliated entity shall have any record of being prohibited from being engaged in business-starting investment or business of investment consultancy, or being punished on the ground of fraud, by the judicial departments and other relevant agencies of the country where it is located; and (6) An indispensable investor of a non-legal-person enterprise shall subscribe to and actually pay not less than 1 per cent of the subscribed contributions and the actual total contributions, respectively, and it shall bear joint liabilities for the debts of this enterprise. An indispensable investor of an incorporated FBIE shall subscribe to and actually pay not less than 30 per cent of the subscribed contributions and the actual total contributions, respectively. The Provisions Concerning the Administration of Foreign-funded Business-starting Investment Enterprises 2003 [外商投资创业投资企业管理规定] (Order No. 2 [2003] of the Ministry of Foreign Trade and Economic Cooperation, the Ministry of Science & Technology, the State Administration for Industry and Commerce, the State Administration of Taxation, and the State Administration of Foreign Exchange [外经 贸部、科技部、工商总局、税务总局、外汇局令2003年第2号]. For the advantages of the limited partnership, see supra text accompanying notes 20–28.

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In early 2011, another related development was introduced. The Qualified Foreign Limited Partners (QFLP) regime was established to encourage further investment, through a pilot programme that was launched in Shanghai. Thereafter, the QFLP was gradually introduced in Beijing, Tianjin, Shenzhen, Qingdao, Chongqing, Guizhou (Guiyang Comprehensive Protective Tariff Zone), Fujian Pingtan, and other areas. The QFLP regime was intended to serve as a channel through which foreign LPs can participate in the Chinese market and quickly succeeded in becoming a key point of access for foreign investors. Under the QFLP regime, foreign funds can invest in the equity of non-listed companies under the supervision of AMAC and related authorities. The QFLP has proven popular. Some QFLP regimes have already undergone improvement to be more foreign investor-friendly. For example, the ‘Pilot Programme for Foreignfunded Equity Investment Enterprises’ issued by the government of Shenzhen287 on 22 September 2017 now allows for the new QFLP models of ‘foreign investor management of domestic capital’ and ‘domestic investor management of foreign capital’. Another instance of improvement was the Implementation of Measures for the Launch of Pilot Reforms for Foreign-invested Equity Investment Enterprises (For Trial Implementation)288 promulgated by the Fujian Pingtan Comprehensive Pilot Zone Management Committee in 2018, which put forward relatively more favourable and relaxed conditions for investors from Hong Kong, Macau, and Taiwan, in comparison to other foreign investors, in terms of the amount of proprietary assets, the scale of assets under management, and the amount of subscribed capital contributions from equity investment enterprises. This was clearly an attempt to attract more foreign LPs by relaxing regulations. Being a limited partnership, the QFLP fund is regarded as a taxtransparent entity at the fund level. The State Administration of Foreign Exchange (SAFE) grants pre-emptive approvals for QFLP funds (i.e. approval must have been granted at the time of establishing the fund), allowing the settlement of the QFLP fund at the custodian bank to take place directly after its establishment. This allows the contributions made by foreign investors to be converted into RMB, such that 287

288

No. 1 [2017] by the Shenzhen Local Government Financial Development Service (深金 规[2017]1号) (深圳市外商投资股权投资企业试点办法), 11 October 2017, http://jr .sz.gov.cn/sjrb/xxgk/zcfg/gfxwjcx/content/post_3175655.html. Pingtan QFLP Measures, [平潭QFLP办法] Fujian Pingtan Comprehensive Pilot Zone Management Committee, [2018] No. 50.

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they can be placed as investment into the fund within a shorter period of time. Additionally, for overseas PE/VC institutions which have not managed domestic funds before, the QFLP fund can bring intangible advantages, such as a certain level of repute, government links, and so on. The QFLP funds have typically utilised three basic structural arrangements (with each structure having different variants): (1) the quasi-domestic funding model, where a foreign PE/VC institution establishes a wholly foreign-owned enterprise to serve as the GP/ management company of the domestic limited partnership, only raising RMB funds from domestic investors; (2) the joint venture model, where both the domestic and foreign PE/VC institutions jointly establish a GP/management company, and simultaneously raise funds from domestic and foreign investors; (3) the pure foreign funding model, where foreign PE/VC institutions set up and operate as GPs/management companies, only raising funds in foreign currency from foreign investors. One notable variant that emerged as an extension of the QFLP pilot programme is the RMB Qualified Foreign Limited Partner (RQFLP) pilot programme. This is another route for foreign investors to invest in domestic RMB funds. Shanghai, Shenzhen, and other areas which have launched the pilot programme now allow foreign investors to use offshore RMB funds instead of foreign currency funds to invest in foreigninvested equity investment enterprises. However, as RQFLP funds were limited by the control of the People’s Bank of China over their use of offshore RMB (amongst other reasons), the RQFLP pilot programme was not widely used. Nevertheless, the very fact that these QFLP programmes are entertained indicate that local governments have begun to take a more liberal approach to encouraging private capital flows into the VC market.

2.6 Ways Forward for Fundraising in China In evaluating the many different aspects of VC fundraising in China, the earlier discussion suggests that there is much room for improvement to facilitate VC fundraising. Following from that, this part scopes out in more comprehensive and systematic fashion the existing flaws and the corresponding avenues of development which the Chinese market may pursue to address those flaws.

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2.6.1 Strengthening Investor Protection 2.6.1.1 Agency Cost The root of the investor protection problem in the VC context is the agency problem. Investors expect managers to maximise returns on their investments, whereas managers may be primarily motivated by selfinterest. Agency problems are further exacerbated by the structure of limited partnerships. A typical fund is structured as a limited partnership. The management firm serves as the GP and actively manages the fund’s activities while the investors act as LPs who provide capital to the fund and enjoy the protection of limited liability from the debts and obligations of the firm. However, the LPs are not allowed to participate in the management of the fund under the default rule of the limited partnership289 and this provides opportunities for managerial abuse. Since the LPs (the principal) cede control and delegate the decisionmaking authority to the GP (the agent), the GP may not always act in the best interests of the LPs and could abuse his managerial position.290 As a result, agency costs could easily arise. Limited partnership law further constrains the ability of LPs to curb managerial excesses by the ‘control rule’, which renders LPs liable for the limited partnership’s liabilities if they intervene in the management of the partnership.291 Unlike shareholders in a company who can constrain managerial misbehaviour by exercising voting rights in the shareholders meeting, LPs do not have similar rights to participate in the management or control of the partnership. Furthermore, unlike shareholders who can select and change the management of a company by exercising their powers in a shareholder meeting, it is more difficult to change a GP in a limited partnership since doing so generally requires the partners’ unanimous consent.292 As discussed earlier, the agency problem afflicts the limited partnership more severely than the company. In essence, there are conflicts between (1) the self-interests of GPs in respect of collecting management fees, carried interests, and other forms of compensation, and (2) the self-interests of LPs in respect of obtaining 289 290

291

292

Partnership Enterprise Law 2006 (PRC), Art. 68. M. C. Jensen and W. H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, 3(4) (1976), 305, at p. 308. L. Lin, ‘Managing the Risks of Equity Crowdfunding: Lessons from China’, Journal of Corporate Law Studies, 17(2) (2017), 1–40. L. Lin, ‘Private Equity Limited Partnerships in China: A Critical Evaluation of Active Limited Partners’, Journal of Corporate Law Studies, 13 (1) (2013), 185.

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high-risk-adjusted performance at a low cost. For example, the GP may engage in opportunistic behaviour and exploit the LPs by disclosing misleading information, omitting materially adverse information, or artificially inflating reported values of portfolio companies with the intent of exaggerating fund performance in order to receive benefits. Apart from overvaluing assets, the GP may also act myopically in an attempt to maximise its collectible carried interest at the expense of the long-term interests of the LPs. High-potential investments may be prematurely exited to reduce monitoring costs while underperforming investments may be continued in the hope of increasing value.293 There is also a moral hazard problem where the GP misuses the raised funds and engages in excessively risky investments. One could argue that the personal liability borne by GPs may sufficiently deter them from pursuing risky activities (such as excessive borrowings and overleveraged activities) and thus reduce agency costs.294 However, such optimism is misplaced.295 First, the GP is commonly organised as a company and this effectively sidesteps the issue of unlimited liability. Second, this device only reduces creditors’ risks without improving the position of LPs. In China, due to regulatory restrictions on the use of bank loans to fund merger and acquisition transactions,296 a Chinese VC fund usually does not use highly leveraged debt financing on the fund level. Therefore, insolvency (of funds) is a rare event,297 and the supposed protection provided by the unlimited liability of GPs is even less relevant in the context of Chinese practice. Furthermore, even in the US, a VC fund is unlikely to owe significant debts to outside creditors, such that the 293

294

295

296

297

C. Brown and R. Kraeussl, ‘Risk and Return Characteristics of Listed Private Equity’ in D. Cumming, The Oxford Handbook of Private Equity (Oxford University Press, 2012), 614. L. E. Ribstein, ‘An Applied Theory of Limited Partnership’, Emory Law Journal, 37 (1988), 835, 848. L. E. Ribstein, ‘Unlimited Contracting in the Delaware Limited Partnership and its Implications for Corporate Law’, Journal of Corporation Law, 17 (1991), 299, at p. 304. China’s limited partnership funds cannot engage in large scale debt-financed investments and cannot publicly issue corporate bonds. In addition, they are subjected to further restrictions under the Lending General Provisions 1996 [贷款通则], People’s Bank of China, No. 2 [1996] and cannot obtain bank loans easily. There is thus little external debt for limited partnership funds. As such, the fact that GP bears unlimited liability for obligations of the limited partnership is insufficient to constitute an effective constraint on the GP. Ibid. See S. Ruo, ‘Interpretation of the Unlimited Liability of General Partner (Interview with Zhang Ying, the Representative of the Beijing Office of the Akin Gump Strauss Hauer & Feld LLP Chinese Venture)’, China VCPE, 14 September 2009, online: www .chinavcpe.com/news/hot/2009-09-14/47d851398d3df741.html.

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personal liability of GPs will probably be an insignificant factor in the overall assessment of risk.298 Personal liability alone is thus unable to prevent GPs from pursuing opportunistic behaviours or to ensure that they act in the best interests of the partnership.

2.6.1.2 Market Failure As a result of the severe agency problem, as well as the lack of a clear regulatory framework governing the VC sector prior to 2014, various incidents of managerial abuse by fund managers emerged in China from 2011–2016.299 These include illegal fundraising, providing guarantees to investors on investment returns, misappropriating or converting fund assets,300 commingling client funds with personal funds, and publicising fictitious investment projects to fraudulently attract capital.301 Many investors endured huge losses as a result of the involvement of fund managers in illegal fundraising activities. The typical example is when the fund manager misleads retail investors but not accredited investors to make VC investments by publishing false information, fabricating non-existent projects, and guaranteeing returns that would not materialise.302 There were also a large number of fund managers engaging in moderate non-compliant acts such as unauthorised public fundraising, failure to abide by contractually stipulated investment strategies, and other contractual breaches.303 Some funds failed to provide accurate and timely disclosures and did not have adequate risk assessment systems in place.304 Moreover, given the importance of personal relations with business associates (in Chinese: guanxi)305 within Chinese society, a more pertinent issue is that many LPs may rely on recommendations from friends to make investments, and fail to do any form of check whatsoever.306 298

299 300

301 302 303 304 305 306

L. E. Ribstein, ‘Fiduciary Duties and Limited Partnership Agreements’, Suffolk U. L. Rev, 37 (2004), 927, at p. 935. L. Lin, supra note 97, at pp. 43–91. B. Feng, ‘Increase in Private Equity Fund Absconding Incidents: CSRC highlights four regulatory principles’, National Business Daily, 29 April 2016, online: www.nbd.com.cn /articles/2016-04-29/1001751.html. L. Lin, supra note 97. B. Feng, supra note 300. L. Lin, supra note 97. Ibid. ‘Guanxi’ means personal networks and relationships. Telephone interview with Mr Xu Kaixi, Investment Manager, October Capital, 20 December 2019; Telephone interview with Mr Chen, Vice President, Linyi Capital, 6 March 2017.

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In any case, investors may not be able to obtain or verify the fund’s true information. Some funds even deliberately up the ante by holding road shows, creating the illusion that the fund has many potential investors through means such as finding temporary LPs to turn up and act like they have invested, in order to attract the investment of prospective LPs.307 Other funds organise seminars and plant questions specifically designed to give the spokesperson an opportunity to advertise the investment’s strengths and advantages, so as to further lure prospective LPs.308 One could argue that wealthy investors can seek their own financial advice and bear the associated costs before committing themselves to investments. However, due to the absence of a well-designed entry licensing mechanism for fund managers before 2014 and the short history of the Chinese VC market, China lacks experienced and competent GPs as well as financial advisers capable of advising these investors. Most GPs are first-time fund managers raising their maiden funds.309 Investors may also be starved for choice due to the dearth of higherquality funds or GPs. In terms of industrial experience, many GPs were previously lawyers or investment bankers and do not have any VC or entrepreneur experience.310 This is different from the situation in the US or the UK, where GPs and venture capitalists have longer track records, which serve as more reliable economic signals. China also does not have a sound credit system that is comparable to the one in the US,311 further limiting the information that investors can rely on. These problems increase the investment risks and reduce the effectiveness of reputational mechanisms in mitigating managerial abuse. The conventional view on regulation of the VC sector is that it requires no regulatory attention since the sector is a highly competitive market 307

308

309

310

311

Yubin Shi, ‘Present Chaos and Crisis Faced by Chinese LPs When Choosing PE’ (9 August 2016), online: https://m.newseed.cn/news/1325946. Telephone interview with Mr Yuan, Partner, Jingtian & Gongcheng Shanghai office, 16 April 2017. Interview with Ms Kang, Partner, Global Law Office, 27 October 2016, Beijing; interview with Mr Chen Jian, founder of a start-up based in Shanghai, 20 December 2017, Singapore. See Org. for Econ. Co-Operation & Dev. & The Ministry of Science and Technology, China, ‘OECD Reviews of Innovation Policy: China Synthesis Report’ (August 2007), online: OECD, www.oecd.org/dataoecd/54/20/39177453.pdf at 18; Telephone interview with Mr Yuan, supra note 308; Telephone interview with Mr Lin, Vice President, Shenzhen Cedar Fund Management Company, 18 April 2017; Telephone interview with Mr Chen, supra note 306. See further discussion on this issue in Chapter 4 and Chapter 5 of this book.

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involving accredited investors312 and those who invest in VC funds are aware of the risks involved and know how to safeguard their interests via contractual negotiations.313 However, these assumptions are challenged by the evidence of market failure in the Chinese VC sector. In particular, the assumption that investors are always able to protect themselves by effective private ordering is especially flawed,314 as many investors in China are financially unsophisticated individuals and not institutional investors. Thus, there is a strong case for introducing stronger LP protection via regulation in China. Moreover, these fundraising cases arise in the context of the relationship between GPs and LPs in China, which thus should be the main subject of regulatory focus. In designing responses for the Chinese market, regulators have to tailor their approach to the relationship between GPs and LPs in the context of China.315 The following parts suggest possible solutions to enhance investor protection.

2.6.1.3 Fiduciary Duties of GPs Financial economics argue that GPs (VC firms and venture capitalists) play a crucial role to the success of VC. By scrutinising portfolio companies before providing capital and then monitoring them thereafter, venture capitalists help to reduce the information asymmetries and capital constraints of VC investments.316 The area of fiduciary duties is perhaps one in which reform is most sorely required. It has been an area neglected by Chinese partnership law.317 There are two broad categories of obligations included under the umbrella term of ‘fiduciary duties’ – the duty of loyalty and the duty of care. Between these two, the duty of loyalty lies at the core of fiduciary duties, requiring fiduciaries to subordinate their personal interests to the interests of their principals. In the context of VC funds, this means that 312

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See for example S. Thomsen, ‘Should Private Equity Be Regulated?’, European Business Organisation Law Review, 10 (2009), 97, at p. 104; I. MaeNeil, ‘Private Equity: The UK Regulatory Response’, Capital Markets Law Journal, 3(1) (2008), 18–31. S. Thomsen, ibid. L. Lin, supra note 97. See P. Morris and L. Phalippou, ‘A New Approach to Regulating Private Equity’, 2011, SSRN, https://ssrn.com/abstract=1762840; see also Financial Services Authority, ‘Private equity: A discussion of risk and regulatory engagement DP06/6’, FSA, November 2006, online: www.treasurers.org/ACTmedia/dp06_06.pdf. Supra note 2, at 160. There is no specific national law on private equity in China.

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all decisions regarding fund management shall be made in the best interests of the investors and fund managers shall avoid putting themselves in a position of conflict of interest when making such decisions. The duty of care, on the other hand, is essentially a duty to maintain a requisite level of diligence and care in the management of the fund. In the US, apart from equitable fiduciary duties, many partnership statutes provide default rules governing the internal relationship among general partners, who usually serve as the fund managers in the VC funds.318 However, the Chinese law regulating partnerships, the PEL, does not impose any concept of equitable fiduciary duties owed by partners in a manner equivalent to that present in common law jurisdictions.319 Arguably, the absence of fiduciary duties contributes to opportunism and misbehaviour by GPs in China’s PE/VC market as discussed earlier.320 Nevertheless, the PEL outlines the following provisions on the duties of partners.321 • The partners should not engage in activities which may harm the interests of the partnership.322 • The GPs should not carry out any business competing with that of the partnership solely or cooperatively.323 318

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The Uniform Partnership Act (1997), §103 also provides that ‘relations among the partners and between the partners and the partnership are governed by the partnership agreement. To the extent the partnership agreement does not otherwise provide, this Act governs relations among the partners and between the partners and the partnership.’ The lack of fiduciary duty in the Chinese partnership law is readily understandable. The fiduciary duty is a longstanding concept originally developed out of equity and trust in common law jurisdictions. However, as a civil law jurisdiction, China does not have the equivalent concept of equity and trust. Moreover, the PEL was drafted during the economic transitional period in the 1990s. There was limited judicial and practical experience of partnerships at that time and inadequate understanding of the fiduciary duties. Further legislative background of the promulgation of the PEL is available. See Yicheng Huang, ‘Explanations on the Draft Partnership Enterprise Law of the PRC, delivered to the 22nd Meeting of the Standing Committee of the 9th National People’s Congress on 26 October 1996’, 1 Gazette of Standing Committee of the National People’s Congress of the PRC 12. See Section 2.3.2 of this Chapter. L. Lin, “Private Equity Investor Protection: Conceptualizing Duties of Partners in China” (2018) 15 Berkeley Business Law Journal 43, at pp. 75–76. Ibid. Article 32 of PEL provides that: ‘No partner may, solely or jointly with others, operate any business competing with the partnership enterprise. Unless it is otherwise prescribed in the partnership agreement or is unanimously approved by all partners, no partner

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• The partners should not engage in any self-dealing business with the partnership.324 • The partner should not abuse any benefit of the partnership by taking advantage of his position or misappropriating any property of the partnership by other illegal means. If he does so, he shall return the benefit or property to the partnership. If his act results in any loss to the partnership or to other partners, he shall be liable for compensation.325 • The partner owes a duty to account to the firm for any benefit derived by him from any transaction competing with that of the partnership, or from any self-dealing business by him with the partnership. The partner shall bear compensation liabilities if any loss is caused to the partnership or to other partners.326 • The managing partner (zhixing shiwu hehuoren) should regularly report to the other partners on the process of partnership activities as well as the business and financial status of the partnership.327 Arguably, the rules mentioned earlier stipulating non-competition (Article 32(1), Article 99), the duty not to misappropriate company property (Article 96), and the duty to not engage in self-dealing (Article 32(2), Article 99), as a composite, create a duty that is similar to the duty of loyalty found in the US. However, the standard provided in Article 32 is that ‘the partners should not harm the interests of the partnership’. This is a far lower standard than that prescribed by the duty of loyalty at common law, which requires partners to act in the best interest of the partnership.328

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may have any trade with the partnership enterprise. No partner may engage in any activity that may impair the interests of the partnership enterprise’. Ibid. Article 96 of PEL provides that: ‘Where any partner executing the partnership affairs or any practitioner of a partnership enterprise occupies any benefit that attributes to the partnership enterprise by taking the advantage of his position, or misappropriates any property of the partnership enterprise by other illegal means, he shall return the benefit or property to the partnership enterprise. In case his act results in any loss to the partnership enterprise or to other partners, he shall bear the compensation liabilities.’ Article 99 of PEL provides that: ‘Where any partner, in violation of the provisions of this Law or the stipulations of the partnership agreement, undertakes any business competing with the partnership enterprise or trades with the partnership enterprise, the relevant proceeds shall attribute to the partnership enterprise. If any loss is caused to the partnership enterprise or to other partners, he shall bear the compensation liabilities’. Partnership Enterprise Law 2006 (PRC), Art. 28. F&C Alternative Investment Holdings (Limited) v. Barthelemy (2011) EWHC 1731 (Ch). Sales J identified the typical fiduciary duties: a fiduciary must not put himself in a position of conflict; a fiduciary must not make a profit from his position without

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Moreover, the Delaware Code complements the equitable duties by imposing strict and detailed statutory duties on partners.329 In contrast, the PEL does not adequately ensure that partners (especially GPs) are honest and disclose all relevant facts when dealing with fellow partners. Even though the PEL imposes a duty of reporting (Article 28), it is too limited and does not apply to all information affecting the partnership.330 The limited scope of disclosure required perpetuates information asymmetry and effectively prevents LPs from monitoring the investment decisions made by GPs. Furthermore, the provisions mentioned earlier apply to both general partnerships and limited partnerships.331 While these duties may be sufficient in the context of a general partnership, they are insufficient for limited partnerships since LPs in a limited partnership have surrendered control of the partnership to GPs. It is for this reason that the fiduciary duties imposed on the GP are usually stricter than those of a partner in a general partnership in the US.332 Common law also generally imposes higher standards on the GPs than the LPs in a limited partnership.333 It is regrettable that similar enhancements have not been made in the PEL with regard to the duties of a GP in a limited partnership. Nevertheless, there might be some basis to find a broader duty imposed on GPs via Article 5 of the PEL, which articulates the general principle of good faith: ‘The principles of willingness, equality, fairness and good faith shall be followed in the conclusion of a partnership

329

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informed consent; a fiduciary is required to act in the best interests of his beneficiary and a fiduciary must act in good faith. The duty to act in good faith is a compendious expression of duty and encompasses each of the first three duties. Delaware Code, Chapter 15 – Delaware Revised Uniform Partnership Act, s. 15-403 ‘Partner’s rights and duties with respect to information’. Del. Code Ann. Tit. 6, § 15-403. Law v. Law (1905) 1 Ch 140. Article 60 of PEL provides that the PRC LP is regulated under the Chapter III of the PEL which contains twenty-five provisions. Where Chapter III does not specifically provide for the relevant situation, there is a fall-back clause which states that the provisions on general partnership and its partners shall be used. Palmer v. Fuqua, 641 F.2d 1146, 1155 (5th Cir. 1981), which held that the sole general partner of the limited partnership, having exclusive power and authority to control and manage partnership, owed limited partners even greater duty than is normally imposed on partners; Bassan v. Investment Exch. Corp., 83 Wash. 2d, 524 P.2d 233 (1974), held that limited partners had no effective voice in decision-making process and were entitled to rely on high standard of conduct from general partner. See J. W. Callison, M. Sullivan, Partnership Law and Practice: General and Limited Partnership (Clark Boardman Callaghan, 2012).

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agreement and in the establishment of a partnership enterprise.’334 It is possible that this overarching principle may provide much-needed flexibility to the courts in a rapidly developing area of law. However, this article does not apply at all times in the course of a partnership business. Instead, it only applies to situations pertaining to ‘the conclusion of a partnership agreement and in the establishment of a partnership enterprise’335 and provides no significant assistance to LPs in need of protection. While the principle of good faith (chengshi xinyong yuanze) is an overriding principle (diwang tiaokuan) in PRC civil law,336 the current state of law remains unsatisfactory due to its many lacunas. Courts may only apply this principle when there is no specific legal provision governing a particular civil issue,337 limiting the application of the principle of good faith. In addition to the duties under the PEL, there are also statutory duties imposed upon fund managers of private funds338 under the Interim Measures for the Supervision and Administration of Privately Raised Investment Fund 2014:339 • In the case of a fund manager managing multiple funds simultaneously, the same fund manager should adhere to the principles of professional management. The fund should also establish a mechanism to prevent conflicts of interest.340 • Article 23 stipulates nine prohibitions for fund managers, including, inter alia: ‘not to treat the assets of different funds under management in an unfair manner’, ‘not to take advantage of fund assets or their positions to seek benefits for, or transfer benefits to, themselves or persons other than investors’, ‘not to divulge undisclosed information obtained 334 335 336

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Partnership Enterprise Law 2006 (PRC), Art. 5. Ibid. H. Liang, ‘Principle of Good Faith and Gaps Filling’, Chinese Journal of Law (法学研究), 2 (1994), 23. D. Fang, ‘Good Faith Principle and New Contract Law (诚实信用原则与新合同法)’ (1999) 63 Social Scientist (社会科学家), online: https://core.ac.uk/download/pdf/ 41436499.pdf. Pursuant to the Private Equity Measures, the private equity investment funds refers to the investment funds established within the People’s Republic of China that conduct private offering and target qualified investors during fundraising. Interim Measures for the Supervision and Administration of Privately Offered Investment Funds 2014 [私募投资基金监督管理暂行办法], CSRS, No. 105, effective on 21 August 2014 [hereinafter ‘CSRC Interim Measures’]. Article 22 of CSRC Interim Measures.

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by virtue of their positions, or make use of such information to engage in, or expressly ask or imply others to engage in, related trading activities’, ‘not to engage in investment activities detrimental to fund assets and investor interests’, ‘not to neglect duties, or fail to perform duties as required’, and ‘not to engage in insider trading, market manipulation or other improper trading activities’. • Fund managers have to disclose fund information to investors.341 • Considering that fund managers can contract out some of the duties in the agreements, Article 20 provides that fund managers in a closely held fund shall bear unlimited liability for the debts of the fund when the assets of the fund are insufficient to pay the debts of the fund according to Articles 93 and 94 of the PRC Securities Investment Fund Law. • Fund managers owe a duty of good faith (chengshi xinyong) and care (jinshen qinmian).342 The duties laid out earlier are similar to the duty of loyalty and duty of care under common law. The AMAC also substantiated the content of the duty of loyalty through supplementary provisions in its other guiding documents, such as the Measures for the Administration of the Disclosure of Information on Privately Offered Investment Funds,343 which grants informational rights to investors to enable better supervision, as well as the Guide on Internal Control for Private Equity Fund Managers,344 which incorporates the duty of loyalty as part of the internal management rules of fund managers to strengthen institutional support. These have helped to clarify aspects of the duty of loyalty to market participants. In order to judge what constitutes proper behaviour, the AMAC investigates industry best practices, picks out what it considers reasonable, and translates them into threshold standards for professional conduct in its guiding documents. For example, the actions required on the part of managers with respect to investor eligibility are provided for 341 342 343

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Articles 24 & 25 of CSRC Interim Measures. Article 4 of CSRC Interim Measures. Measures for the Administration of the Disclosure of Information on Privately Offered Investment Funds, [私募投资基金信息披露管理办法], effective on 4 February 2016, online: www.lawinfochina.com/display.aspx?id=21915&lib=law. Guidelines for the Internal Control of Managers of Privately Offered Investment Funds, [私募投资基金管理人内部控制指引], effective on 1 February 2016, online: www .amac.org.cn/businessservices_2025/privatefundbusiness/xggz/nkjxxpl/202001/ t20200101_5328.html.

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under the AMAC’s Rules on Private Equity Fundraising.345 In this respect, the AMAC performs a seminal role in supplying the duties of loyalty and care with content through setting standards for professional conduct in the areas of fund registration, product registration, fund manager qualification, escrow, and valuation. While these duties may in theory provide some additional protection, it is unclear if they will be effectively enforced. Implementation of these measures may be an issue because these duties, as a set of interim measures promulgated by the CSRC (which is a department under the State Council), are ranked relatively low on the hierarchy of sources of law in China. The guiding documents of the AMAC are only selfgoverning and have no legal effect. Thus, the effectiveness of the measures is of limited use in judicial practice in China. Unlike the PEL, which is binding, the People’s Courts have discretion over whether to refer to this measure and cannot directly apply these measures in making judgments.346 Moreover, the duties laid out are insufficiently detailed and remain vague as to the standard applicable in determining if the fund manager has breached his duties. As the situation stands, clear provision of statutory duties on partners under the PEL will bring much-needed certainty and clarity into this area of law in China.347 Apart from being consistent with China’s legal culture and tradition of codification,348 regulating partners’ duties in statutory form is consistent with the international trend. In the US and the UK, several fiduciary duties have been recently codified in the Partnership 345

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Rules on Private Equity Fundraising, [私募投资基金募集行为管理办法], AMAC, effective on 15 July 2016, online: www.doto-futures.com/Upload/%E7%A7%81%E5% 8B%9F%E6%8A%95%E8%B5%84%E5%9F%BA%E9%87%91%E5%8B%9F%E9%9B% 86%E8%A1%8C%E4%B8%BA%E7%AE%A1%E7%90%86%E5%8A%9E%E6%B3%9512354771307.pdf. According to Art. 4 of Provisions of the Supreme People’s Court on Citation of Such Normative Legal Documents as Laws and Regulations in the Judgments 2009 [最高人民 法院关于裁判文书引用法律、法规等规范性法律文件的规定], Supreme People’s Court Interpretation No. 14 [2009], ‘the Judicial Administration shall use law, legal interpretation or judicial interpretation. Where suitable administrative regulations, local laws or autonomous regulations are concerned, they may be directly applied.’ Art 6 states that ‘in relation to Articles 3, 4, and 5, they may be used as valid legal bases if they are so found to be upon examination and in accordance with the requirements of the case.’ L. Lin, supra note 97, 75–76. Codification exercises in China can be traced back to 536 BCE in Chinese history, see J. W. Head, ‘Feeling the Stones When Crossing the River: The Rule of Law in China’, Santa Clara Journal of International Law, 7 (2010), 25.

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Acts.349 The codification of the duty of good faith and the duty of disclosure owed by partners has also been proposed in the UK.350 The focus of future law reform should be on the duty of loyalty and duty of care. First, the duty of loyalty ensures that the GPs act in the best interests of the partnership. In the US, under the Uniform Partnership Act (UPA) 1997351 and the Uniform Limited Partnership Act (ULPA) 2001,352 the duty of loyalty imputes liability when the partner misuses or misappropriates partnership property, abuses his position, or competes with the partnership.353 Under the Delaware Code, the partner is accountable to the partnership and holds, as a trustee, any property, profit, or benefit derived in his position as partner.354 The partner must also refrain from competing or dealing with the partnership.355 The position in English Law is found in section 29 (duty to avoid conflicts)356 and section 30 (duty not to compete)357 of the Partnership Act 1890.358 Section 29 contains the no-conflict rule and the no-profit 349

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For example, Revised Uniform Partnership Act, §404; Partnership Act 1890 (UK), c 39, s 29 and s 30. It must be noted that the connotation of fiduciary duties differs in the US and the UK. See The Law Commission (Law Com No 283) and The Scottish Law Commission (Scot Law Com No 192), ‘Partnership Law: Report on a Reference under Section 3(1)(e) of the law commissions act 1965’ (November 2003), at pp. 189–192. online: www .lawcom.gov.uk/wp-content/uploads/2015/03/lc283_Partnership_Law.pdf. In the US, apart from common law, partnership agreements, and states law, there are acts (model laws) proposed by National Conference of Commissioners of Uniform State Laws for the governance of business partnerships by US states. Although these model laws are not binding, they remain persuasive as most of the states adopted the model laws in their state laws. Uniform Limited Partnership Act (2001), § 408 (b). Uniform Partnership Act (1997), § 409 (b). See also Uniform Limited Partnership Act (2001), § 409(b). Del. Code Ann. Tit. 6, §15-404(b). Ibid. The Delaware Court of Chancery has also held in in re USA Cafes, L.P. Litig., 600A. 2d 43 (Del. 1991) that when the GP is a corporation, that corporation’s board of directors will owe duty of loyalty to the LPs. ‘Every partner must account to the firm for any benefit derived by him without the consent of the other partners from any transaction concerning the partnership, or from any use by him of the partnership property name or business connection.’ ‘If a partner, without the consent of the other partners, carries on any business of the same nature as and competing with that of the firm, he must account for and pay over to the firm all profits made by him in that business.’ Liability arises once it is shown that the business is in actual competition with the firm. Rochwerg v. Truster (2002) 212 DLR (4th) 498.

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rule.359 This section forces a partner to account for any benefit ‘which was obtained or received by use of his fiduciary position or of opportunity or knowledge arising from it’.360 This is a wide provision that would work to prevent almost all cases of unduly profiting from one’s position as a partner.361 In China, a similar overarching principle is found in Article 32(3) of the PEL, which provides that partners shall not engage in activities that damage the interests of the enterprise. Nevertheless, this standard is much lower than the duty of loyalty in the US and the UK. Although the CSRC Interim Measures supplement the PEL with a list of scenarios which are similar to the duty of loyalty, they are interim rules and are too vague to be of use. As such, China should amend the PEL to clearly establish the GPs’ duties and responsibilities. A better approach would be to frame the scenarios found in Article 23 of the CSRC Interim Measures as a non-exhaustive list under a general duty of loyalty enshrined in the PEL. Second, the concept of a duty of care helps ensure that GPs take proper care in the course of management. In the US, the duty of care requires partners to refrain from engaging in ‘grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law’.362 The duty of care is taken from the development of the tort of negligence in common law.363 Unlike the duty of loyalty, which requires the fiduciary to act in the best interests of the beneficiary, the duty of care is a management duty.364 As discussed earlier, the PEL does not specify any duty of diligence or duty of care. Article 35 of the PEL simply states that the ‘management of the partnership shall fulfil his responsibilities within the scope authorised by the partnership’.365 It also fails to define the standard of care owed and merely provides that ‘the management of the partnership shall bear the 359

360 361 362

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Geoffrey Morse, Partnership and LLP Law (8th ed.) (Oxford University Press, 2016) at 170. The no-conflict rule applies to transactional conflicts (when the partner has an interest in the transaction the firm is undertaking) and situational conflicts (when the partner holds an interest that involves those of the firm). Chan v. Zacharia (1984) 154 CLR 178. See Morse, supra note 359, at 171. Larry E. Ribstein, ‘Fiduciary Duties and Limited Partnership Agreements’, Suffolk University Law Review, 37 (2004), 927, at p. 962. See Donoghue v. Stevenson (1932) AC 562. J.C. Shepherd, The Law of Fiduciaries, (Carswell, 1981). It must be noted that the nature and connotation of the partners’ duty of care is different in the US and the UK. Partnership Enterprise Law 2006 (PRC), Article 35.

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legal liabilities if he exceeds his authority or he incurs such liabilities due to his intentional or material negligence’.366 These general statements have created difficulties in judicial practice. As a result, the Chinese judicial case database367 reports very few cases relating to breach of duty by partners (e.g. Article 32 and Article 35 of the PEL).368 A similar duty of care is found in Article 3 of the CSRC Interim Measures, which requires that parties abide by the principles of ‘honesty, trustworthiness, and protection of the legitimate rights and interests of investors’. Article 6 of the Administrative Measures on Private Investment Fundraising Activities also imposes a duty to act with ‘diligence’.369 Hence, the question revolves around what standard of care should be applied in determining if there has been a breach of this duty. The standard of care has been evolving and varies from one jurisdiction to another.370 Lord Hamilton in the case of Ross Harper and Murphy v. Banks stated that under the UK tort of negligence, the test should be objective and dependent on the context of the partnership.371 Generally, the court considers whether the partner can show that he has acted as a reasonable businessman under the circumstances.372 However, the court will also take into account special skills or experience that the partner claims to possess.373 To promote clarity and certainty, the UK 366

367 368

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371 372 373

While PEL does not directly stipulate GPs’ duty of care and duty of diligence, it imposes such duties on the management personnel of the partnership. The standard of care is low and managers are only liable for intentional or gross negligence. Peking University Legal Case Database, online: en.pkulaw.cn. See e.g. Cheng and others v. He Jinming and Li Chongying (2016) Zhejiang 11 (Final) 41; Tin Li v. Yu Guanghai (2014) Zibo (Final) 143; Cheng Shixuan v. China No 4. Metallurgical Construction LLC and others (2014) Suzhou People’s Intermediate Court (Final) 01002. But there are some other related cases in the context of a general partnership. This is also mentioned in Art. 4 of the CSRC Interim Measures. Initially, American courts tend to use ‘reasonable care standard’ as the test for finding a duty of care in partnerships. Under the reasonable care standard, a partner is held to be liable if his or her conduct is unreasonable. Later, a ‘good faith standard’ prevailed and became the accepted standard for determining partners’ duty of care. Under the good faith standard, a partner is not liable to the partnership or his or her co-partners for acts which are not fraudulent or wanton and which are undertaken in good faith. In recent years, there has been a trend in using the business judgment rule in defining gross negligence in partnerships. Ross Harper and Murphy v. Banks (2000) SLT 699 CS (OH). Ibid. Winsor v. Schroeder (1979) 129 NLJ 1266 as cited in The Law Commission (Law Com No 283) and The Scottish Law Commission (Scot Law Com No 192), supra note 350, at 198.

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Law Commission provisionally proposed the following standard to determine the duty of care in general partnerships: ‘partners are expected to act with such care and skill as can reasonably be expected of those with the general knowledge, skill and experience that the partners have or purport to have’.374 In contrast, in evaluating whether there has been a breach of the duty of care, the UPA375 and the Delaware Code376 consider whether the partner has engaged in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. The US courts have also adopted the business judgment rule to determine the GP’s liability for duty of care breaches.377 A GP will be entitled to the protection of the business judgment rule. To counter this protection, LPs will have to rebut the presumption that the GP was acting with the care that a person would reasonably exercise under similar circumstances when making a business decision.378 Notably, in the context of corporate directors, local Chinese courts have been observed to adopt different standards of care, with one adopting the business judgment rule while others preferring the objective standard of care under English law. It is argued that a clearer duty is required as leaving courts to deal with interpretation leads to inconsistent application.379 It is proposed that China should follow the ‘gross negligence’ standard set by the UPA and the Delaware Code. As highlighted earlier, the aim of this duty is only to guard against bad behaviour and not to find liability for business mistakes. Additionally, the higher threshold required to find breach would be consistent with the business realities in China. A test that is too strict may cause partners to be overly cautious with their business decisions, resulting in a cooling effect and causing further market failure.380 The statutory provision of duty defined by the

374 375

376 377

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Ibid., at 186. Uniform Partnership Act (1997), § 409 (c). See also Uniform Limited Partnership Act (2001), § 409(c). Under the UPA, the duty of care imputes liability when the partner engages in ‘grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law’. Uniform Partnership Act (1997), § 409 (c). Del. Code Ann. Tit. 6, §15-404(c). Jackson v. Marshall 140 N.C. App. 504, 537 S.E.2d 232 (2000). Rosenthal v. Rosenthal 543 A.2d 348 (Me. 1988). Ibid. Tianshu Zhou, ‘Standard of Care Required for Directors’ Duty of Diligence’, Legal Mag. 10 (2014), 93. Supra note 97, at 87.

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UPA and the Delaware Code is clearer than the common law test found in the UK.381 Therefore, the former would be more suitable for transplantation into a civil law jurisdiction.382 Nevertheless, even though the business judgment rule plays an important role in other jurisdictions, its introduction into China should be postponed because of a possible incompatibility with addressing the prevailing concern of investor protection. The business judgment rule favours GPs, who essentially have all the official decision-making power. In a market like China, which still suffers from ineffective market mechanisms, this may result in a whittling down of already deficient avenues for investor protection. In principle, the business judgment rule may be a desirable doctrine as partners who have exercised their management duties in good faith should not be penalised.383 However, if the PEL codified the business judgment rule at the same time the statutory duties are imposed on the GPs, this may send conflicting messages to the market as to what exactly the regulatory focus is (which is, in fact, investor protection).384 The business judgment rule should only be implemented following a periodic review by the legislature.385 A further consideration against the adoption of the business judgment rule is that given that China lacks an existing body of case law that judges can rely on to comfortably determine with certainty whether there has been a breach, having broad definitions under a proposed business judgment rule may result in judges absolving wrongdoing partners from liability due to uncertainty in the law.386 If the business judgment rule was to be adopted, a proposed solution is to impose statutory presumptions of a breach when more common situations involving breaches of duty are involved.387 This shifts the evidential burden onto GPs who tend to be more sophisticated and better placed to disprove any 381 382

383 384 385 386 387

Ibid. The fact that Chinese judges do not have rich experience and sophisticated techniques in applying precedents should not be an excuse for not adopting the business judgment rule in the PRC partnership law. In fact, the Japanese experience also shows that the practical significance of the statutory fiduciary obligation depends on how prepared the legislature and judiciary are to create a favourable legal infrastructure for the invocation of the fiduciary principle. It is therefore suggested that Chinese legislature and judiciary may take a steady manner in introducing the concept of business judgment rule in the context of the PRC limited partnership. Supra note 97, at 88. Ibid. Ibid. Ibid. Ibid.

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wrongdoing when there is an alleged breach of duty and appropriately limits the scope of the business judgment rule.388 When attempting to impose duties on GPs in China, the compatibility of these duties with the existing legal system, including the degree to which judges are competent in applying complex doctrines, must be considered. Before judicial enforcement of duties can play an active role in constraining the behaviour of fund managers, drastic improvement is required in both investor awareness and the professional quality of lawyers and judges. It may be plausible for China to use a case law-style approach to developing a duty of care in China through judicial interpretation by the Supreme People’s Court and guidance issued by the regulators of CSRC.

2.6.1.4 Other Remedies for LPs LPs have several remedies available under the PEL to protect their interests against GPs’ potential wrongdoings.389 They generally enjoy similar rights as LPs in other jurisdictions. First, according to Article 49(1) of the PEL, a partner can be removed from the partnership when he fails to meet capital contribution obligations, causes losses to the partnership through intentional wrongdoing or gross negligence, or conducts himself improperly while carrying out partnership business. However, removing a partner is not easy as it requires unanimous approval from all partners under the PEL.390 Even if the LPs were able to reach a unanimous consensus, removing a GP will have a significant impact on the PE fund as the GP is the manager that designs and executes the long-term investments. Second, aggrieved LPs may pursue dissolution of partnerships to deter errant GPs’ wrongdoings or omissions. Pursuant to the PEL, if LPs can prove that the limited partnership could not be reasonably carried on because of the alleged wrongdoing of the GP, the partnership would be at risk of dissolution.391 388 389

390 391

Ibid. For further discussion on the enforcement issues in the context of private equity limited partnerships in China, see L. Lin, supra note 292; L. Lin, ‘Limited Partners’ Derivative Action: Problem and Prospects in the Private Equity Market of China’, Hong Kong Law Journal, 41 (2011), 2, 517. Partnership Enterprise Law 2006 (PRC), Art. 49(1). These events include: (1) The term of partnership expires and the partners decide not to operate it any longer; (2) Any of the dissolution causes as stipulated in the partnership agreement occurs;

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However, dissolution is often an expensive way to enforce fiduciary duties and therefore not the ideal approach to deter mismanagement of partners.392 Substantial costs and tax consequences would result from dissolution of a partnership. For VC funds which have already made substantial investment in portfolio companies, dissolution of the firm would have significant impact on the operation of the fund, and it would come at substantial expense of LPs. Third, an aggrieved LP may also attempt to withdraw from the partnership. However, withdrawal may not be an optimal solution for aggrieved LPs in the Chinese regime. According to the PEL, in the event that a limited partnership is left with only GPs, the limited partnership must be converted to a general partnership.393 Moreover, if all LPs do not wish to carry on business in conformity with the partnership agreement and threaten to dissociate from the partnership, the remaining GPs have to dissolve the limited partnership first before converting it to a general partnership. This would incur unnecessary formation and dissolution costs and would have significant implication to the business of the VC fund organised as limited partnership.

2.6.1.5

Refine the Rules for Limited Partner’s Derivative Actions The derivative action is an important remedy available to LPs in the limited partnership (which is considered a separate legal entity).394 Since the mid-1960s, US courts have recognised the LP’s right to a derivative action.395 The statutory derivative action of LP was later adopted in the

392

393

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(3) All partners make a decision to dissolve it; (4) Thirty days have lapsed since the number of partners failed to reach the quorum; (5) The objective of the partnership as stipulated in the partnership agreement have been realised or are unable to be realised; (6) Its business licence is revoked, or it is ordered to close up or to be revoked; or (7) Other reasons as provided for by any law or administrative regulation. B. T. Villa, ‘The Status of Enforcing Fiduciary Duties in a Limited Partnership after Duties v Becnel Co’, Louisiana Law Review, 49 (1989), 1217 at text accompanying note 28. Partnership Enterprise Law 2006 (PRC), Arts. 75 and 24; however, the precise manner in which a limited partnership converts to a general partnership remains unclear as the Partnership Enterprise Law does not spell out any rules on the conversion process. In jurisdictions such as England and Singapore where the limited partnership is considered as an aggregate of partners but not a separate legal entity, there is no limited partners’ derivative action in their regimes. See W. Hecker, ‘Limited Partners’ Derivative Suits Under the Revised Uniform Limited Partnership Act’, Vanderbilt Law Review, 33 (1980), 343, at pp. 343–344; Klebanow v. New York Produce Exch., 344 F.2d 294, 298 (2d Cir.1965) (New York). 344 F.2d 294 (2d

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ULPA 1976.396 Today, LPs’ derivative actions are available in most US states.397 Under the Delaware Revised Uniform Limited Partnership Act (DRULPA), the ULPA 1985, and the ULPA 2001, LPs have a right to bring a derivative action in the name of a limited partnership to recover a judgment in its favour if GPs have refused to bring the action or if an effort to cause those GPs to bring the action is not likely to succeed.398 The LP’s derivative action is also frequently used to bring actions for breaches of fiduciary duty by GPs.399 Article 68(7) of the PEL provides legal standing for the LP to pursue a legal action in its own name to safeguard the interests of the limited partnership ‘where the executive partner responsible for the conduct of the partnership affairs has neglected the exercise of his rights’. However, the PEL does not set forth the requirements and procedural steps for bringing such an action. In fact, Article 68 of the PEL bears substantial resemblance to s 303 of the ULPA 1985 and s 17–303(b)(6) of the Delaware code. The purpose of these provisions is to restrain LPs from interfering in the management of the business. The safe harbour lists within these provisions intend to provide clarity to LPs about what safe harbour activities do not amount to participating in the management of limited partnerships, but not to regulate the derivative action. Subclause (7) of Article 68 is merely one of the safe activities which an LP can carry out, but it fails to spell out any procedural rules regarding the derivative action.400 Due to the absence of legal procedural clarity, some courts have adopted a conservative approach and have required consensus by all

396

397

398

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Cir. 1965), 5; See also Debra E. Wax, J.D. ‘Right of Limited Partner to Maintain Derivative Action on Behalf of Partnership’, A.L.R.4th, 26 (1983), 264; B. Troy Villa, ‘The Status of Enforcing Fiduciary Duties in a Limited Partnership after Duties v Becnel Co’, Louisiana Law Review, 49 (1989), 1217 at text accompanying note 24. See Revised Uniform Limited Partnership Act 1976 with 1985 Amendments, §1001–1004. Uniform Limited Partnership Act provides specific provisions on the limited partner’s derivative action. See NCCUSL, ‘Legislative Fact Sheet’, online: www.nccusl.org/Update/ uniformact_factsheets/uniformacts-fs-ulpa.asp. See Delaware Revised Uniform Limited Partnership Act, § 17–1001; Uniform Limited Partnership Act (2001), §1002 and Revised Uniform Limited Partnership Act (1985), § 1001. See P. C. McCullagh, ‘Partnership Derivative Suits: Jennings v. Kay Jennings Family Ltd. Partnership’, University of Richmond Law Review, 44 (2009), 167. L. Lin, supra note 389.

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the LPs before a derivative action is granted.401 This essentially renders the derivative action unusable. It is also unclear how litigation costs are calculated and apportioned. Out of twenty-four cases reported as of December 2019, there are eight cases in which LPs have successfully litigated against the GP under Article 68 (7) of the PEL.402 The first successful derivative action brought by the LP only occurred on 29 March 2017, about ten years after the introduction of the limited partnership in China. This was the case of Anhui Ruizhi Real Estate Development Co. Ltd v. Jiao Jian and others.403 Apart from failing to initiate any legal proceedings on behalf of the partnership after two entrusted loans were due for collection, the GP also ignored the LPs’ repeated requests to exercise the partnership’s creditor rights, failed to respond to subpoenas, and did not appear before the Court of First Instance. Given that the GP had de facto abandoned the partnership’s debt claims, China’s apex court held that the GP had ‘neglected the exercise of [its] right according to Article 68(7) of the PEL.’ Given the discussed imperative need for LP protection in the context of the Chinese VC market, it is suggested that a well-designed system of legal rules should be provided to regulate the LP’s derivative action so as to ensure that it develops into an effective alternative remedy. The following procedural questions have to be clarified through legal reform. Who is the Proper Plaintiff? The PEL fails to specify who can be a proper plaintiff of a derivative action.404 For example, it is unclear whether the plaintiff has to be a partner at the time of instituting the action. It is also unclear whether a minimum percentage of ownership is required before LPs can initiate legal proceedings. Under several US Acts,405 a proper plaintiff of a derivative action must be a partner at the 401

402

403 404 405

Interview, Mr Zhong Kaiwen, Partner, DeHeng Law Offices (Shenzhen office) on 24 November 2016 in Singapore; Mr Deng Weifang, Senior Associate, DeHeng Law Offices (Shenzhen office) on 24 November 2016 in Singapore. As of December 2019, there are 24 cases filed against the GP by LPs listed in the China Adjudication Network. In 22 of the 24 cases, the court allowed the plaintiff to sue on an individual basis. Out of those 22 cases, the court dismissed the claim in 14 and upheld the claim in 8. (2016) Supreme People’s Court (Final) 756. L. Lin, supra note 389 at p. 521. For example, Revised Uniform Limited Partnership Act 1985, § 1002, Delaware Revised Uniform Limited Partnership Act, § 17-1002, and Uniform Limited Partnership Act 2001, §1003.

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time of bringing the action and must have been a partner when the conduct giving rise to the action occurred, or a partner whose status as a partner devolved upon the person by operation of law or pursuant to the terms of the partnership agreement from a person that was a partner at the time of the conduct. Such an approach only permits a partner to bring a derivative claim in respect of wrongs committed after he becomes a partner but not prior to that. Pursuant to the PEL, an external assignee of partnership shares can be a partner after the relevant partnership agreements have been revised.406 If the law permits an external assignee of partnership shares to bring a derivative claim in respect of wrongs committed prior to his becoming a partner, it may induce opportunistic litigation by the partner or by third parties who may attempt to persuade partners to assign rights solely for the purpose of bringing an action (similar to how activist shareholders may buy shares solely for the purpose of making noise at an annual general meeting (AGM) or filing derivative actions). It is thus suggested that in order to prevent those incoming partners from gaining illegal benefits from derivative actions, the law may consider following the Delaware approach by requiring an LP to be ‘a partner or an assignee of a partnership interest at the time of bringing the action and: (1) At the time of the transaction of which the plaintiff complains; or (2) The plaintiff’s status as a partner or an assignee of a partnership interest had devolved upon the plaintiff by operation of law or pursuant to the terms of the partnership agreement from a person who was a partner or an assignee of a partnership interest at the time of the transaction’.407 Another question that follows is whether the plaintiff LP can fairly and adequately represent the limited partnership and whether the plaintiff is acting in good faith in bringing the derivative action. There are cases in common law which held that a plaintiff whose interest is adverse to the LPs is not an adequate representative of the limited partnership.408 In Davis v. Comed In,409 an eight-part test was established to determine the standing requirement of fair and adequate representation in derivative 406 407 408

409

Partnership Enterprise Law 2006 (PRC), Art. 24. Del. Code Ann. Tit. 6, § 17-1002. Frazier v. Manson, 651 F. 2d 1078, 1081 (5th Cir. 1981); Allright Missouri, Inc. v. Billeter, 829 F.2d631, 639 (8th CIR. 1987), cited in Alan R Bromberg and Larry E. Ribstein, Bromberg and Ribstein on Partnership (Boston: Little, Brown, 1988) Vol IV, §15.05(d), 15:54. 619 F. 2d 588 (6th Cir. 1980).

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actions. They are as follows: ‘(1) the economic antagonism between the plaintiff limited partner and other limited partners; (2) the plaintiff’s enumerated remedy; (3) whether the plaintiff is the driving force behind the litigation; (4) the familiarity of plaintiff with the litigation; (5) other existing litigation between the parties; (6) the magnitude of the plaintiff’s personal interest compared with his interest in the derivative claims; (7) any vindictiveness between the parties; and (8) any support or approval obtained from other limited partners’.410 This would be particularly beneficial in that it guides the judges through every step of the process, alleviating any problems that might arise due to differences in practical standards. A similar approach can be used for duty of loyalty since these rules deal with conflicts of interest. Such detailed requirements would serve to deter any potential abuse of the derivative action in bad faith by LPs. In Jennings v. Kay Jennings Family Ltd Partnership,411 the Supreme Court of Virginia emphasised that the criteria for determining a suitable plaintiff LP are the economic antagonisms between the plaintiff LP and other LPs.412 In other words, if the plaintiff’s economic interests are different from those of other LPs, the plaintiff is unlikely to be considered as the adequate plaintiff for the derivative action. US-Virginia also provides statutory provision requiring that ‘the derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the limited partners and the partnership in enforcing the right of the partnership’.413 The PRC Supreme People’s Court may consider introducing these tests and specifying them in the Judicial Opinion, as a guide to judicial practice in China. Exhaustion of Remedies? The PEL is silent on the prerequisites which LPs have to satisfy before bringing a derivative action. It is uncertain whether the plaintiff must urge the GP to exercise his rights first before bringing the derivative action.414 Under the ULPA, the LP must initially show its demand and the GP’s response to that demand, as well as any failure to act upon the request of the LP on the part of the GP. However, the LP does not need to make 410 411 412 413

414

Ibid. 275 Va. 594, 659 S.E.2d 283 (2008). For discussion on this case, see supra note 399. Annotated print copies of the Code of Virginia (Va. Code Ann) § 50-73.62 (Repl. Vol 2009). See supra note 404, at 541–542.

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a demand if the GP has shown that such a demand would be futile.415 For example, in circumstances where the plaintiff LP is denied access to the partnership books or investment materials, or the only third party is the defendant.416 At common law, LPs shall take certain procedural steps prior to filing a derivative action.417 The PEL may consider providing similar guidelines and requiring the plaintiff to state with particularity: (1) the date and content of plaintiff’s demand and the GPs’ response to the demand, or (2) why demand should be excused as futile.418 In addition, partners may always contractually prescribe additional prerequisites for bringing a derivative action in the partnership agreement, such as: (1) waiting for the expiration of the given deadline for the GP to act after receiving such a request from the LP unless there are urgent circumstances that may cause incurable damage to the limited partnership in the absence of an immediate action; or (2) consulting other LPs and ascertaining whether they would support the derivative action.419 For instance, a demand of an LP can be satisfied by the errant GP’s exercising of legitimate rights for the interest of the limited partnership; or by the relevant LP ratifying the transaction in question.420 A conversation among LPs would reduce and eliminate the prospect of an LP bringing an action, especially when that particular LP harbours bad faith. Hence, it is preferable to require parties to explore all possibilities of reconciliation before a derivative action is commenced. But there is also a risk that this might be used as a delaying tactic to frustrate the claim. Who Are the Defendants? The PEL states that the defendant should be ‘the partner who is responsible for the conduct of the partnership affairs but who has neglected to vindicate partnership rights’.421 However, what constitutes ‘neglect in exercising partner’s rights’ is unclear. LPs can rarely obtain the evidence required to prove such a misconduct. Key evidence is often retained by the GP and since LPs have no right to 415

416 417 418 419 420 421

Uniform Limited Partnership Act 2001, §1004 provides that ‘In a derivative action, the complaint must state with particularity: (1) the date and content of plaintiff’s demand and the general partners’ response to the demand; or (2) why demand should be excused as futile’. See Bromberg and Ribstein on Partnership, supra note 408, Vol IV, §15.05(g), 15:65. Ibid., §15.05(d), 15:51–15:53. See supra note 404, at 541–542. Ibid. Ibid., Vol IV, §15.05(d). Article 68(7) of the Partnership Enterprise Law, People’s Republic of China.

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participate in the actual management and operation of the partnership, it is difficult for LPs to collect relevant evidence through legitimate channels.422 In addition, the GP is often a shell company set up for the purpose of managing the fund. Even if the LPs successfully obtain a favourable judgment or arbitration award, it is likely that no property will be available in the GP company for execution. As mentioned earlier, the law remains silent as to whether LPs have to exhaust other remedies before bringing a derivative action.423 Moreover, the PEL is unclear as to whether the derivative action can be brought against a former GP who failed to exercise the legitimate rights of the limited partnership. The ULPA does not consider a former GP as a proper defendant.424 It seems undesirable to pursue a derivative action against a former GP as the PEL has provided a compensation mechanism whereby the GP will assume joint liability with the existing partners for the debts incurred by the partnership before joining the firm.425 In addition, the PEL provides that dissociated GPs have to bear joint liability for the debts of the firm incurred before his dissociation from the firm.426 Since these statutory provisions already impose a liability burden should a former GP fail to exercise his rights and cause harm to the firm, there is no need to additionally burden former directors with the liability arising from a derivative suit.427 Moreover, the scope of application under Article 68(7) is too narrow when compared to its counterpart in the US. In the US, a derivative claim generally exists when the entire body of LPs is injured by the actions or omissions for which a complaint has been submitted.428 Given the pervasiveness of managerial abuse by GPs discussed earlier,429 the PEL ought to provide a broader scope of application to the plaintiffs so as to cover potential claims. For example, the grievance of 422

423 424

425

426 427 428

429

Interview with Mr Zhong, Partner, DeHeng Law Offices, in Singapore (24 November 2016); interview with Mr Deng, Senior Associate, DeHeng Law Offices, in Singapore (24 November 2016). Lin, supra note 389, at 538–542. Uniform Limited Partnership Act 2001, §1002; Revised Uniform Limited Partnership Act 1985, § 1001. Partnership Enterprise Law 2006 (PRC), Art. 44. Note that Art 77 of the Partnership Enterprise Law provides that a new limited partner must bear liabilities to the extent of his capital contribution even for the firm’s debts incurred before he joins the firm. Art. 53 of the Partnership Enterprise Law of People’s Republic of China. Lin, supra note 389, at 539. See William Meade Fletcher, and B. Jones et al., Fletcher Cyclopedia of the Law of Corporations (Thomson West, 2009), § 5911. Text accompanying notes 302–317.

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the plaintiff LP may include any injury or wrong done by the GP to the partnership and any legitimate rights of the partnership which the LP seeks to vindicate. Security for Expenses? The security requirement of bringing a derivative action is not addressed by the PEL.430 Security for expenses is an effective means to deter abuse of derivative actions in practice, so as to avoid unnecessary expenses for both sides.431 However, it is useful only when the plaintiff LP acts in bad faith in bringing the derivative action.432 This requirement may however be an inappropriate disincentive to an aggrieved LP.433 In New York434 and California,435 the plaintiffs are required to provide the security for expenses. California law requires a security for expenses to prevent unmeritorious suits, such as when the plaintiff sues for the benefit of another or when there is a reason to believe that he will be unable to pay the costs of the defendant.436 On the other hand, it provides conditions to avoid making security for expenses an inappropriate disincentive to the aggrieved LP.437 One such condition is that after hearing, the court has to be satisfied that the party asking security has established that there is no reasonable possibility that the cause of action will benefit the partnership or the partners or that the party asking security did not participate in the transaction that is the subject of the complaint.438 This approach appears an advisable one in achieving the appropriate balance between the plaintiffs and the defendants. As the competency of Chinese judiciary varies from place to place,439 the requirements of security for 430

431 432 433 434

435

436 437 438

439

This is also not required under Singapore’s Companies Act but might be frequently ordered by the courts as part of civil procedure. Lin, supra note 389, at 543. Ibid. Ibid. New York Partnership Law §121–1003. See Bromberg and Ribstein on Partnership, supra note 408, Vol IV, §15.05(g), 15:66. California Corporation Code §15702(a) (1) and (e). See Bromberg and Ribstein on Partnership, supra note 408, Vol IV, §15.05(g), 15:66. Lin, supra note 389, at 543. Ibid. See M. D. West, ‘The Pricing of Shareholder Derivative Actions in Japan and the United States’, Northwestern University Law Review, 88(4) (1994), at p. 1436, 1466 (noting that Japanese corporate rules, modelled after those of California, allow the court, at the request of the defendant, to order the shareholder-plaintiff to furnish adequate security). Lin, supra note 389 at p. 541.

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expenses should be specifically spelt out by law so as to avoid different courts setting forth different conditions to order security for expenses in China.440 Who Bears the Expenses? The PEL is silent on who is to bear the expenses of the derivative action. The issue of costs has a great impact on the utility of the derivative action and is of the utmost practical importance.441 After all, the high cost of litigation can serve as a major disincentive against bringing a derivative action, weighed against the possibility of recovering costs and fees.442 A plaintiff LP shall by default pay the expenses of the derivative suit in the US. If a derivative action is successful in whole or in part, the court may award the plaintiff a certain amount of expenses including reasonable attorney fees from the recovery of the limited partnership.443 However, if the court finds that the action was commenced without reasonable cause or the plaintiff did not fairly and adequately represent the interests of the LPs and the partnership in enforcing the right of the partnership, it may require the plaintiff to pay reasonable expenses of the defendant, including reasonable attorney fees incurred in defending the action.444 In Smith v. Croft, Judge Walton held that a shareholder’s ability to finance the action himself is relevant to whether the court makes a costs order.445 In China, plaintiffs of civil suits have to advance the filing fees based on the sliding scale relative to the amount of damages claimed.446 Also, plaintiffs have to pay application fee for enforcement of the judgments and the application fees are payable according to the amount claimed for enforcement.447 Thus plaintiffs would have to pay substantial fees if the amount claimed is large. In addition, the losing party would have to bear the filing fees and other litigation fees charged by the court apart from 440 441

442 443

444 445 446

447

Lin, supra note 389, at 545. See generally Mark D. West, ‘Why Shareholders Sue: The Evidence from Japan’, The Journal of Legal Studies, 30(2) (2001), 351–382; A Williams, ‘Japan’s Recipe for Dispute Resolution’, International Commercial Litigation, 2 (1996). See Bromberg and Ribstein on Partnership, supra note 408, Vol IV, §15.05(d), 15:56. See, for example, Uniform Limited Partnership Act 2001, §1005; Delaware Revised Uniform Limited Partnership Act, § 17–1004(b). Va. Code Ann. § 50–73.62 (Repl. Vol 2009). Smith v. Croft [1986] 1 WLR 580. Measures on the Payment of Litigation Costs [诉讼费用交纳办法], State Council, No. 481, Art. 13. Ibid., Art. 14.

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attorney’s fees. If the plaintiff loses the case, he has to pay a considerable amount of litigation costs.448 As the LPs in China are ‘accredited investors’ who are financially sophisticated, there is little doubt as to these LPs’ capacity to pay the expenses of the derivative suit in cases of moderate complexity. It is suggested that the law ought to require plaintiff LPs to pay the expense of the suit in general, but grant the court with discretion to award the plaintiff reasonable expenses, including reasonable attorney fees, filling fees, and application fees. Nevertheless, the costs and fees rules would need to be re-evaluated if any real change is to occur.449 Who Receives the Proceeds? Who shall receive the proceeds or benefits of a successful derivative proceeding remains unclear under the PEL. The US practice is that the benefit of a derivative action goes to the firm and not to the derivative plaintiff.450 If the derivative plaintiff receives any proceeds, the derivative plaintiff shall immediately remit them to the limited partnership.451 As those LPs who bring an action will not directly benefit from the suit, but will have to share any proceeds with other LPs and GPs, there is a clear disincentive against them bringing the suit on behalf of the firm. Nevertheless, the interests of the limited partnership and those of the LPs are generally aligned over the long run, and they may both benefit from the proceeds. Moreover, the expectation for LPs to bring a derivative action is not just to receive the proceeds from successful litigation, but also to deter misconduct of the errant GP. Since the LP’s derivative claim is a protection of the limited partnership firm, the proceeds or benefits of a derivative action should be owned by the limited partnership firm, not by the individual plaintiff LPs. This is also in line with the practice in the corporate derivative action.

2.6.2 Improving Regulatory Framework Governing VC Two major problems haunt VC regulation, the first being the sustained difficulty in striking a balance between regulation and free market 448

449 450

451

The Supreme People Court’s Measures on the People’s Courts’ Acceptance of Litigation Fees 1989 [人民法院诉讼费用交纳办法], Supreme People’s Court, No. 14 [1989], Art. 19. L. Lin, supra note 389, at 545. Uniform Limited Partnership Act 2001, §1005; Revised Uniform Limited Partnership Act. 1985, §1004. Ibid.

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development, and the second being the multiplicity of regulations. As of now, the State Council,452 the NDRC, and the CSRC have each issued their own series of regulations over privately raised funds. Specifically, all market-based funds need to register with the AMAC, which operates under the CSRC, while GGFs need to obtain approval from the NDRC and local finance departments. Both market-based and GGFs are then subject to further regulations in the relevant market sphere upon entering the market. In addition, foreign funds require approval from the Ministry of Commerce before they can commence business. A multiplicity of actors exist across different levels of bureaucracy and in different regions; in these circumstances, regulatory coordination is understandably difficult to achieve. While each institution has enacted regulations with the aim of facilitating growth while minimising risk, the sheer volume of regulations resulted can instead impede market growth, not least because of the compliance burden it places on market participants. This is especially so where regulators continue to focus on adding to the administrative aspects of regulations in terms of policy design and implementation while, in relative terms, disregarding the technical aspects, thus leading to a profusion of bureaucratic red tape that hinders the organic flow of capital and neutralises the innovative capacity of the capital market. With the rapid development of the VC market from 2013–2017, many agencies have engaged in unlawful activities such as public fundraising, insider trading, and illegal fundraising under the guise of PE. Because of stricter financial regulations accompanied by other factors such as stock market slumps and price regulation on real estates, private investments have been pouring into the PE/VC industry. Nevertheless, some companies operate as VC firms to invest in real estate and stocks. Confronted with such phenomena, various monitoring bodies have introduced a series of legal regulations and self-regulatory mechanisms, setting out detailed requirements for private fundraising, and imposing more onerous obligations on managers of private funds.453 However, over-regulation increases the operation costs of funds, thereby negatively affecting the development of the industry. One example is the promulgation of the Guiding Opinions on Regulating the 452

453

For example, the Legislative Affairs Office of the State Council issued the Administrative Measures for Privately Raised Funds (Draft for Comments) on 30 August 2017. See the discussion on the evolution of regulatory framework governing VC in Part 1.5 of Chapter 1 of this book.

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Asset Management Business of Financial Institutions in 2018,454 which restricted capital flow into the VC market. VC fundraising thus took a direct hit from these policy changes. This shows the importance of calibrating the implementation of regulatory initiatives to the response of the market. The danger lies in adopting one of the two extreme positions of over-regulation, which kills market activity, or under-regulation, which condones chaos in the market. Appropriately calibrated regulatory initiatives must tread the line between these extremes. Moreover, the political system in China has determined the inevitable lack of independence of financial monitoring bodies. Regulatory policies may be influenced by other political goals or policies as a result of the lack of independence. For example, the monitoring of VCs is influenced by the macro-economic policies of the NDRC. The current regulatory framework emphasises supervision by government agencies and industry-dependent supervision. However, issues such as regulatory lacunae or overlaps of jurisdiction of government agencies continue to stymie the effectiveness of regulatory implementation. There is also clearly a lack of coordination between various policies, the incompatibility (and sometimes, inconsistency) of which further impedes the development of the industry. In summary, there is a need to revamp the regulatory framework of VC to tailor it to the development of VC. It is suggested that the focus of AMAC should be on VC firms, not the investors. So as long as the funds have been registered in accordance with the law, there is no need to subject investors to strict scrutiny as long as they are accredited investors. This would help to alleviate the burden for investors who are keen to invest in start-ups, encouraging them to invest in the VC industry.

2.6.3 Less Government Intervention and Ways Forward for GGFs It has already been suggested that reducing the extent of government intervention in the GGFs would improve efficiency pertaining to the allocation of capital. In similar fashion, state-owned VC firms adopt the management model of state-owned companies: their investment decisions and determination of the rewards and salary system are still influenced by government agencies and government policies. Therefore, a further recommendation is to ensure greater accountability to guard 454

The Guiding Opinions on Regulating the Asset Management Business of Financial Institutions 2018, supra note 96.

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against the tendency among the state-owned VC firms to treat financial projects as vanity projects and in doing so waste vast amounts of public resources. This leads to the enforcement question: if enforcement is purely internal, accountability will be sacrificed. The nature of hierarchy is after all such that its upper echelons cannot be meaningfully checked by the subordinate levels. In such a situation, the personal interests of the subordinates (in terms of being promoted) are best served by conforming to the dictates of those at the apex of the hierarchy. In light of the public nature of the GGFs, the unique party-state system, and protectionism at the local level, the following solutions are proposed to improve the quality of government participation in GGFs. First, having the government cede control of capital allocation to market forces would mitigate operational inefficiencies arising from the incompetence and lack of professional experience on the part of government authorities.455 In reality, many enterprises place value on having support from the local government and choose to focus on building personal relations with the members of the local government rather than investing in research and development as a means of attracting support from government policies. A study shows that some of the government’s innovation subsidies go to less innovative SOEs, rather than more innovative and therefore deserving companies.456 Moving forward, it is recommended that GGFs should aid specific industries but not specific companies in particular. Any company that does well should have a chance of obtaining support from GGFs. Requiring matching funds from the private sector would help to reduce the dangers of uninformed decisions and political interference in public funds.457 Local governments should avoid intervention in the selection of portfolio companies and fund managers. Funding should be provided to early-stage start-ups in greater need of capital, instead of later-stage, government-linked companies that generate quick returns. Second, the selection of competent managers is also critical to ensuring the impact of government-sponsored funds.458 Instead of appointing 455 456

457 458

Supra note 267, at 128–133. H. B. Fan and C. Y. Xu, ‘Does China’s Government Subsidy Promote Substantial Innovation in Enterprises?’ (我国政府补贴促进了企业实质性创新吗?) Jinan Journal (Philosophy and Social Sciences), 234 (2018), online: http://cees.whu.edu.cn/att/wg47.pdf ; X. Wang, Z. Xie, X. Zhang, and Y. Huang, ‘Roads to innovation: Firm-level evidence from China’, China Economic Review, 49 (2008), 154. Ibid. D. Cumming and S. Johan, ‘Pre-Seed Government Venture Capital Funds’, Journal of International Entrepreneurship, 7 (2009), at pp. 26–27.

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government-linked VC firms as GPs, governments should select experienced, professional, and independent VC firms to manage the funds. Third, policymakers or those in charge of managing the fund have to be held accountable for the failures of their policies or at least be penalised for such outcomes. A well-designed appraisal and compensation system (such as the 2/20 rule459) should also be established to provide incentives to the fund manager to maximise returns. Furthermore, more detailed rules should be established to fill the legislative gap in the existing regulations governing GGFs. These rules should require regular reporting, auditing, and evaluation of the GGFs.460 In the past, many members of the guidance fund’s management team were typically part-time employees of the government’s finance department, which meant that management faced the problems of inexperience and inefficiency flowing from excessive spread of their attention and resources. Further, it is applaudable that some guidance funds have commissioned local or external fund management institutions with a wealth of experience to serve as managers. Fourth, the structure of the GGFs should be simplified to reduce bureaucracy and transaction costs. The FOF approach taken by the SVCIGF seems more desirable for GGFs as compared to the current model.461 Under the FOF model, the consolidated fund will make investments in a number of other funds, and each of these funds will invest in a portfolio of companies. By doing so, the consolidated fund enjoys broader exposure to the industry and diversification of the risks associated with a single investment, in contrast to GGFs of old, in which a local fund is usually restricted to only one project.462 Fifth, under various local regulations, there are no detailed rules governing the stage wherein investments are made into portfolio companies.463 Giving the funds greater representation or even control of the portfolio company’s board of directors could help reduce agency costs 459 460

461 462 463

See the explanation in supra note 264. See, for example, Implementation Rules of the Shanghai Angel Investment Guidance Fund (上海市天使投资引导基金管理实施细则), supra note 245; Measures on the Jiangsu Emerging Industrial Venture Capital Investments Guidance Fund (江苏省新 兴产业创业投资引导基金管理办法), supra note 257. Various local regulations governing GGFs do not provide rules on these issues. See Figure 2.1 of this chapter. Ibid. Ibid.

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at the financing stage.464 Hence, GGFs should appoint a representative to serve as a director on the board of the portfolio company to check the entrepreneur’s discretion and behaviour in using the GGF funding. The GGFs should also consider requiring veto rights in important matters or the power to replace the entrepreneur as the portfolio company’s chief executive officer. Recognising the problems within the local GGFs discussed previously, the Chinese central government and many local governments have begun reform efforts on GGFs.465 This involves attracting more private investors to the VC market by relaxing the relevant rules, and reducing government intervention in the operation of the GGFs. Since 2015, government agencies including the NDRC and Ministry of Finance, as well as many local governments have issued measures to reduce government intervention in the fundraising and operation of local GGFs and mandate the market-oriented approach among GGFs.466 We will need to wait and see whether these reforms bring about greater efficiency and effectiveness in the operation of the GGFs in practice. Having examined the sources of fundraising and the LP–GP relationship for VC in China, the next chapter of this book turns to further analyse the nature and the methods of VC contracting and investing in China. 464

465 466

R. J. Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’, Stanford Law Review, 55 (2003), 1067, at 1082. Ibid. See, for example, the Interim Measures of the Government Investment Fund 2015 [政府投 资基金暂行管理办法], Ministry of Finance, No. 210 [2015], which govern GGFs, specify that GGFs should operate based on market forces, and the fund should be managed by professional GPs instead of the government. The NDRC Interim Measures for Management of Government Funded Industrial Investment Fund 2016 [政府出资产 业投资基金管理暂行办法], CPC Central Committee, No. 18 [2016] also specified that the government investment funds shall operate based on market forces, and the government who provides capital ‘shall not participate in the daily operation of the funds’. This would allow venture capitalists and entrepreneurs to work more effectively and achieve positive results in a VC cycle that is driven primarily by market forces.

3 Venture Capital Investing

3.1 Introduction The legal literature relating to venture capital (VC) investments has largely been compiled in the context of the United States (the US). Existing scholarship has generally dealt with the various methods through which VC contracts address the agency problems inherent in the VC cycle and the specific contractual terms invented to that end in the US.1 In contrast, there has scarcely been any legal literature concerning VC investment in China to date, making it difficult for practitioners and academics alike to navigate and theorise VC contracting in the Chinese context. There are generally two major legal relationships or contracts within a VC cycle.2 The first is the Investor-VC Fund Contract. The fund is typically set up as a limited partnership and this contract is concluded at the fundraising stage between investors (who usually serve as the limited partners (LPs) of the fund) and VC firms (who usually serve as the general partners (GPs) of the fund). The second is the VC FundPortfolio Company Contract concluded between the VC fund (or the venture capitalists) and the portfolio company (also termed as ‘invested companies’) at the investment stage. Beyond these express contracts, there is also an implied agreement in the venture capitalist–investor 1

2

See, for example, K. Litvak, ‘Monte Carlo Simulation of Contractual Provisions: An Application to Default Provisions in Venture Capital Limited Partnership Agreements’, Cornell Law Review, 98 (2013), 1495. K. Litvak, ‘Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements’, The University of Chicago Law Review, 76 (2009), 161. Ibid., at 1077–1078.

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relationship under which investors are expected to reinvest in future VC funds that are sponsored by successful venture capitalists.3 Legal research on the private ordering within the VC market has thus far dealt with the ways that VC contracts circumvent the agency problems and information asymmetry inherent between the three actors in the VC industry: the VC firm, the LPs, and the target company. A number of academics have discussed how VC contracts circumvent these problems by introducing appropriate incentives,4 while others have analysed the effects of specific contractual terms.5 At this point, it must be emphasised that the private nature of VC contracts means that they are protected by confidentiality. Therefore, the insights these materials offer are likely to be helpful only on a general level. Additionally, these materials have been compiled in the US context, and care should be taken when transposing their findings to other jurisdictions. Nevertheless, the success of the American VC market suggests that the US experience may serve as a crucial developmental guide for China’s relatively younger VC industry. As Professor Ronald Gilson notes, ‘the keystone of the American VC market is private ordering’.6 By this, he refers to ‘the contracting structure that developed to manage the extreme uncertainty, information asymmetry, and agency costs that inevitably bedevil early-stage, high-technology financing’;7 this structure covers the entire VC cycle, from the initial investment by LPs in a VC fund, to the VC fund’s investment in a portfolio company, and ultimately to the exit by which the fund realises its profits and recycles its investment. If the foundations of the US success lie in private ordering, replicating this success must necessarily include some analyses on how this ordering can be engineered. The strategic challenge, identified by Professor Gilson, is to craft a role for government that facilitates creation of a market 3

4

5

6

7

B. S. Black and R. J. Gilson, ‘Venture Capital and the Structure of Capital Markets’, Journal of Financial Economics, 47 (1998), at pp. 256–257. M. D. Klausner and K. Litvak, ‘What Economists Have Taught Us About Venture Capital Contracting’ in M. Whincop (ed.), Bridging the Entrepreneurial Financing Gap: Linking Governance with Regulatory Policy (Ashgate, 2001); R. J. Gilson, ‘Engineering Venture Capital Markets: Lessons from the American Experience’, Stanford Law Review, 55 (2003), 1067. K. Litvak, ‘Monte Carlo Simulation of Contractual Provisions: An Application to Default Provisions in Venture Capital Limited Partnership Agreements’, supra note 1; K. Litvak, ‘Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements’, supra note 1. R. J. Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’, Stanford Law Review, 55(4) (2003) 1067–1103, at p. 1069. Ibid.

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premised on private contracting, while avoiding government participation in the actual capital allocation decision. This observation is particularly pertinent to China, where governmental regulation tends to interfere with market forces. This chapter uses hand-collected qualitative and quantitative data regarding VC in the Chinese context to fill the literature gap. The data set consists of five parts, which are used to support the arguments made throughout the chapter: (1) hand-collected Chinese-based investment agreements concluded between 2017 and 2019;8 (2) interviews with key market participants, including lawyers, venture capitalists, founders of start-ups and large technology or e-commerce companies, individual investors, and representatives of institutional investors;9 (3) judgments from 2012–2019 relating to the use of a clause known as the valuation adjustment mechanism (VAM) in VC investments that were obtained from the database maintained by the Chinese courts;10 (4) a study of a wide range of data and reports published by leading law firms and service providers in China and the US;11 and (5) a study of model contractual agreements used in the American VC market.12 Tapping on the empirical data, this chapter seeks to answer three fundamental questions. First, what are the peculiar features of VC

8 9 10

11

12

For details on the agreements, see note 170 in Chapter 1 of this book. For details on the interviewees, see note 171 in Chapter 1 of this book. These judgments were obtained from the database maintained by the Chinese courts, available at China Judgments Online, http://wenshu.court.gov.cn. 1072 results were obtained using the search term ‘VAM agreement’ (‘对赌协议’). Each judgment was read to ascertain the factual context and the reasoning of the court so as to identify the cases which involved the use of VAM in the context of a private equity or venture capital investment. Of the 1,072 results obtained, 253 judgments involved the use of VAM agreements. This chapter is based on the results of these 253 judgments. Although there are a large number of arbitrations on VAMs, these are not accessible by the public as arbitral awards are confidential by nature. These reports include: (1) the Annual Report of the VC Market in China published by the Zero2IPO Research Center; (2) the China Venture Capital Yearbook published by China Venture Capital Research Institution; (3) the annual reports on VC published by the VentureChina.cn; (4) Han Kun’s Data Analysis Report for VC/PE Deals, Han Kun Law Offices; and (5) Silicon Valley VC Survey, Fenwick & West LLP. These model legal documents include the model legal documents made by the Han Kun Law Offices, the National Venture Capital Association Model Legal Document (NVCA), Cooley LLP, the Simple Agreement for Future Equity (SAFE), as well as the Singapore Venture Capital Investment Model Agreements (VIMA) and Convertible Agreement Regarding Equity (CARE).

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contracting in the context of China? Second, why are VAMs only prevalent in the Chinese market? Third, how will VC contracting in China develop in the future? First, the first part of this chapter summarises the common contractual mechanisms used in VC investments and the legal obstacles faced in their implementation in the Chinese market. This summary shows that some contractual terms typically prescribed in international VC investment agreements are not readily recognised under the People’s Republic of China (PRC) Company Law.13 Furthermore, a unique contractual design exists in the Chinese VC sector in the form of the VAM. A VAM (also termed as a ‘bet-on agreement’, pinyin: duidu xieyi) is a term included in a contract between the VC funds and the portfolio company, or its shareholders, and identifies conditions which, if not met, confer onto investors a contractual right to adjust the portfolio company’s valuation or to otherwise obtain compensation from the company or its shareholders.14 Second, the second part of this chapter examines the economic function of the VAM, the reasons behind its prevalence in China, and the problems of VAM. It finds that the creation and prevalence of VAM in China is mainly attributable to: (1) severe information asymmetry in the less developed Chinese market; (2) the lack of convertible preferred stock as an investment option, and other excessive legal restrictions over investment tools and contractual mechanisms in VC financing; and (3) insufficient legal protection for investors under Chinese law.15 Unlike the terms in American VC contracts, which are designed to encourage longterm and sustainable investor–entrepreneur relationships, VAMs are predominantly investors’ self-help mechanisms to address specific and serious investor protection issues in the transitional and less informed 13

14

15

(中华人民共和国公司法) [Company Law of the People’s Republic of China], amended and effected on 26 October 2018, online: National People’s Congress www.fdi.gov.cn /1800000121_23_74633_0_7.html. Many of these special contractual clauses are directly imported and are not altered to fit into the existing Chinese legal framework. However, the potential conflicts are not that apparent as disputes in the Chinese VC industry are typically not litigated and, even if litigated, are often resolved via settlement (Telephone interview with Mr Yuan, Partner, Jingtian & Gongcheng Law Firm, 4 September 2017). See, ‘Validity of Valuation Adjustment Mechanism’, LehmanLaw, www.lehmanlaw.com /resource-centre/faqs/financial-services-and-regulation/validity-of-valuationadjustment-mechanism-vam-agreement.html (last visited 3 July 2019). The author has discussed this issue in detail in L. Lin, ‘Contractual Innovation in China’s Venture Capital Market’ European Business Organization Law Review 21(1) (2020), 101–138, at p. 105.

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Chinese market. Hence, while the VAM may currently appear desirable to parties in the Chinese market, it is merely a stopgap that serves as an imperfect and less desirable form of contractual design in VC investments.16 Third, this chapter also contributes to the existing literature on contractual innovation in the context of VC practice. Drawing from existing scholarship, Coyle and Green suggested that the following groups have been considered as most likely to develop long-lasting contractual innovations: (1) contract users; (2) high-volume intermediaries such as law firms; and (3) trade associations.17 However, this chapter seeks to show, in the context of the development of the VAM in the Chinese market, that contract users are the real and primary initiators of contractual innovation. It is demonstrated that Chinese contract users, especially investors who have undertaken great financial risks amidst inadequate legal protection and high risks in an immature market, are unwilling to passively delegate contractual creation to lawyers. Instead, investors have actively promulgated norms and provided the impetus behind the creation and prevalence of VAMs. Finally, this chapter advances the debate concerning the legal transplantation of contractual terms from the US to a less mature and informed market. There are various contextual considerations weighing against transplanting well-established contractual terms from the US to China: (1) the lack of various investment tools and the legal restrictions in the PRC Company Law; (2) the lack of effective protection of investors by law; and (3) the absence of more experienced and sophisticated venture capitalists and entrepreneurs in China. These conditions are likely to be fatal to any attempted transplantation of contractual terms commonly used in the US VC sector. Arguably, these contextual barriers may be gradually lowered as the market evolves and develops an increasingly sophisticated VC community as well as an effective national credit system. They can, however, also be solved through law reforms such as improving minority protection and relaxing the restrictions on investment tools. It is only when parties finally feel sufficiently protected and confident enough about their counterpart’s bona fides that there will no longer be a need for VAMs. Once this milestone is reached, the Chinese

16 17

Ibid. J. F. Coyle and J. M. Green, ‘Contractual Innovation in Venture Capital’, Hastings Law Journal, 66 (2014), 141.

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VC market will have taken a crucial step towards sustainable development. When analysing the terms of VC contracts in the context of the Chinese VC market, references will be made to US practice given that the US is the biggest and most established VC market in the world.18 As the boundary between VC and private equity (PE) is blurred in China,19 the discussion in this chapter unavoidably covers both interlinked areas.

3.2 Core Investment Clauses There are two major documents governing the investment relationship between VC funds and the portfolio companies they invest in: the Term Sheet, which on its own is not legally binding,20 and the Investment Agreement (touzi xieyi). While it is common for investors to bargain for covenants that would best protect their interests, such as liquidation preference and redemption provisions, many common contractual terms used in other jurisdictions, such as those prescribed by the National Venture Capital Association (NVCA) model agreements,21 are not readily recognised under the PRC Company Law.22 The interpretation and enforceability of such clauses thus becomes a challenge in Chinese judicial practice. The following section analyses the core contractual clauses used in Chinese investment agreements. Each clause is first analysed based on its definition and function in the international context. The legality of the clause under Chinese law is then considered. This analysis is bifurcated as there are two major types of companies, the

18

19 20

21

22

L. Lin, ‘Engineering a Venture Capital Market: Lessons from China’, Columbia Journal of Asian Law, 30(1) (2017), 160, at p. 162. Ibid. While the Term Sheet itself is not legally binding, parties often treat it as indicative of the final agreement and thus will also include contractual rights to the same effect. The NVCA agreements, developed by the US industry practitioners, intend to reflect current practices in the US VC industry with a fair representation of both East Coast and West Coast practices and a relatively mutual position between venture capitalists and portfolio companies. These include, inter alia, Term Sheet, certificate of incorporation, stock purchase agreement, voting agreement, investor rights agreement, and ROFR and co-sale agreement. See https://nvca.org/resources/model-legal-documents/. Company Law of the People’s Republic of China, supra note 13. Many of these special contractual clauses are directly imported and are not altered to fit into the existing Chinese legal framework. However, the potential conflicts are not that apparent as disputes in the Chinese VC industry are typically not litigated and, even if litigated, are often resolved via settlement (Interview with Mr Yuan, supra note 13).

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limited liability company (LLC)23 and the joint stock company (JSC),24 for which the PRC Company Law has established different regulatory frameworks. The analysis then concludes with a discussion on the use of the particular term in the Chinese VC industry.

3.2.1 Liquidation Preferences 3.2.1.1 The Economic Function of Liquidation Preferences To start with, it must be noted that convertible preferred shares are not allowed under current Chinese law. The Guiding Opinions of the State Council on Preferential Share25 (State Council Opinions) and Article 6 of Pilot Measures on Preferred Stock26 make extremely limited allowance for the use of preferred stock. Thus, the following core terms, which reflect the characteristics of convertible preference shares, can only be used as special contractual terms attached to ordinary shares in Chinese practice. A liquidation preference provides for a fixed return to investors prior to any payment to common shareholders in the event of a sale.27 As VC investments are high risk and the failure rate of portfolio companies is extremely high,28 a liquidation preference is an especially important tool to protect the interests of venture capitalists in the event that a portfolio company is sold for less than the invested capital29 or if it becomes bankrupt. In the event of liquidation or sale, the liquidation preference triggers a distribution waterfall and a specified multiple of the original 23

24

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26

27

28

29

An LLC approximates the concept of a closely held corporation or private company in Western jurisdictions, consisting of not more than fifty owners in total. See Part 2 of the PRC Company Law for the establishment and organisational framework of LLCs. A JSC is characterised by share ownership rather than percentage of capital contribution and is therefore the only permissible corporate form that can be listed in China. See Part 4 of the PRC Company Law for the establishment and organisational framework of JSCs. Opinion on Pilot Program of Preferred Shares by the State Council (State Council (2013) No. 46), effected on 30 November 2013, Central People’s Government (2013), www .gov.cn/zwgk/2013-11/30/content_2539046.htm (last visited 3 July 2019). Measures for the Administration of the Pilot Program of Preferred Shares (CSRC No. 97), effected on 21 March 2014, China Securities Regulatory Commission, www.csrc.gov.cn /pub/heilongjiang/xxfw/hljflfg/201602/t20160214_291252.htm (last visited 3 July 2019). M. Klausner and S. Venuto, ‘Liquidation Rights and Incentive Misalignment in Start-up Financing’, Cornell Law Review, 98(6) (2013), 1404. W. W. Bratton, Corporate Finance: Cases and Materials, 8th ed. (St Paul, MN: Foundation Press, 2016), at p. 864. B. Feld and J. Mendelson, Venture Deals: Be Smarter than Your Lawyer and Venture Capitalist, 2nd ed. (Wiley, 2012), at p. 45.

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investment per share is first returned to venture capitalists before common stockholders receive any distribution.30 Accordingly, economic literature has accurately characterised this right as a higher-order ‘debtlike claim’ of investors,31 who enjoy priority in recouping their stake in the company upon exit. The prescribed term in the NVCA Term Sheet is as follows: In the event of any liquidation, dissolution, or winding up of the Company, the proceeds shall be paid as follows: [Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.] [(Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A preferred. Thereafter, the Series A Preferred participates with the Common stock pro rata on an asconverted basis.] [Alternative 3 (cap on Preferred Stock participation rights): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [X] times the original Purchase Price (including the amount paid pursuant to the preceding sentence).] A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license, or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [Y]% of the Series A Preferred elect otherwise].32

Two critical elements are generally defined in the liquidation preference clause: (1) the type of liquidation events that will trigger the distribution waterfall and (2) the type of compensation that venture capitalists will receive should any of these events occur. Another factor that will determine the amount of compensation received is the extent to which the 30 31 32

Ibid. M. D. Klausner and K. Litvak, supra note 4. NVCA Model Legal Document – Term Sheet, Clause on Liquidation Preference, at p. 2.

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liquidation preference clause allows further participation by holders of the preferred stock. This liquidation preference clause is generally classified into three classes: (1) full participation; (2) no participation; and (3) capped participation.33 A fully participating stockholder will receive the amount in priority as stipulated under the liquidation preference clause, and then share in the balance of the proceeds on an as-converted basis, as if the preferred stock had been converted into common stock based on the prevailing conversion ratio.34 Fully participating preferred stock is favoured by venture capitalists because they will receive a preferential return over both low and high exit transaction values. By comparison, no participation indicates that the holder of the preferred stock does not participate in any further dividend after receiving the stipulated amount in priority. In this scenario, the venture capitalist makes a choice – he can either get the investment sum back, or he can convert into common stock and obtain proceeds equal to his percentage of ownership of the company on an as-converted basis.35 This type of participation provides a hard cap on the amount of dividends paid out to the VC fund and is beneficial to the entrepreneur. Finally, capped participation indicates that the holder of the preferred stock will receive the stipulated amount in priority and then share in the balance of the proceeds on an as-converted basis up till a specified limit. If the return is greater than the cap, the venture capitalists should give up his liquidation preference, converting his stock such that all shareholders will share the returns on an absolute pro rata basis. The capped participation is a compromise between the entrepreneur-friendly nonparticipating preferred stock and the venture capitalist-friendly participating preferred stock.

3.2.1.2 Legal Obstacles in China There is uncertainty with regard to the legality of contractual preference rights in liquidation under Chinese law as its operation does not appear to fully comply with the PRC Company Law. PRC Company Law states that the residual assets of a company after the assets are respectively applied to the payment of liquidation expenses, employees’ wages, social insurance premiums, and statutory compensation, 33 34 35

B. Feld and J. Mendelson, supra note 29, p. 46. Ibid. Ibid., p. 47.

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and the outstanding taxes shall be distributed, in the case of a limited liability company, in proportion to the capital contributions of its shareholders, and in the case of a joint stock company, in proportion to the shareholdings of its shareholders.36 There is scholarly disagreement as well as practical uncertainty as to whether this is a mandatory provision or just a default provision that companies can opt out of by issuing preferred stock. In the former case, the law prescribes that both LLCs and JSCs only distribute liquidation proceeds in proportion to either the capital contributions or the shareholdings of their shareholders. Shareholders may not contract out of this provision and investors cannot receive liquidation preference in priority to other shareholders. In the latter case, portfolio companies and venture capitalists may be able to depart from this default position and adopt liquidation preference provisions. The position is arguably clearer for JSCs than for LLCs. The PRC Company Law stipulates that the State Council may make separate provisions on the issuance of other kinds of shares in JSCs other than those provided for in the PRC Company Law, barring JSCs from issuing any other kind of shares apart from ordinary shares without express authorisation from the State Council.37 Currently, under the State Council and the China Securities Regulatory Commission (CSRC) regulations,38 preference shares with different priorities for distribution of residual assets may not be issued during the pilot period. This means that liquidation preferences issued by JSCs will be recognised only if the State Council publishes a separate provision allowing them to be issued. Although China does not expressly recognise liquidation preferences in law, such a clause is still widely used in Chinese practice. A brief comparison between the standard liquidation preference clauses used in the US and China shows that the liquidation preference typically found in 36

37 38

Article 186, paragraph 2, PRC Company Law states that ‘company assets, after being applied to the payment of liquidation costs, employees’ wages, social security, and statutory compensation, taxes and debts of the company, shall be distributed in proportion to the relative capital contributions in the case of limited liability companies and relative shareholding in the case of joint stock companies’. Article 131 of the PRC Company Law. Article 1 of the Guiding Opinions of the State Council on Preferential Share Pilot Plan (State Council [2013] No. 46) 国务院关于开展优先股试点的指导意见 (国发[2013] 46 号), enacted on 30 November 2013, online: Central People’s Government, www.gov.cn /zwgk/2013-11/30/content_2539046.htm. Article 6 of Pilot Measures on Preferential Shares (CSRC Order No. 97), 优先股试点管理办法 (2014年3月21日证监会令第97 号), enacted on 21 March 2014, online: China Securities Regulatory Commission, www .csrc.gov.cn/pub/heilongjiang/xxfw/hljflfg/201602/t20160214_291252.htm.

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the hand-collected Chinese agreements does not differ too substantively from an NVCA clause. The only difference is that the US clauses typically provide for a third method of calculation not found in Chinese agreements: apart from fully participating and non-participating stocks, the NVCA term also includes a capped participation provision that places a limit on the maximum amount to which venture capitalists are entitled.39 This is empirically confirmed by the quarterly statistics published by Fenwick & West LLP, an established US law firm in the West Coast VC industry, on VC terms typically used in Silicon Valley (Fenwick Reports).40 The essence of the typical US liquidation preference provision is that venture capitalists should calculate their entitlements as preferred shareholders and separately as ordinary shareholders upon the exercise of conversion rights to see which option gives them greater returns. As preference shares are not allowed in China for the majority of companies,41 venture capitalists would, by definition, not be able to opt to convert their shares, as they must hold only ordinary shares. Thus, logically, introducing a capped participation provision does no good for venture capitalists at all in a market that habitually provides for fully participating stock. Data compiled by Han Kun Law Offices42 provides further insight on how the liquidation preference has been used in China. Out of the 217 investigated contracts in the Han Kun Report (Han Kun 2016 Data),43 198 included a liquidation preference in the relevant Investment Agreements.44 Among these, 90.91 per cent stipulated full participation and 9.09 per cent stipulated no participation.45 These proportions did not change significantly in the Han Kun VC/PE Data Analysis Report 2017

39 40

41 42 43

44

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NVCA Model Legal Document – Term Sheet, Clause on liquidation preference, at p. 2. See, for example, Fenwick & West LLP, ‘Silicon Valley Venture Capital Survey Third Quarter 2018’ (29 November 2018). See text accompanying supra notes 64–67. Han Kun Law Offices is a leading Chinese law firm specialising in VC. Han Kun Law Offices, ‘18 Critical Clauses in 217 VC/ PE Projects’ [VC/PE 18大关键条 款, 在21个项目中都是如何约定的?] (14 September 2017), online: https://cj.sina.com.cn /article/detail/6085205919/401992. The annual report provides statistics and analysis of all VC/PE deals handled by Han Kun Law Offices in a given year, with specific attention paid to key business terms analysed in this chapter. Matrix Partners, ‘Study of 217 Companies’ Financing Terms’ (29 August 2017) [我们研 究了两百多家公司的融资条款，告诉你如何防止被’套路’][经纬低调报告], online: https://36kr.com/p/1721801129985. Ibid.

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(Han Kun 2017 Data).46 For agreements that included the liquidation preference, 64 per cent stated the liquidation multiple to be 1X, or simply the amount of money invested.47 In total, 33 per cent stated the multiple to be 1.1X to 1.5X of the investment sum and only 3 per cent stated the multiple to be other variables.48 The author’s hand-collected agreements49 corroborate the Han Kun 2016 Data and further show that it is extremely rare for venture capitalists to omit liquidation preferences from agreements.50 Furthermore, most of the investigated agreements have a much broader definition of liquidation events compared to the statutory liquidation provision set forth in the PRC Company Law. This allows for a broader scope of events following which venture capitalists can trigger the liquidation preference provisions to reduce their losses and protect their financial interests. In light of the legal uncertainty surrounding the enforceability of liquidation preferences, most investigated agreements also provided that the pre-existing shareholders shall compensate the venture capitalists for their entitlements under the liquidation preference provision where the liquidation priority clause is invalid or unenforceable.51 This provides another avenue by which the preference can be enforced. Alternatively, 46

47 48

49

50 51

Han Kun Law Offices, ‘VC/PE Data Analysis Report 2017’ [汉坤2017年度VC/PE项目数 据分析报告], online: Han Kun Law Offices, https://hankunlaw.com/downloadfile/ newsAndInsights/9be8ff02c61f5dcf3d49da6711bfffe9.pdf. Ibid. Ibid., 1X liquidation multiplier is more common for financing rounds after Series C round. As later-stage investors often invest higher quantum and receive preferential payouts, later-stage investors should have a smaller liquidation multiplier compared to early-stage investors. Telephone interview with Mr. Yang, Legal Counsel, Golden Concord Holdings Limited, 4 September 2017. For the explanation of the Investment Agreements collected by the author, see text accompanying note 170 in Chapter 1 of this book. Ibid. The typical clause states as follows: ‘founders, employee stock option holders, and other pre-existing shareholders shall take any necessary action allowed under Chinese law to ensure that investors receive their liquidation preference from the distributable proceeds of the liquidation event prior to other shareholders in due accordance with law, including but not limited to the following: (A) dividend distribution by the company in accordance with the directions of investors; (B) founders, employee stock option holders, and other pre-existing shareholders personally compensate investors with the proceeds that they receive from the distributable proceeds; and (C) founders and/or the company purchase or redeem in part or in whole the shares owned by investors at a price mutually agreed upon among all parties. If investors do not receive their entitled proceeds through the above means, founders, employee stock option holders, and other pre-existing shareholders shall become personally liable to compensate the investors for the difference by cash’.

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the shareholders may agree that the portfolio company shall first distribute the available cash among all the shareholders according to their shareholding proportion following which the funds will then be privately reallocated among the shareholders in accordance with the proportions required by the liquidation preference.52 Aside from providing alternative methods of enforcement, the liquidation preference clause is also often incorporated into both the portfolio company’s articles of association and the shareholders’ agreement, so as to ensure a greater prospect of enforceability in China.53 However, the inclusion of a liquidation preference in the company’s articles of association may also cause practical problems when trying to register the portfolio company with the PRC Administration for Industry and Commerce (AIC). Some local AICs, depending on differences in regional practice, only accept articles of association that model after the prescribed standard forms.54 Therefore, if the articles of association contain non-standard provisions relating to liquidation preferences, these AICs may read the articles of association as being incongruent with the prescribed standards and refuse registration. It is suggested that China should expressly recognise the legality of liquidation preferences under the PRC Company Law. In view of China’s policy of encouraging entrepreneurship, an express recognition of liquidation preference would go a long way towards building a more robust business environment by enhancing the certainty of the contractual protections that the venture capitalists bargain for. This becomes even more important if one considers the volatile nature of portfolio companies in the VC industry and thus their higher likelihood to face liquidation or encounter deemed liquidation events.

3.2.2 Priority in Dividends 3.2.2.1 Definition and Function The contractual right to a priority in dividends confers priority in dividend payments to venture capitalists over original shareholders in 52 53

54

Ibid. Interview with Mr Guo, Partner, China Commercial Law Firm, 1 December 2018, Shenzhen. Unlike shareholders’ agreements, which are private in nature and only binding between the signatory shareholders, the articles of association are a publicly available document. The logic then is that the fact that other shareholders having notice of the preference clause would cause its enforcement to appear less objectionable. Interview with Mr Guo, Partner, China Commercial Law Firm, Shenzhen; interview with Ms Zou Jing, Partner, Grandall Law Firm, 26 April 2019, Shanghai.

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the event where the board declares a dividend payment.55 While the portfolio firm is a start-up that is unlikely to be declaring substantial dividends as it is an early-stage company with high risks, priority in dividends provides venture capitalists with downside protection.56 This limits the dividends that original shareholders can receive, preventing them from cashing out of the business by declaring dividends. This in turn protects the interests of venture capitalists by ensuring that any capital supplied by venture capitalists cannot be withdrawn and is, instead, used to further develop the business.57 Besides this protective function, a priority in dividends is also directly economically valuable to investors if it provides for cumulative dividends, allowing dividends to automatically accrue and become senior claims in favour of investors if they remain unpaid upon the company’s liquidation.58 In the Term Sheet, the language is often as follows: The holders of the Series A Preferred Stock shall be entitled to receive [non] cumulative dividends in preference to any dividend on the Common Stock at the rate of [x%] of the Original Purchase Price per annum [when and as declared by the Board of Directors]. The holders of Series A Preferred Stock shall also be entitled to participate pro rata in any dividends paid on the Common Stock on an as-of-converted basis.59

3.2.2.2 Legal Status in China Priority in dividends is widely recognised in countries such as the US and the UK.60 However, its legal status is uncertain in China. In the case of LLCs, the PRC Company Law stipulates that a shareholder shall receive dividends in proportion to its paid-up capital contribution, except where all shareholders agree otherwise.61 PRC 55 56 57

58 59 60

61

B. Feld and J. Mendelson, supra note 29, p. 82. Ibid., p. 81. W. Bratton and M. Wachter, ‘A Theory of Preferred Stock’, University of Pennsylvania Law Review, 161 (2013), 1815, at 1825. M. D. Klausner and K. Litvak, supra note 4. B. Feld and J. Mendelson, supra note 29. Thomsen Reuters Practical Law, Preference Shares, online: https://uk .practicallaw.thomsonreuters.com/7-107-7028?transitionType=Default&contextData= (sc.Default)&firstPage=true&bhcp=1 (accessed 9 December 2019). Article 34 of the PRC Company Law states that ‘shareholders shall receive dividends in proportion to their paid-up capital contributions; when a company increases capital, shareholders may subscribe to the newly issued capital in proportion to their paid-up contributions.’ However, this is subject to an agreement to the contrary among all

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Company Law implies that the LLC has autonomy over dividend allocation, and shareholders have the right to receive dividends disproportionate to their paid-up capital contributions.62 Although there is no academic consensus regarding the right for the LLC to make an agreement on priority in dividends,63 the prevailing opinion is that there is no reason why the law should prohibit such an arrangement as long as a common consensus is established amongst the shareholders. In the case of JSCs, the PRC Company Law stipulates that the State Council may formulate separate regulations for the issue of shares other than those provided for in the PRC Company Law.64 Therefore, unless the State Council publishes separate provisions to authorise the issuance of preference shares with priority in dividends, JSCs are not legally permitted to do so and cannot otherwise allow dividends to be paid in preference. Pursuant to the State Council Opinions65 and the CSRC Measures,66 only listed companies and non-listed public companies have the right to issue preference shares. Even then, preference shares with different priorities for distribution of dividends may not be issued during the pilot period,67 although preference shares differentiated in other ways may be issued. The above-mentioned administrative measures and opinions imply that JSCs are generally prevented from issuing shares with priority rights in dividends.

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64 65

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shareholders that they shall not receive dividends or subscribe to newly issued capital in proportion to their paid-up capital contributions. Paragraph 4 of Article 166 of the PRC Company Law stipulates that after-tax profits of the company shall be distributed as per Article 34 of the PRC Company Law. However, some Chinese academics believe that a priority dividend right will be invalid because the PRC Company Law does not expressly allow for a class of shareholders to be accorded priority in the distribution of dividends, suggesting that it does not contemplate the existence of a right to priority in dividends. Proportion and order are fundamentally different and Article 34 of the PRC Company Law does not imply that shareholders of a limited company can be contractually entitled to the priority dividend right. Article 131 of the PRC Company Law. Guiding Opinions of the State Council on Preferential Share Pilot Plan, supra note 38, Article 8. Article 3 of Measures for the Administration of the Pilot Program of Preferred Shares, (CSRC Measures) (CSRC No.97), effected on 21 March 2014, online: CSRC, www .csrc.gov.cn/pub/heilongjiang/xxfw/hljflfg/201602/t20160214_291252.htm (last visited 3 July 2019). The State Council Opinions and the CSRC Measures were issued to create only a pilot period for legislative experimentation on preference shares for certain kinds of companies.

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3.2.2.3 Practice in China The Han Kun 2016 Data revealed that out of the 188 contracts that provided for dividend distribution, 55.32 per cent classified shareholders into groups with differing priorities for dividend allocation, 38.83 per cent did not provide for differing priorities, and 38.3 per cent provided that certain investors shall receive a fixed percentage of dividends in priority to other shareholders.68 The proportion of contracts that expressly provided for priorities dropped slightly in 2017 but remained substantial at 49.88 per cent.69 An analysis of the relevant contractual clauses70 shows that the general practice is to allow the distribution of dividends only where unanimous approval to do so is obtained at the shareholders’ meeting. This provides the venture capitalists with a de facto veto. Even if the venture capitalists agree to dividend distribution, it is typically provided that dividends payable to the venture capitalists are paid in priority. Much like the liquidation preference, provisions relating to priorities in dividend distribution are typically included in both the articles of association and the shareholders’ agreement to enhance enforceability. This also engages the same practical considerations regarding company registration.71 Care must also be taken when the company is seeking a listing. A Chinese company must be registered as a JSC before it can be publicly listed and the CSRC would not approve the listing of companies if their shares provide dividend distribution rights. Hence, the common practice is for portfolio companies to include terms on priority in dividends in their shareholders’ agreements or articles of association, but to remove these clauses before applying for listing.72 Finally, a notable difference between dividend rights in China and the US is that the NVCA standard form certificate of incorporation provides an option for cumulative dividends on preferred stock at a fixed percentage per annum, payable when declared by the board.73 The Fenwick 68 69 70 71 72

73

Supra note 43. Supra note 46. See text accompanying note 170 in Chapter 1 of this book. See supra text accompanying note 54. An interviewed lawyer also mentioned that if the IPO application is not successful, the applicant can restore the articles of association of the company. Interview with Ms Zou Jing, Partner, Grandall Law Firm, 26 April 2019, Shanghai. NVCA Model Legal Document – Certificate of Incorporation, Clause on dividend distribution, at p. 5.

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Reports confirm that cumulative dividends are used in West Coast deals, albeit only in a minority of instances.74 As far as the hand-collected agreements show, this concept is absent in China75 where the usual practice is that priority in dividend provisions, whether with a fixed percentage or not, is generally pre-conditioned on the board declaring a dividend in the first place. There is a subtle but important difference between accruing dividends and board-declared dividends. In the former case, even if the board does not declare any dividends throughout the life cycle of the portfolio company, such dividends will generally accumulate and be payable at liquidation or redemption.76

3.2.3 Pre-emptive Right to Participate Pro Rata in Future Rounds A pre-emptive right (also termed as ‘subscription rights’, pinyin: youxian rengouquan, in Chinese: 优先认购权) entitles investors to participate on a pro rata basis in subsequent financing rounds.77 A typical pre-emptive right will also provide that when an investor chooses not to participate in the share issuance on a pro rata basis, other investors can purchase the remaining shares pro rata.78 Pre-emptive rights allow investors to maintain their original percentage ownership and ensure that their shareholdings are not diluted without their consent.79 Venture capitalists often choose to exercise their right to subscribe for new shares on a pro rata basis for high-performing portfolio companies to protect against ownership dilution and extend their upside profit potential.80 At the same time, the exercise of pre-emptive rights allows investors to deny entry to outside investors and avoid having to deal with them.81 74 75 76 77

78

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Supra note 40. See text accompanying note 170 in Chapter 1 of this book. Ibid. A. Schwienbacher, ‘Venture Capital Exits’, in D. Cumming (ed.), Venture Capital: Investment Strategies, Structures, and Policies (New Jersey: Wiley, 2010), at p. 387 and p. 391. NVCA Model Legal Document – Term Sheet, Clause on Right to Participate Pro Rata in Future Rounds, at p. 9. D. Klonowski, The Venture Capital Deformation: Value Destruction throughout the Investment Process (London: Palgrave Macmillan, 2017), at p. 209. Some investors with a smaller shareholding in the company may be more willing to purchase more shares when the company conducts subsequent financing rounds. The company may give due consideration to the wishes of these investors and grant them over-subscription rights to subscribe for new shares in excess of their pro rata allocation. See also Matrix Partners, supra note 44. D. Klonowski, supra note 79.

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The flip side of such a right is that it may have a market-cancelling effect on the seller’s equity.82 If the market is aware of the existence of pre-emptive rights, it demonstrates less enthusiasm for the seller’s equity, since they may not be able to expand their shareholdings even if they purchase a controlling stake. This reduces the price at which pre-emptive rights holders can obtain further equity, providing another avenue by which investors may enhance their economic interests.

3.2.3.1 Legal Status in China The PRC Company Law stipulates that when the (limited liability) company increases its share capital, the existing shareholders of an LLC shall have the priority right to subscribe for new shares in proportion to their paid-up capital contributions, except where all shareholders agree not to receive dividends in proportion to their paid-up capital contributions or not to exercise the priority right to subscribe for new shares in proportion to their paid-up capital contributions.83 In the absence of any special agreement amongst the shareholders, the existing shareholders shall have priority over new shareholders when the company conducts subsequent rounds of financing. Thus, pre-emptive rights are well recognised in Chinese law for use in LLCs, as long as they are structured on a pro rata basis; where pre-emptive rights are structured on a pro rata basis, only adoption by usual majority is required. This proposition is well illustrated in the case of Guizhou Jiean Investment Co Ltd v. Guizhou Qianfeng Biological Products Co Ltd and others,84 where the Supreme People’s Court held that Article 34 of the PRC Company Law only grants existing shareholders a priority right for new shares in proportion to their paid-up capital contributions and does not grant existing shareholders a priority right to further purchase any 82

83

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S. Bikhchandani, S. A. Lippman, and R. Ryan, ‘On the Right-of-First-Refusal’, The B. E. Journal of Theoretical Economics, 5(1) (2005), 1–42. Article 34 of the PRC Company Law states that ‘subject to any agreement among all shareholders to the contrary, shareholders shall receive dividends in proportion to their paid-up capital contribution, and when a company issues new capital, shareholders may first subscribe to such new capital in proportion to their paid-up capital contribution.’ Dispute between Guizhou Jiean Investment Co. Ltd. (Defendant) and Guizhou Qian Feng Biological Products Co Ltd, Chongqing Dalin Biotechnology Co Ltd, Guizhou Econ Pharmacetuical Co Ltd and Shenzhen Yigong Shengda Technology Co Ltd (Plaintiffs) over Share Subscription Priority Right in the event of Company’s Share Capital Increase. Supreme People’s Court [2009] Civil Final Appeal Matter No 3. [贵州捷安投资有限公 司与贵州黔峰生物制品有限责任公司、重庆大林生物技术有限公司、贵州益康制 药有限公司、深圳市亿工盛达科技有限公司股权确认及公司增资扩股出资份额优 先认购权纠纷案 最高人民法院(2009)民二终字第3号民事判决书].

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unsubscribed shares should another investor fail to purchase all of its allocated shares. Thus, in the absence of any evidence of unanimous agreement amongst shareholders that the relevant pre-emptive rights extended beyond pro rata entitlements, investors were barred from purchasing unsubscribed shares. There is no express provision in the PRC Company Law as to whether existing shareholders of a JSC can have pre-emptive rights. However, the law states that when a company issues new shares, the shareholders shall, at the shareholders’ general meeting, determine the type and number of shares to be issued.85 This effectively allows existing shareholders a preemptive right over new shares, allowing them to purchase these shares in priority to third parties. The Chinese courts are of a similar opinion that since the PRC Company Law does not impose any mandatory requirements on the issuance of new equity for JSCs, specific matters such as price, number of shares, and category of offerees shall be jointly decided by the shareholders as long as there is no violation of any other mandatory laws and regulations.86 Thus, existing shareholders of a JSC may confer themselves pre-emptive rights by passing a shareholder resolution to that effect. There may be further rules for companies listed on certain boards. Public companies listed on the National Equities Exchange and Quotations (NEEQ) are subject to Article 8 of the Rules for Offering of Shares on the NEEQ (for Trial Implementation),87 which provides that, subject to the articles of association providing otherwise, if a company listed on the NEEQ makes an offering of shares to a third-party investor, the company’s existing shareholders shall have a pre-emptive right to purchase these shares pro rata on the same conditions offered to the third-party investor. 85

86

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Article 133 of the PRC Company Law states that ‘when a company issues new shares, the following shall be the subject of a resolution by the shareholders’ meeting: (1) the class and number of shares to be issued; (2) the price at which shares are to be issued; (3) the start and end date for such share issuance; and (4) the class and number of shares to be issued to existing shareholders.’ See Zhang Ren v. Yunnan Textile (Group) Co Ltd. New Capital Subscription Dispute Second Instance Civil Judgment, Kunming Intermediate People’s Court [2015] Kun Civil 5 Final Appeal No 41 [张仁与云南纺织(集团)股份有限公司新增资本认购纠纷二审 民事判决书，云南省昆明市中级人民法院 (2015) 昆民五终字第41号]. Issuance and Implementation of the Business Rules of the National Equities Exchange and Quotations System (for Trial Implementation) (NEEQ [2013] No. 2) 全国中小企业 股份转让系统股票发行业务细则(试行) 股转系统公告[2013]2号, enacted and effected on 30 December 2013, online: National Equities Exchange and Quotations www .neeq.com.cn/uploads/1/file/public/201804/20180427172718_geu9nmustt.pdf.

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3.2.3.2 Practice in China A total of 203 out of 217 contracts (nearly 94 per cent) surveyed in the Han Kun 2016 Data specified that venture capitalists would enjoy preemptive rights during subsequent financing rounds. Out of the 203 contracts with pre-emptive rights, 77.34 per cent permitted venture capitalists to exercise the pre-emptive right on a pro rata basis, that is, subscription based on their shareholding proportions vis-à-vis all shareholders while 22.66 per cent permitted venture capitalists to exercise the pre-emptive right on a super pro rata basis, that is, subscription based on their shareholding proportions vis-à-vis other investors. In either case, venture capitalists were additionally permitted to subscribe for unsubscribed shares that were renounced by other existing shareholders.88 These two figures underwent a moderate change in the Han Kun 2017 Data, with 68.27 per cent providing for a pro rata pre-emptive right and 31.73 per cent providing for a super pro rata one.89 The widespread use of pre-emptive rights is also reflected in the surveyed agreements,90 which often stipulated that existing shareholders shall have the pre-emptive right to subscribe for new shares in accordance with their shareholding percentage. Even if the agreements do not expressly provide for a pre-emptive right, the Chinese practice is to assume that there is a right for preferential subscription in accordance with shareholding percentage unless the shareholders agree otherwise. It should be noted that some agreements do not stipulate a pre-emptive right but instead establish a subscription hierarchy. As explained earlier, this type of clause is unlikely to have any legal effect in China unless all shareholders unanimously agree to its use. Venture capitalists can also exert control over the share issuance process by clearly stipulating in the shareholder agreement that directors appointed by venture capitalists will have a veto right regarding new issuances. Furthermore, venture capitalists may as an alternative to providing pre-emptive rights instead obtain an undertaking from the portfolio company that it will not issue new shares or change its ownership structure prior to an initial public offering (IPO). However, the power of any contractual pre-emptive rights created through the shareholders’ agreement only binds shareholders and cannot be enforced against third parties. Even if the portfolio company were to 88 89 90

Matrix Partners, supra note 44. Supra note 46. See text accompanying note 170 in Chapter 1 of this book.

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be included as a party to the shareholder agreement, it is unlikely that this can fetter the company’s statutory powers to increase its capital, so that shareholders’ only likely remedy would be a claim in breach of contract.91 By contrast, the pre-emptive right of venture capitalists and the right of other investors to purchase remaining shares not fully subscribed to by a venture capitalist are standard terms in the US, and are found in the NVCA standard term sheet.92 Clearly, these terms in the US context do not generate as much legal controversy as when these terms are utilised in the Chinese context.

3.2.4 Right of First Refusal The right of first refusal (ROFR) (in Chinese: 优先购买权, pinyin: youxian goumai quan) provides that if any of the existing shareholders wish to sell their shares to a third party, the venture capitalists have the right to acquire these shares on the same terms and conditions as offered to the third party.93 Therefore, the ROFR serves a similar function as a pre-emptive right in preventing third parties from obtaining shares in the company and having the same indirect economic advantage of reducing the prices at which incumbent investors may obtain shares.94 It is different, however, insofar as it only applies to shares being sold by existing shareholders, and does not provide any anti-dilution protection.95

3.2.4.1 Legal Status in China The PRC Company Law recognises the use of a ROFR in LLCs. It stipulates that in the absence of any provision in the company’s articles of association that suggests otherwise, shareholders of a limited liability company may transfer all or part of their shareholdings to each other. While a shareholder may transfer its shareholdings to third parties if it successfully obtains the consent of more than half of the shareholders, the 91

92 93 94 95

There is currently no Chinese case law on this point. Nevertheless, for a comparative reference, the UK House of Lords held in the leading case of Russell v. Northern Bank Development Corp Ltd [1992] 1 WLR 588 that a private shareholders’ agreement could not fetter a company’s statutory powers to increase its share capital even if the company itself was a party to the shareholders’ agreement. While the agreement could bind the shareholders, it could not bind the company itself. NVCA Model Legal Document – Term Sheet, Clause on pre-emptive rights, at p. 9. D. Klonowski, supra note 79, p. 213. See text accompanying supra note 82. S. Bikhchandani, S. A. Lippman, and R. Ryan, supra note 82.

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other shareholders are first entitled to purchase the shares on the same terms and conditions as offered by the third party.96 As this provision does not specify the procedural rules for exercising the ROFR, the Supreme People’s Court promulgated its Interpretation of Company Law (IV) (Interpretation IV) to provide further legal certainty.97 Interpretation IV requires the transferor shareholder to notify other shareholders about the terms and conditions of the intended transfer. The exercise period of the ROFR is then determined by the articles of association. In the event the articles of association are silent on the matter, the courts will regard the applicable time period to be that specified by the transferor shareholder in its notice to the other shareholders. Should the notice be silent on the matter, the default time for exercise is thirty days. As to whether the offer is made to the existing shareholder on the ‘same terms and conditions’, the courts will look beyond price and quantity and also take into consideration other material factors such as payment method and payment date. As the legislative intention of Article 71 of the PRC Company Law is to preserve the quasi-partnership nature of LLCs and not to guarantee the transfer of shares to other existing shareholders, Article 20 of Interpretation IV clearly stipulates that other existing shareholders cannot compel the transferring shareholder to dispose its shares if the transferring shareholder decides not to sell after other existing shareholders exercise their ROFRs. 96

97

Article 71 of the PRC Company Law states that ‘shareholders in a limited liability company may transfer all or part of their ownership to each other. A transfer of ownership to a non-shareholder shall be approved by a majority of shareholders. The transferring shareholder shall solicit such approval from other shareholders by way of a written notice. Within thirty days of receiving such notice, if the other shareholders do not reply, they are deemed as having given consent to the transfer; if a majority of the other shareholders do not consent to the transfer, the non-consenting shareholders shall purchase the ownership from the transferring shareholder. Non-consenting shareholders who do not purchase such ownership shall be deemed as having given consent to the transfer. If consent is obtained from the other shareholders with regard to a sale of ownership, the other shareholders are first entitled to purchase the shares on the same terms and conditions offered by the third party. When there are two or more shareholders who intend to exercise such a right, they shall negotiate over the relative proportions at which they purchase the ownership. If negotiations yield no agreement, they shall purchase the ownership in proportion to their relative capital contributions. If the articles of association of the company provide differently for the transfer of ownership, such provisions shall prevail.’ Supreme People’s Court, ‘Supreme People’s Court promulgates ‘Judicial Interpretation of Company Law (IV)’: Full Text and Analysis’ [最高法院发布《公司法司法解释(四)》: 全文及解读] (28 August 2017), online: http://bit.ly/2CDhA5S.

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In addition, Interpretation IV clarified that share transfer contracts in breach of Article 71 of the PRC Company Law will not be void ab initio; they can only be rescinded by the courts upon application by the other shareholders. Should the contract be rescinded, the aggrieved third party transferee will have the right to claim for damages from the transferring shareholder. In the case of a JSC, Article 137 of the PRC Company Law stipulates that ‘shares may be transferred according to law’. Some may argue that since no other provision in the PRC Company Law imposes any restrictions on the transfer of shares in JSCs, these shares are freely transferable by law, and an ROFR is contrary to this legislative principle and should be rendered void. This view is generally in line with Chinese case law and the courts have thus far refused to enforce an ROFR over shares in JSCs.98 Despite the earlier analysis, a more principled argument construes Article 137 as a voluntary rather than mandatory provision. First, this provision does not utilise language of a compulsory nature, such as ‘shall’ or ‘must’. Instead, it uses the word ‘keyi’ (translated to ‘may’)99 to describe the free tradability principle, implying that this provision is merely a default position that can be departed from. Furthermore, any interpretation that restricts the manner in which shareholders may contract for the transfer of shares is tenable since share transfers are predominantly concerned with shareholders’ personal interests over which they should have autonomy. Thus, shareholders’ autonomous decision-making with respect to the use of ROFRs should be properly recognised, in line with the general legislative spirit of the PRC Company Law to respect contractual freedom.

3.2.4.2 Practice in China Out of 217 contracts, 197 (nearly 91 per cent) surveyed in the Han Kun 2016 Data specified that venture capitalists are entitled to ROFRs 98

99

See Liao Zhihong v Jitai Entrust Financial Manager [2016] Guizhou 1 Civil Final 4906 (廖 志红、吉太委托理财合同纠纷二审民事判决书); Xintai Life Insurance Co Ltd and others v Zhejiang Lianchuang Industrial Development Co Ltd and others [2015] Zhejiang Civil 2 [信泰人寿保险股份有限公司、温州银行股份有限公司衢州分行与 浙江联创实业发展有限公司、连云港市宾逸建设工程有限公司等金融借款合同纠 纷执行裁定书]. Although legal Chinese is generally more ambiguous than legal English, this translation should not be taken literally.

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whenever a shareholder intends to transfer his shares. Out of the 197 contracts with ROFRs, three types of contractual provisions can be identified: (1) venture capitalists’ ROFR when a pre-existing shareholder intends to transfer (93.91 per cent); (2) shareholders’ ROFR when any other shareholder intends to transfer (8.63 per cent); and (3) venture capitalists’ ROFR when any shareholder intends to transfer (15.23 per cent).100 While these figures differed slightly in the Han Kun 2017 Data, where the proportion of contracts that provided for some kind of an ROFR increased to 95.56 per cent, the distribution of the three types of provisions among the sampled contracts stayed largely the same.101 Most of the Investment Agreements in the data set102 also provide for ROFRs. Compared with the general provisions of the PRC Company Law, the conditions for the exercise of an ROFR, the exercise mechanism, and the hierarchy of purchase are more detailed and greater practical detail is provided in these agreements. In the US, ROFRs are commonplace, much like pre-emptive rights. However, the practice is often to grant the portfolio company an ROFR before it can be exercised by any shareholder. Venture capitalists’ ROFRs and oversubscription rights kick in only if the portfolio company decides not to exercise its ROFR.103

3.2.5 Tag-along Rights 3.2.5.1 Definition and Function Tag-along rights (in Chinese: 共同出售权, pinyin: gongtong chushou quan), also referred to as co-sale rights, may be exercised if the portfolio company’s founders or other controlling shareholders sell shares to a third party. Such rights allow venture capitalists to join the transaction and sell a proportional amount of their shares on the same terms and conditions as the selling shareholders.104 This clause protects venture capitalists by preventing the controlling shareholders from exiting the portfolio company unilaterally and ensures that venture capitalists are not left behind with unsalable or devalued shares if a major shareholder 100 101 102 103

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Supra note 44. Supra note 46. See text accompanying notes 170 in Chapter 1 of this book. NVCA Model Legal Document – Right of First Refusal and Co-Sale Agreement, Clause 2, at p. 4. PE Manager, ‘Tags and Drags: the Ties that Bind’, online: http://bit.ly/2ECMw6Y.

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decides to exit the venture.105 It also provides the venture capitalists an opportunity to share in the control premiums that would otherwise be paid only to the controlling shareholders.106 Tag-along rights are thus essentially put options on venture capitalists’ own shares, which they can execute when a good exit opportunity presents itself to the other shareholders.107

3.2.5.2 Legal Status in China Although the PRC Company Law does not positively enable LLCs to provide for tag-along rights, it stipulates that if the articles of association differ from the statutory provisions with respect to share transfer, any transfer of shares shall be governed by the articles of association.108 This implies that shareholders of LLCs are entitled to exercise tag-along rights so long as the covenant is included in the articles of association. The PRC Company Law only expressly provides that shares in JSCs can be transferred in accordance with law and does not positively permit shareholders to provide for and exercise tag-along rights.109 Nevertheless, tag-along rights differ in nature from ROFRs and should not face any legal impediment in terms of their enforceability, as they do not hinder share transfers per se (if it were otherwise considered a share transfer restriction, such rights may be unenforceable because they are inconsistent with Article 137). Should founders or the controlling shareholders sell their shares in breach of a tag-along clause, the relevant venture capitalists would be entitled to claim damages for breach of contract. However, the terms of the tag-along clause do not bind the third party since he would not be privy to the agreement containing the tag-along clause. If the third party decides that it is commercially impracticable to purchase shares from both the venture capitalists and the controlling shareholders, he can therefore walk away from the deal with impunity. Such a circumstance could arguably be conceived as the prospective seller’s loss of the opportunity to dispose of his shares, which in turn should be regarded as a form of share transfer restriction, even if the impediment is practical and not legal in nature. Thus, it is a weak 105 106 107

108 109

Ibid. Ibid. C. Bienz and U. Waiz, ‘Venture Capital Exit Rights’, (2010), online: SSRN https://ssrn .com/abstract=1140128. Article 71 of the PRC Company Law. Article 137 of the PRC Company Law.

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argument that under the language of Article 137, any additional contractual arrangement between the venture capitalists and existing shareholders that restricts share transfers should not be recognised by law.

3.2.5.3 Practice in China Out of 217 contracts surveyed in the Han Kun 2016 Data, 204 contracts included general share transfer restriction provisions, of which 92.65 per cent specifically included tag-along rights. The majority of the sample contracts collected110 also included tag-along rights in favour of venture capitalists. Although tag-along rights are legally valid in China for both LLCs and JSCs, there are several practical problems that may prevent them from being used effectively. First, as mentioned, many Chinese business registration administrative departments (i.e. AICs) still conduct substantive examinations of a company’s articles of association before they will allow it to be registered.111 Certain registration departments may take a negative view of non-standard clauses and articles of association that provide for tag-along rights and refuse to register the company on the basis that these clauses are not permitted. Second, tag-along rights are not binding on third parties and only bind the shareholders of the company. Third parties are not privy to the agreement between the controlling shareholders and the venture capitalists, and thus any share transfer actually made to the third party in breach of the Investment Agreement is technically legally valid and irreversible. This problem is usually resolved by contractually requiring the controlling shareholders to obtain the prior consent of the venture capitalists before any share transfer to third parties is carried out. Prior consent is therefore a valuable bargaining chip for the venture capitalists and incentivises the controlling shareholders to include the venture capitalists in any negotiations for the sale of shares. Third, as the sale transaction between the controlling shareholder and the third party will not be void and courts and arbitral tribunals cannot compel the third party to retransfer the shares back to the controlling shareholder, aggrieved venture capitalists can only sue the controlling shareholders for breach of contract. Unless the contract has expressly 110 111

See text accompanying note 170 in Chapter 1 of this book. Qi Jingzhi, ‘Is Business Registration Review a Procedural Examination or Substantive Examination?’ [工商局对变更登记是形式审查还是实质审查？] (29 August 2017), online: www.pkulaw.com/specialtopic/ce9b29e6918f6249f9cb7048de6bdfedbdfb.html.

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provided for liquidated damages, it would be difficult for the venture capitalists to prove causation and quantify the actual losses that were suffered as a result of the controlling shareholder’s breach. In the US, tag-along rights are also commonplace provisions.112 However, there is a sharp contrast between the US and China regarding share transfers, as can be seen from the more restrictive and mandatory Chinese position. Unsurprisingly, both countries manifest differing legislative approaches on striking a balance between market autonomy and regulatory discipline in the context of company law.

3.2.6 Drag-along Rights 3.2.6.1 Definition and Function A drag-along provision (in Chinese: 强制随售权, pinyin: qiangzhi suishou quan) allows venture capitalists to force a sale of shares held in the portfolio company by requiring the founding shareholders and certain other shareholders to, in certain conditions, waive their appraisal rights and participate in the sale on the same terms and conditions as those negotiated by the venture capitalists for the sale of their own shares.113 Drag-along rights are therefore options that venture capitalists have over others, which they can execute when they wish to engage in a trade sale.114 The drag-along provision is particularly important for venture capitalists. One of the primary methods of exit from a VC investment is a trade sale and often, a potential third buyer is only willing to purchase shares if they are able to obtain all of the company’s shares. The drag-along provision thus helps to avoid a situation where a few minority shareholders or the founding shareholders are able to veto a transaction approved by a majority of the shareholders. It is now apparent that the duo of tag-along rights and drag-along rights, residing only with venture capitalists but not founders, is a powerful indication of the strong bargaining position of venture capitalists that allows them to negotiate for contractual rights, which maximise their chances of a good exit event.115 112

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NVCA Model Legal Document – Right of First Refusal and Co-Sale Agreement, Clause on co-sale rights, at p. 6. B. Feld and J. Mendelson, Venture Deals: Be Smarter than Your Lawyer and Venture Capitalist, 3rd ed. (Hoboken, New Jersey: John Wiley & Sons Inc, 2016), at pp. 74–75. C. Bienz and U. Walz, supra note 107. D. J. Cumming and J. G. MacIntosh, ‘Venture-Capital Exits in Canada and the United States’, The University of Toronto Law Journal, 53(2) (2003), 102.

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As it is difficult for founders to completely resist the inclusion of the drag-along provision in the Investment Agreements, they will typically negotiate for a high threshold before the drag-along right can be triggered. This can either be supermajority support from all the shareholders or the requirement that the drag sale receives board support.116 Founding shareholders also often prefer having a price limitation because a sale at a price below the amount distributed to venture capitalists according to the liquidation preference could result in holders of the common shares walking away with nothing. However, venture capitalists will often be reluctant to agree to a price limitation as a transaction with poor returns for the common shareholders is exactly a situation where venture capitalists will need to exercise their drag-along rights.117

3.2.6.2 Legal Status in China Similar to the earlier analysis on ROFRs and tag-along rights, drag-along rights as a form of contractual arrangement on share transfers in JSCs face substantial uncertainty as to their enforceability when read together with Article 137 of the PRC Company Law. To resolve any uncertainty over enforcement, venture capitalists should seek to include liquidated damages in the drag-along provisions. 3.2.6.3 Practice in China Out of the 217 contracts surveyed in the Han Kun 2016 Data, 153 contracts included a drag-along provision. Out of these 153 contracts, 16.99 per cent had a time-based trigger, 31.37 per cent had a valuationbased trigger, and 30.07 per cent had a trigger dependent on both time and valuation.118 This shows that the drag-along provision is prevalent in Chinese practice. In particular, venture capitalists are often entitled to exercise their drag-along rights when the portfolio company fails to go public within a stipulated period.119 However, as drag-along rights can be potentially draconian (as when they force a pre-mature sale of a portfolio company), founders and other 116

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Zhongchoujia, ‘An Interpretation of the Most Important Terms of the VC Investment Agreements’ [解读:股权投资协议最关键条款与投资条款清单核心条 款] (25 October 2016), online: http://bit.ly/2lH706I. A. Singh, ‘Drag-Along Provisions: What Startups Need to Know’, Startup Blog, online: http://bit.ly/2qiDSYc. These 2016 statistics did not show significant change in the Han Kun 2017 Data. See supra note 46. See also Matrix Partners, supra note 44. ‘Interpretation of Core Terms of PE Investment’ [私募股权投资核心条款解读] (8 March 2017), online: http://bit.ly/2DUQXJf.

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existing shareholders would seek to restrict the exercise of the drag-along rights in the following ways to limit the potential for abuse by venture capitalists.120 First, the drag-along right could be restricted to situations where a minimum percentage of shareholders approve of its exercise (usually 75 per cent or 100 per cent).121 Second, the existing shareholders could request for a black-out period or require a guaranteed minimum price or rate of return over a given time period before the drag-along right is exercised.122 This ensures that the portfolio company has a longer time period to develop its business and prevents any premature sale of a high-potential company. Third, in order to prevent malicious acquisition, the existing shareholders could require that drag-along rights be triggered by a sale to a bona fide third-party purchaser. Venture capitalists should not be able to trigger drag-along rights by transferring their ownership interests to their officers, directors, or associated companies.123 Fourth, the drag-along sale could and should be conditioned on receipt of either cash or liquid securities in listed companies. This ensures that the existing shareholders would not be stuck with another private company’s illiquid shares in the event of a share swap acquisition.124 Fifth, the existing shareholders could negotiate for an ROFR that is triggered when venture capitalists wish to exercise their drag-along rights. This would allow the existing shareholders to block an unpopular third-party acquisition as long as they are able to purchase the shares on the same terms and conditions. Among the collected Investment Agreements,125 the most common condition is the presence of a black-out period. For example, one shareholder agreement stipulated that the drag-along right could only be exercised three years after the initial investment by the venture capitalists. The Investment Agreements also typically restrict the exercise of drag-along rights to the situation where a bona fide purchaser purchases either a large majority or all of the company’s shares, and a 75 per cent or unanimous approval is obtained from the shareholders. Furthermore, as 120 121 122

123 124 125

Ibid. Ibid. R. B. Little and J. O. of Gibson, ‘Issues and Best Practices in Drafting Drag-along Provisions’, Dunn & Crutcher LLP (14 December 2016), online: http://bit.ly/2CviJPZ. Supra note 119. Ibid. See text accompanying note 170 in Chapter 1 of this book.

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most existing shareholders (especially the founding shareholders) lack resources and bargaining power, the ROFR condition is rarely negotiated.126 In the US, drag-along provisions can be controversial; while an overwhelming majority of West Coast deals include them, many East Coast deals avoid their inclusion.127 Even when they are included, they tend to be similarly circumscribed as in China128 and rarely exercised.129

3.2.7 Veto Rights A veto right (in Chinese: 一票否决权, pinyin: yipiao foujue quan) refers to the right to veto specified corporate decisions which may be used by either the venture capitalists at shareholders’ meetings or the venture capitalist-appointed directors at board meetings. In the existing Western literature, the shareholders’ veto is the form that is most often used and discussed.130 Unlike many of the other contractual rights analysed here, such as dividends priority, veto rights allow venture capitalists to directly influence or restrain the entrepreneur’s business decision-making. Veto rights thus play a significant role in limiting entrepreneur opportunism in areas where it may cause the most tangible economic harm to investors, such as the issuance of new equity or debt, which leads to ownership dilution, or the sale of substantial assets, which leads to asset substitution.131

3.2.7.1 Veto Rights at Shareholders’ Meetings In the case of LLCs, the PRC Company Law stipulates that shareholders must exercise their voting rights in proportion to their capital contributions unless otherwise provided by the articles of association. It then 126

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129 130

131

M. He, VP at Softbank Asia Investment Fund (SAIF) Partners, ‘Data Analysis of the Status Quo of Chinese Venture Capital’ [数据化解析国内风险投资现状] (17 May 2016), online: http://bit.ly/2Cq2ZNk. See, for example, statistics gathered by Cooley Go, a resource center launched by Cooley LLP specialising in VC deals in the West Coast, which point to a 95 per cent adoption rate of drag-along rights, online: Cooley Go www.cooleygo.com/trends/. Information about East Coast deals was obtained through an interview with an East Coast VC lawyer (anonymity required). NVCA Model Legal Document – Voting Agreement, Clause on exceptions to the dragalong, at p. 8. Supra note 127. O. Bengtsson, ‘Restrictive Covenants in Venture Capital Contracts’ (21 August 2009), online: SSRN, https://ssrn.com/abstract=1459012. Ibid.

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states that the same principle applies to how shareholders’ meetings shall be conducted and how voting takes place.132 However, matters pertaining to the amendment of corporate articles of association, any increase or decrease in capital and merger, split-up, dissolution, or change of corporate form shall be approved by shareholders holding at least two thirds of the voting powers. Thus, it is clear that the PRC Company Law allows shareholders to create new provisions regarding voting rights, shareholders’ meetings, and voting procedures as long as the minimum threshold for approval is met. This has also been confirmed in judicial decisions.133 Veto rights are therefore non-controversial for shareholders in LLCs, provided that the matter at hand falls within the scope of shareholder powers under Article 37 of the PRC Company Law. As for JSCs, Article 103 of the PRC Company Law stipulates that each share held by a shareholder (apart from the company itself) entitles him to one vote at shareholders’ meetings. This enshrines the ‘one share, one vote’ principle, casting doubt on the legal validity of shareholder veto rights in JSCs, since veto rights would allow the shareholder to exercise voting power disproportionate to his shareholdings. It is thus advisable that LLCs with shareholder veto rights provisions in their articles of association make appropriate amendments when converting to JSCs. In addition, other rules apply to listed companies and non-listed public companies with preferred shareholders. The State Council Opinions134 and the CSRC Measures135 provide that preferred shareholders have no voting rights and do not attend shareholders’ meetings except when certain important corporate decisions are concerned, in which case they may attend the relevant meetings and decisions made at these meetings must receive approval from preferred shareholders holding more than two thirds of the voting powers of all preferred shareholders present at the meeting. Nevertheless, as the rules of the State Council Opinions and the CSRC Measures only apply to listed companies and non-listed public companies, this has little applicability to portfolio companies in the VC industry, a majority of which are non-public in nature. 132 133

134 135

Article 43 of the PRC Company Law. See, for example, Qihoo 360 Software (Beijing) Co Ltd v Shanghai Laoyouji Internet Technology Co Ltd and others [2014] Shanghai 2 Civil Final 330 [奇虎三六零软件（北 京）有限公司与上海老友计网络科技有限公司、蒋学文等请求变更公司登记纠纷 二审民事判决书]. Article 5 of the State Council Opinions, supra note 38. Articles 2 and 10 of the CSRC Measures, supra note 66.

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3.2.7.2 Veto Rights at Board Meetings In the case of LLCs, the PRC Company Law stipulates that apart from specific provisions under the law, board deliberations and voting procedures shall be governed by the articles of association.136 It then goes on to specifically provide that each director is entitled to one vote at board meetings. Board veto rights for LLCs therefore contradict an express provision of the PRC Company Law and are legally controversial. For JSCs, similarly, the PRC Company Law stipulates that directors vote on a one-person-one-vote basis.137 Further, the PRC Company Law does not even authorise JSCs to introduce different rules pertaining to board deliberations and voting rules, possibly influenced by the general legislative philosophy of focussing more on public interests rather than shareholder autonomy since JSCs are of an open nature. The legal validity of board veto rights in the context of JSCs is therefore even more uncertain than when such rights are provided for in the context of LLCs. 3.2.7.3 Practice in China Many of the hand-collected agreements138 provide for veto rights over significant corporate decisions, including changes in equity position, amendments to the articles of association, annual budgets, corporate spending, borrowing beyond a certain threshold amount, and relatedparty transactions. Out of 217 contracts sampled in the Han Kun 2016 Data, 203 included some form of veto rights, exercisable by venture capitalists or venture capitalist-appointed directors, or both. These are consistent with the agreements in the data set,139 which generally provided for both shareholder and director vetoes. However, it should be noted that although veto rights are frequently found in draft contracts, these are merely a reflection of venture capitalists’ preference. The commercial reality is that they often go completely unutilised owing to strong objection from other investors that participate in subsequent rounds of investment.140 In the US, shareholder veto rights for fundamental corporate decisions are standard terms, provided for as elaborate protective provisions for 136 137 138 139 140

Article 48 of the PRC Company Law. Article 111 of the PRC Company Law. See text accompanying note 170 in Chapter 1 of this book. Ibid. Telephone interview with Mr Guo, Partner, China Commercial Law Firm, 7 January 2019.

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preferred shareholders.141 However, board veto rights are generally left out of agreements,142 possibly reflecting venture capitalists’ less hands-on philosophy in relation to the running of the portfolio company’s day-today business.

3.2.8 Summary of the Contractual Terms A couple of general observations of legality and practice emerge from the previous analysis of specific terms. First, the PRC Company Law takes a legislative philosophy that prescribes more than it liberalises. The abundance of mandatory provisions and the corresponding lack of voluntary provisions, founded on the overarching legislative goal of the ‘promotion of social economic order and enhancement of economic development of a socialist capital market’,143 pose great legal obstacles to the recognition and enforcement of terms that are otherwise recognised internationally as key contractual terms in the VC/PE industry. This can perhaps be explained by the current immature state of the Chinese market and its mechanisms. A prohibitive regime is understandably necessary as allowing market participants to have excessive autonomy may create chaos. However, this approach remains inconsistent with the state’s current policy of promoting Mass Entrepreneurship and Innovation. Hence, it may be desirable to strike a more businessfriendly balance in the PRC Company Law by giving more autonomy to companies, especially LLCs, when such autonomy poses little risk to external parties. Second, the analysis shows that many common contractual terms, which find their roots in Western capitalist systems, do not find support in, and in some cases even directly contradict, the provisions of Chinese law. A further complicating factor in this regard is the multiplicity of the PRC Company Law and other ancillary rules, which adopt different legislative approaches for LLCs and JSCs, as well as other specific rules in relation to particular concerns, such as listed companies on the Main Boards and the new third board (i.e. NEEQ), as well as foreign-invested enterprises. This creates massive legal uncertainty, which poses substantive difficulties to contracting parties when they seek to enforce these terms in the Chinese context. From a practical perspective, this means 141 142 143

NVCA Model Legal Document – Term Sheet, Clause on protective provisions, at p. 4. NVCA Model Legal Document – Voting Agreement, Clause on board matters, at p. 2. Article 1 of the PRC Company Law.

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that participants in the VC/PE industry should properly evaluate and account for the enforceability risks of certain terms when designing contracts. Third, it is observed that many venture capitalists continue to include many common terms in Investment Agreements, specifically within supplementary agreements to the main investment documents or shareholders’ agreements – despite legal uncertainty as to their interpretation and enforceability. This is mainly due to two reasons. First, as discussed, many AICs continue to run substantive checks on the articles of associations and are likely to reject the registration of companies with nonstandard provisions in their articles of association. Including investment terms only in private contracts ensures that the portfolio company faces no obstacle in registration or any administrative updates. Second, Chinese law and judicial practice heavily emphasise the protection of creditors and minority shareholders, in deals that involve the company. This endangers the enforceability of substantive contractual terms included in the main Investment Agreements to which the portfolio company is usually a party. However, provisions in the supplementary agreements or shareholders’ agreements involving only the existing shareholders and venture capitalists are generally recognised as expressions of party autonomy. Fourth, based on the contractual terms selected to govern their relationship with entrepreneurs and portfolio companies, there appears to be a difference in investment philosophy between US venture capitalists and their Chinese counterparts. Chinese venture capitalists seem to be more aggressive and hands-on with regard to the day-to-day running of their portfolio companies or have greater bargaining power, making ready use of drag-along rights and board veto rights, which are otherwise not often invoked or used in the US practice. As we shall see, this observation is further corroborated by the subsequent analyses on VAMs and investor activism in China. Separately, a couple of points about the drafting of terms in the Chinese context can be gathered from observing the hand-collected contracts. In terms of general style, there is a crude divide between more sophisticated agreements closely modelling the NVCA standard forms and more localised, simplistic agreements. This could stem from regional differences in investor sophistication and profiles of portfolio companies. As for the drafting of each individual term, Chinese contracts tend to be brief, focussing only on the substance of the right but not so much on the procedures and logistics regarding its exercise. Finally, there

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does not seem to be a widely accepted standard form of investment agreement in China, and different firms and practitioners appear to be accustomed to their own precedents. This is understandable considering that the Chinese market is too big and varied, as well as relatively immature, for circulated and used standard forms like the NVCA to develop. However, Singapore’s recent attempt at producing a set of standard investment documents called the VC Investment Model Agreement (VIMA)144 may be illustrative for China. Unlike the NVCA, the VIMA did not organically emerge from widely accepted norms or established industry practice. Instead, it was a forwardlooking initiative by a few key industry players with the aim of providing a starting point to guide and nurture the developing Singapore VC market.145 China may also wish to consider appointing key market participants to put together a set of standard norms to proactively streamline market practices, instead of waiting for a standard to slowly and organically emerge.

3.3 Valuation Adjustment Mechanism The VAM is a form of contractual design unique to the Chinese VC market and is found in contracts concluded between VC funds and portfolio companies or the shareholders of the portfolio companies.146 The VAM identifies pre-determined conditions which the company must meet, failing which investors are granted a contractual right to adjust the portfolio company’s valuation or demand compensation from the company or its shareholders.147 These conditions may include financial (such as revenue and profits) or non-financial performance indicators (such as product sales, launching a product, and getting a patent), as well as the occurrence or non-occurrence of specified events such as an IPO or merger and acquisition (M&A).148 The main method of adjusting the 144

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Venture Capital Investment Model Agreement, online: Singapore Venture Capital & Private Equity Association, www.svca.org.sg/publications/vima-kit. Singapore Academy of Law and Singapore Venture Capital & Private Equity Association launch Venture Capital Investment Model Agreements (23 October 2018), online: Singapore Academy of Law, www.sal.org.sg/Newsroom/News-Releases/NewsDetails/ id/745. The author has discussed this issue in L. Lin, supra note 15, at pp. 101–138. See Validity of Valuation Adjustment Mechanism, online: LehmanLaw, www .lehmanlaw.com/resource-centre/faqs/financial-services-and-regulation/validity-ofvaluation-adjustment-mechanism-vam-agreement.html (last visited 3 July 2019). L. Lin, supra note 15, at p. 101.

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company’s valuation or compensating the investor is compensation by cash or a transfer of equity to the investors for little or no consideration. Although VAMs are prevalent in the Chinese market,149 they are not commonly found in other jurisdictions such as the US, the UK, Singapore, and India.150 This part of the chapter outlines how VAMs function as contractual protection for investors by bridging the valuation gap, reducing overvaluation risks, and providing incentives for entrepreneurs to perform. An alternative and popular mechanism used elsewhere, especially in America, is convertible preferred stock. However, Chinese companies, including both LLCs and JSCs, are not allowed to issue convertible preferred stock under the PRC Company Law.151 Given the contextual 149

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Twenty out of forty hand-collected investment agreements contain VAMs (on file with author). NVCA Model Legal Documents, online: NVCA https://nvca.org/resources/model-legaldocuments/. The NVCA agreements, developed by US industry practitioners, intend to reflect current practices in the US VC industry with a fair representation of both East Coast and West Coast practices and a relatively mutual position between venture capitalists and portfolio companies. These include, inter alia, Term Sheet, certificate of incorporation, stock purchase agreement, voting agreement, investor rights agreement, and ROFR and co-sale agreement. Silicon Valley Venture Capital Survey (2019), available at: Fenwick & West LLP, www.fenwick.com/topics/pages/topicsdetail.aspx?topicna me=vc%20survey, Cooley’s Series Seed Equity Financing Package (2017), online: Cooley Go www.cooleygo.com/documents/series-seed-equity-financing-package/ (last visited 3 July 2019), the SAFE (simple agreement for future equity), online: www .ycombinator.com/documents/(last visited 3 July 2019), and CARE (convertible agreement regarding equity), online: www.svca.org.sg/publications/vima-kit, do not mention VAMs or equivalents. I also interviewed a number of American attorneys, Singaporean lawyers, and Indian lawyers, and they also mentioned that they have never made use of VAM in their VC deals. These interviews include an interview with the head of legal department of Temasek Holdings on 30 May 2019 in Singapore, an interview with two partners of WongPartnership LLP on 30 May 2019 in Singapore, an interview with two partners of Clifford Chance on 5 July 2019, and an interview with a former partner of Amarchand & Mangaldas & Suresh A Shroff & Co (India) on 6 June 2019. The Indian lawyer mentioned that although VAM is uncommon in India, it is common for Indian investors to use a VAM-like put option in VC deals, (i.e. investors have the option to sell shares at an agreed price if the investee company does not meet the set performance target). The Singaporean lawyers mentioned that investors in Singapore do not use VAM, but they use convertible preferred stock very often. Moreover, a search for ‘valuation adjustment’ or ‘price adjustment’ with ‘venture capital’ or ‘private equity’ in Lexis and WestLaw yields no result insofar as American and commonwealth jurisprudence is concerned. See L. Lin, supra note 15, at p. 101. The reason for the lack of convertible preferred shares in China can be attributed to the restrictions in PRC Company Law which provides the general principle of ‘one share one vote’ (see, for example, Article 103 of the PRC Company Law). My interview with a consultant of the PRC Company Law Reform experts committee, Professor Zhu

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needs of these investors and the limitations of the Chinese regulations, the creation and prevalence of VAMs in China are attributable to the following factors. First, severe information asymmetry in the less informed Chinese market. Second, excessive legal restrictions over investment tools and contractual mechanisms in VC financing, such as the restriction against issuing a convertible preference stock. Finally, insufficient legal protection for investors under Chinese law.152 This chapter develops a narrative of market participants creating selfhelp mechanisms through private ordering in response to a chaotic market with inadequate legal protection. Unlike American VC contracts, which are designed to possess universal and long-term applicability,153 VAMs answer specifically to the investor protection issues in the transitional and less informed Chinese market. However, such contractual innovation is unhealthy for the long-term development of party dynamics in the VC market, neither is it a desirable contractual innovation that can be transplanted to other jurisdictions. Hence, turning to the future of VC contracting in China, regulators should discourage the use of VAMs by: (1) removing legal obstacles in issuing investment tools by Chinese companies and allowing the issue of convertible preferred stock and (2) improving the regulatory environment to provide better investor protection. These measures would enable parties to freely adopt established contractual instruments widely recognised in international practice and facilitate the healthy and sustainable development of the market. In the meantime, the Supreme Court of China should also issue judicial interpretations154 regarding the validity and enforcement of VAMs and select guiding cases155 to remove judicial uncertainty relating to the legal effectiveness of VAMs.

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Ciyun, on 20 April 2019 also indicated that regulators (especially the company registrars) lack capacity and willingness to administer companies with convertible preferred shares. The gaps in investor protection are due to: (1) the lack of an effective statutory derivative action; (2) the lack of comprehensive fiduciary duties on directors; (3) the lack of a common law oppression mechanism; and (4) the lack of fiduciary duties on controlling shareholders or their equivalents. See L. Lin, supra note 15, at p. 104, n 11. B. S. Black and R. J. Gilson, supra note 3. The Supreme People’s Court has been issuing judicial interpretations to fill the legislative gap. On judicial interpretation, see further in Li Wei, ‘Judicial Interpretation In China’, Willamette Journal of International Law and Dispute Resolution, 5(1) (1997), 87. In November 2010, the Supreme People’s Court of China established the Case Guidance System, a system in which certain Chinese court judgments are selected and re-issued as de facto binding Guiding Cases to guide the adjudication of similar subsequent cases and

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3.3.1 The Concept of VAM and Its Prevalence in China A VAM is a contractual arrangement concluded between the VC fund and a portfolio company or its shareholders (typically the largest shareholder, founder, or actual controller).156 The parties agree upon specified conditions, which act as financial or non-financial performance indicators of the portfolio company.157 If the condition is not met, the investor may exercise a contractual right to adjust the valuation of the company without incurring any significant additional cost.158 While this outlines the general terms of a VAM agreement, the specific terms are subject to negotiation between the VC fund and the portfolio company and, consequently, vary widely across different companies and industries.159 VAMs envisage future adjustments to the portfolio company’s valuation through forward-looking mechanisms.160 These mechanisms protect the interests of investors by altering the relative shareholding in the portfolio company or providing financial compensation should the portfolio company’s performance fall short of pre-determined conditions or targets.161 The performance conditions (‘bet-on’ targets) of VAM can be categorised into three types. The first category includes financial performance indicators such as revenue, realisation proceeds, profits, growth rates, net asset value, turnover volume, market share, or market capitalisation. The second category includes non-financial performance indicators such as the acquisition of new patents, successfully bringing a new product to the market, securing a new strategic alliance, or the retention rate of technical staff. Third, the occurrence or non-occurrence of specified events, which may not directly correlate with the portfolio company’s performance, such as a merger with or acquisition by another company, or a successful IPO.162

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160 161 162

ensure the uniform application of law. For further information relating to the guiding case, see online: https://cgc.law.stanford.edu/about-the-cgcp/. PRC Company Law has recognised the concept of an ‘actual controller’ in its 2005 amendments, which refers to anyone who is not a shareholder but is able to hold actual control of the acts of the company by means of investment relations, agreements, or any other arrangements under Part 3 of Article 216. L. Lin, supra note 15, at p. 106. See Validity of Valuation Adjustment Mechanism, LehmanLaw, supra note 14. For further discussion on VAM, see also K. P. Yong, Private Equity in China- Challenges and Opportunities, 1st ed. (Hoboken, New Jersey: John Wiley and Sons, 2012), p. 114. L. Lin, supra note 15, at p. 106. Ibid. Ibid., at pp. 106–108 and Table 1.

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The chosen condition depends on the particular stage at which the fund makes its investment. When the investment is made in the early stage of the portfolio company’s development, the VC fund is typically more concerned with the delivery of a workable product and profit margins, whereas the focus turns to milestone events such as an IPO if the investment is made later in the portfolio company’s life cycle.163 As a whole, the most common conditions included in VAM agreements relate to the listing or financial performance of the portfolio company.164 The popularity of the IPO as the primary means of VC exit in China may explain the reason why it is the most popular bet-on target for investors.165 However, these events are not mutually exclusive and many VAMs subject the portfolio company to both targets. In addition to IPOs and financial performance, venture capitalists may opt for sixteen other types of conditions, such as the portfolio company’s corporate management standards,166 corporate structure,167 and the presence of related-party transactions.168 For the compensatory mechanisms, there are four main methods that are engaged when the conditions are not met. These are: (1) compensation by equity; (2) compensation by cash; (3) redemption of shares; and (4) increase in board representation for investors. There may also be 163

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See notes 170 and 171 in Chapter 1 of this book for the methodologies used in the empirical study. As evidenced by the investigated judicial decisions, out of 253 cases, 65 cases set IPOs and 65 set performance goals as their respective targets. The reasons why IPO is the most popular exit for VC investments in China has been explained in L. Lin, ‘Venture Capital Exits and the Structure of Stock Markets: Lessons from China’, Asian Journal of Comparative Law, 12(1) (2017). (These reasons include: (1) IPO exits in China tend to give high returns; (2) M&As are less feasible as regulatory approvals are required for M&A transactions; and (3) stringent control over debt financing). Corporate management conditions include: (1) a substantial breach of contract, including the breach of warranty in the VAM agreement; (2) the sale of shares by the shareholders resulting in a change in control of the company; (3) disputes over intellectual property that adversely affect the prospects of listing of the invested company; (4) changes to the key business of the company; (5) insolvency of the invested company; (6) serious deviations from plans adopted by shareholders at general meeting or by the board of directors; (7) the invested company’s failure to obtain appropriate licences; and (8) the invested company ceasing to be financially viable within five years after the investment. Corporate structure conditions include a change in the controlling shareholder of the invested company before listing, or a significant change in the core management team of the invested company. For example, the transactions between the invested company and related companies have an adverse effect on the interests of the investor.

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some level of mutuality in the agreement by requiring the VC fund to reward the portfolio company and its management should the conditions be met.169 As among these compensation mechanisms, compensation by cash is the most popular.170 An illustration of the typical terms in this scenario is as follows.171 The VC fund, the portfolio company, and an existing shareholder of the portfolio company agree that if the company’s aftertax profits in a specified year are lower than a stipulated amount, the VC fund has the right to choose between (1) cash compensation, to be calculated using a prescribed formula that yields at least 115 per cent of the investment amount, and is jointly and severally payable by the company and the shareholder; or (2) a further transfer of shares in the company from the existing shareholder to the investor at no cost, using a prescribed formula.172 This contract would be termed a one-way VAM if it does not provide for rewards to the target company when the profit target is successfully met. Prima facie, the described arrangement indicates that Chinese VC funds are looking for guaranteed returns in VC investments, despite the fact that these investments are inherently high risk. This is especially counter-intuitive as these VC funds are ‘accredited investors’, who are supposedly capable of appreciating the nature of their investments and bearing the corresponding risks. The refusal to bear any risk and the decision to instead transfer all risks to the portfolio company and its controllers seem to indicate a severe lack of trust in the integrity of Chinese entrepreneurs. A few observations can be made about how the VC fund is typically compensated. First, the preferred form of compensation is via a cash payout to the VC fund, be it by payment of direct cash compensation or a share redemption.173 This preference for cash compensation is another unique feature of the Chinese market not seen in the US or Singapore markets. It is also not unheard of for the VC fund to reserve greater flexibility by contracting for a right to subsequently decide how it wishes to be compensated.174 Finally, compensation by equity is almost 169 170

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See L. Lin, supra note 15, Table 1. Based on the hand-collected agreements. See note 170 and 171 in Chapter 1 of this book for the methodologies used in the empirical study. This sample is commonly used in the investigated hand-collected agreements by the authors. See L. Lin, supra note 15, at p. 110, Figure 1. Based on the investigated cases summarised in Figure 3 in L. Lin, supra note 15. Term found in fourteen of the investigated VAM agreements.

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exclusively used with another form of compensation, be it conjunctively or as an alternative option, further suggesting that the market prefers cash compensation.175 One may also ask whether the VAM is a peculiar Chinese practice. Due to the private nature of investment contracts, it is impossible to determine specifically which parties initially drafted it, nor the context in which it was first used. Similarly, it is not possible to assert with absolute certainty that VAMs are only used in China. However, based on the author’s empirical studies, it appears that VAMs are used as a matter of general practice only in China.176 Interestingly, the earliest mentions of the use of VAMs in China are found in deals between US investors and Chinese companies, such as Morgan Stanley’s and CDH’s investments in Mengniu Dairy in 2003,177 Goldman Sachs’ investments into Yurun Group in 2005,178 and Morgan Stanley’s investments into Yongle Electronics in 2005.179 However, it cannot be ascertained whether VAMs were created by American investors specifically for Chinese deals, or whether their origins lie elsewhere. Even if VAMs originated as terms drafted by American investors, the use of VAMs in the Chinese market has since acquired unique Chinese characteristics, such as a predisposition for cash-based compensation mechanisms for unsatisfactory corporate performance.180 VAMs also bear some similarity to some contractual rights commonly found in international VC practice, such as redemption rights and ‘earnouts’.181 Redemption rights allow investors to collectively opt for share redemption by the company after a certain time frame. These rights are superficially similar to VAMs in that they both provide protection in light of future uncertainties concerning the portfolio company.182 However, the aim of a redemption right is to enable investors to preserve 175 176

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See the empirical findings in L. Lin, supra note 15. With regard to agreements in other jurisdictions, VAMs are not found in the model legal documents provided by the NVCA, model legal documents provided by Cooley LLP, surveys conducted by Fenwick & West LLP, as well as other investigated private agreements and interviews. See further, Mengniu v. Morgan Stanley and CDH, Sina Finance (19 June 2005), online: http://finance.sina.com.cn/stock/s/20050619/17241699972.shtml (last visited 3 July 2019). See further, Cases on VAMs (1 February 2016), online: PE Daily, https://news.pedaily.cn /201602/20160201393132_all.shtml (last visited 3 July 2019). L. Lin, supra note 15, at p. 112. Ibid. Ibid., at pp. 112–113. Ibid., at p. 112.

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what they have negotiated in the original contractual bargain. This allows investors to keep their initial investment horizon by providing a back-up exit right when other exit options are closed.183 Also, the extent of investor protection provided by redemption rights is limited due to the manner in which the price at which the shares are redeemed is computed.184 Transactions in the US tend to prefer weighted-average anti-dilution formulas, which favour the portfolio company, rather than investor-friendly full-ratchet anti-dilution formulas. In any case, redemption is rarely used in practice.185 On the other hand, the right to compensation in a VAM does not aim to provide protection by preserving the initial bargain but transfers the risk inherent in the transaction from VC fund to portfolio company, by requiring compensation from the portfolio company or its shareholders for failing to meet pre-agreed targets. It leverages on future exigencies that lie beyond the contours of the parties’ initial contractual bargain, such as whether a company can obtain a certain profit margin in five years’ time, to improve either party’s position. This reveals the fundamental motivation behind using VAMs in China – VC funds are not confident that the bargain that they have secured is adequate to protect their investment.186 Although an ‘earnout’ under an M&A also bears similarity with VAMs, a VAM should not be confused with an earnout.187 First, earnouts, as mechanisms of contingent consideration in an M&A context, involve only potential payments from the buyer to the seller in case of fulfilment of key performance metrics.188 However, VAMs are used in VC and PE financing in China.189 Unlike an earnout, which does not involve the divestment of all shares, a VAM seeks to facilitate investor exit when the investment goes wrong, predominantly by providing for contingent payments made by the portfolio company to the VC fund,190 183 184 185

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Ibid. Ibid. This is confirmed by the quarterly statistics of Fenwick & West LLP, an established US law firm in the West Coast VC industry, on Silicon Valley venture capital terms. See, for example, Silicon Valley Venture Capital Survey, Fenwick & West LLP (2019), supra note 11. L. Lin, supra note 15, at text accompanying footnote 42. The reasons for such a lack of confidence are explored later in sub-section 3.3.2.1 in this chapter. L. Lin, supra note 15, at p. 113. Ibid. Ibid. This was seen from the author’s hand-collected agreements and interviews with practitioners. See text accompanying notes 170–174 in Chapter 1 of this book.

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depending on whether the bet-on target is achieved. Therefore, these two mechanisms have fundamentally different purposes: earnouts are a mechanism for consummating an M&A transaction whereas VAMs are predominantly used to allow investors to recover from a failed investment. Second, earnouts involve the buyer making contingent payments to the seller in tranches and are essentially a form of instalment payments made by the investor.191 However, VAMs involve returning to the investor a part of the investment that has already been paid out.192 Third, the prospects of a payout eventuating for earnouts are much higher than those for most VAMs in practice, as the former obligates deep-pocketed buyers but the latter obligates have-not entrepreneurs.193

3.3.2 The Popularity of VAMs in China 3.3.2.1

Agency Cost, Information Asymmetry, and Valuation Gaps In the Chinese VC sector, the prevalence of VAMs may be primarily explained by the higher degree of agency problems and information asymmetry.194 VAM agreements are structured to align the interests of the management with those of the VC fund to reduce agency costs and information asymmetries. Many VAMs also incorporate incentive plans to further align the interests of the managers of the portfolio companies to those of the VC fund, for example, by providing for the release of the next round of capital injection and greater management control by the managers if the targets specified in the VAM are met, and vice versa.195 Nevertheless, high levels of agency costs and information asymmetry exist in every portfolio company across all VC markets and this is an insufficient explanation for VAMs being prevalent only in China.196 Further explanation can be found by examining the special features of the Chinese market. First, there is a general lack of trust and confidence in the portfolio companies’ valuation.197 This can be directly linked to the 191 192 193 194 195 196 197

L. Lin, supra note 15, at p. 113. Ibid. Ibid. See discussion in Chapter 2 of this book. K. P. Yong, supra note 159, at p. 116. L. Lin, supra note 15, at p. 114. Interview with Mr Xu Kaixi, October Capital, 27 April 2019, Shanghai. The interviewee mentioned a case where the invested company provided false information. ‘In December 2018, the company claimed that they were working with one of Didi’s subsidiaries. We also interviewed an associate of the subsidiary. The company colluded

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trend of inflated valuations of start-ups in recent years198 and is attributable to factors such as the less sophisticated valuation market, the lack of a sound national credit system,199 and the lack of effective enforcement of defaults in China.200 Second, besides the general obstacles in ensuring the veracity and completeness of disclosures by a non-listed company, portfolio companies, especially ‘unicorns’ that have strong bargaining powers in the fundraising exercise, tend to strongly resist due diligence exercises that they deem excessive.201 Requests for financial information alone, without a further display of commitment to invest or the strong enforcement of a non-disclosure agreement, could be seen as intrusions into the company’s privacy, providing an obstacle to the transaction.202 Third, many unicorns and start-ups are over-valued in China.203 In this unique Chinese context, VAMs function as a timely response to bridge valuation gaps, mitigate concerns uncovered during due diligence, and provide incentives for entrepreneurs.204 For instance, a VAM can stipulate that if the company reaches the agreed performance targets, the company and its shareholders are entitled to adjust its valuation upwards to compensate for their losses from undervaluation; on the other hand, if the targets are not reached, investors are entitled to adjust the company’s valuation downwards to compensate for their losses from overvaluation.205

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with the staff of that subsidiary and told us a half-truth. It was only months later, in April 2019, that we were told the full truth. While the company had worked with Didi’s subsidiary in the past, the business relationship had been terminated in November 2018’. Interview with Mr Lu, founder of the Startup Salad, 1 December 2019, Shenzhen, China. While China’s credit rating system has been rapidly improving, it still has yet to replicate the standards found in the United States. See L. Lin, ‘The Private Equity Limited Partnership in China: A Critical Evaluation of Active Limited Partners’, Journal of Corporate Law Studies, 13(1) (2013), 214. Telephone interview, Ms Xu, Associate, Global Law Office (Shanghai office) on 28 March 2019. (The interviewee mentioned that some unicorns do not accept due diligence as they have strong bargaining power in fundraising.) See K. P. Yong, supra note 159, at p. 114, ‘This is understandable as many of these founders may be experts in their business but can be unsophisticated when it comes to the concept of capital markets and private equity investments’. See Y. Chen, ‘Bubbles in Unicorn Valuation’, Sohu (30 November 2018), online: www .sohu.com/a/278900530_118622 (last visited 3 July 2019). Telephone interview with Ms Ding, Partner, Yincubator, 12 June 2017; telephone interview with Mr Lin, Shenzhen Cedar Fund Management Company, 26 March 2019; interview with Mr Xu Kaixi, October Capital, 19 April 2019, Shanghai; interview with Mr Ding, Tembusu Capital, 18 April 2019, Shanghai; telephone interview with Mr Tian, Partner, iVision Ventures, 29 March 2019. L. Lin, supra note 15, at p. 115.

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3.3.2.2 The Ban on Convertible Securities The prevalence of VAM could also be attributed to the lack of access to financial instruments such as convertible preferred stock in the Chinese market.206 Convertible securities such as convertible preferred stock provide an alternative method of addressing many concerns that underlie the use of VAMs.207 In China, VAMs are commonly used to channel equity stakes or cash payments back to the investors if the portfolio company fails to achieve certain targets within a period of time.208 In the US, the NVCA model documents provide for a similar outcome in the limited situation of a down round. A down round happens when a further round of financing (Round B) is happening at a price per preferred stock that is lower than the price in the previous round of financing (Round A).209 The financial implication of such a down round is that the portfolio company’s performance is likely to have declined in the interim, such that it is now willing to sell stocks at an even lower price.210 Upon the occurrence of a down round, the standard NVCA certificate of incorporation211 provides in excruciating detail for the adjustment of the conversion price of Round A preferred stock into common shares. A lower price per preferred stock offered in Round B results in the downward adjustment of Round A preferred stock.212 As a result, holders of Round A preferred stock are able to convert their stocks into a greater number of common shares and effectively improve their equity position in the company on an as-converted basis at the expense of common shareholders.213 This outcome is in substance similar to a VAM, which provides for a manual adjustment of the portfolio company’s equity in favour of the investors.214 Therefore, the concept of optional conversion and the adjustment of conversion price explain the bulk of the investors’ concerns underlying the use of VAMs.215 206 207 208 209 210

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Ibid. Ibid. Ibid. Ibid. See ‘What you need to know about down round financings’, online: Cooley Go www .cooleygo.com/down-round-financings/. NVCA Model Legal Document – Certificate of Incorporation, Clause on the right to convert, at p. 16. L. Lin, supra note 15, at p. 115. Ibid. Ibid. Ibid.

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It is worth noting that there are material differences between convertible preference stock and VAMs.216 The adjustment of the conversion price in an NVCA-style certificate of incorporation is pre-conditioned upon the occurrence of a down round in the first place.217 The conversion price cannot be adjusted in the absence of a further round of financing.218 This means the overarching rationale behind the conversion mechanism is to act as an anti-dilution mechanism to prevent earlier investors from being unfairly disadvantaged when new investors come in at a lower point in the portfolio company’s life cycle and purchase a bigger stake in the company.219 In contrast, VAMs are triggered by mere poor performance and are blatant risk-transferring compensation mechanisms.220 Convertible preference stocks are also used in line with a code of conduct between investors and portfolio companies, which would be incongruent with the use of VAMs.221 Convertible preferred stocks have been famously conceptualised by Bratton and Wachter as a hybrid species of rights that sits on the fence between two grand private law paradigms – contract law and company law.222 On the one hand, preferred holders rely on specifically negotiated special rights to protect their interests.223 On the other hand, preferred holders are also proper owners of the company and may possess certain interests at risk as shareholders.224 It thus follows that a preferred shareholder has two relevant interests and correspondingly two weapons to safeguard his rights when dealing with the portfolio company.225 One is contractual, in the form of previously negotiated, concrete, and specified entitlements.226 The other is decisional, in the form of ongoing, flexible, and non-determinant governance rights (although such rights are often limited in the case of preferred shareholders).227 Convertible preferred stockholders are accustomed to exercising both rights in the most sensible manner, which usually means that they expend 216 217 218 219 220 221 222 223 224 225 226 227

Ibid., at p. 116. Ibid. Ibid. Ibid. Ibid. Ibid. W. Bratton, and M. L. Wachter, supra note 57. L. Lin, supra note 15, at p. 116. Ibid. Ibid. Ibid. Ibid.

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efforts in negotiating for specific contractual rights at the start of the investment and leave the rest to on-going corporate governance measures.228 This could be why conversion rights for preferred shareholders, predicated on a specified formula of conversion price calculation, are still pre-negotiated rights, which are activated upon the occurrence of a certain event.229 In contrast, due to the lack of convertible preferred stock, VC/PE funds operating in China, who are just holding common stock with a bunch of special contractual rights,230 may focus too heavily on their identity as fixed contractual right holders.231 This may explain their mentality of contractual entitlement, leading to excessive interference even when considerations like corporate performance three years down the road and the prospects of IPO are better and more sensibly left to the realm of ongoing corporate governance.232 Arguably, VC funds operating in the US appear to have a different role as valueadding preferred shareholders who contribute to the ongoing governance of the portfolio company during the investment,233 instead of relying purely on pre-negotiated contractual rights to protect their interests.234 However, despite these tangible benefits, convertible preferred shares are not allowed for general use under Chinese law as of the date of the book. There are extremely limited situations under which preferred stock can be issued in China.235 Even when preferred stock is issued, conversion is not allowed.236 Further, the issuance of preferred stock is accountable as financial liabilities in China. Hence, the issue of convertible stock 228 229 230

231 232 233 234 235 236

Ibid. Ibid. Interview with Mr Guo Junhui, Partner, China Commercial Law Firm, 1 December 2018, Shenzhen; interview with Ms Zou Jing, Partner, Grandall Law Firm, 26 April 2019, Shanghai; and telephone interview with Ms Shao, Legal Counsel, Gaorong Capital, 29 May 2019. In practice, it is common for investors to contract for preference rights in distribution of dividend and in the event of liquidation. However, these contractual rights have to be cleared and removed from the agreements when the portfolio company goes public. Interestingly, if the company is unable to proceed with an IPO, these special preference rights can be ‘restored’ back to the agreements. L. Lin, supra note 15, at p. 116. Ibid. See generally B. S. Black and R. J. Gilson, supra note 3. L. Lin, supra note 15, at p. 116. See text accompanying note 38. Article 33 of the Pilot Measures on Preferred Stock stipulates that ‘listed companies shall not issue preferred stock that is convertible into ordinary stock. However, commercial banks may issue preferred stock that is mandatorily converted into ordinary stock upon the occurrence of non-public offering trigger events in accordance with relevant laws such as the administrative measures for the capital of commercial banks.’ In addition,

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does not help portfolio companies to reduce their financing costs. Finally, a maximum dividend rate at face value pegged to the issuing company’s average rate of return over the last two years is prescribed for the shares. This essentially discourages SMEs with humble balance sheets from issuing preferred stocks as the dividend rates would not be attractive enough to investors. Other commonly used convertible securities in VC financing are convertible bonds. These are quasi-debt instruments, which create a debt obligation but may be converted into equity in the issuing company.237 Convertible bonds also answer many of the concerns that investors have sought to address using VAMs.238 First, convertible bonds avoid the valuation problem at the contracting stage, as the investment quantum is a debt amount with no reference to the portfolio company’s valuation.239 The valuation issue only comes in at a later point in time when there is a possibility of conversion and the bond holder’s equity stake upon conversion is affected by any subsequent rounds of funding.240 Moreover, both VAMs and convertible bonds provide investors with some protection, in the form of cash compensation, should the portfolio company fail catastrophically, such as if it becomes insolvent.241 While the VAM provides for this through a contractual right to compensation, convertible bonds allow the investor to decide whether to maintain their holdings as creditors with a prior claim in insolvency or to convert their holdings into shares.242 Nevertheless, convertible bonds are arguably a less effective financing instrument for VC funds than convertible preferred stock.243 Convertible

237 238 239 240 241 242 243

although Article 15 of the Interim Measures for the Administration of Venture Capital Firms[创业投资企业管理暂行办法] (Order No. 39 [2005], National Development and Reform Commission) effected on 1 March 2006 provides that ‘pursuant to investment agreements entered into with portfolio companies, venture capital firms may invest in non-listed enterprises through equity-equivalent means such as common stock, preferred stock and convertible preferred stock’, these measures are merely departmental regulations and not law; nor have specific provisions been put in place as to how preferred stock can be used in this regard’. L. Lin, supra note 15, at p. 117. Ibid. Ibid. Ibid. Ibid. Ibid. See, for example, D. Mayers, ‘Why Firms Issue Convertible Bonds: The Matching Of Financial And Real Investment Options’, Journal of Financial Economics, 47(1) (1998), 83; H. W. Lee and R. E. Figlewicz, ‘Characteristics of Firms that Issue Convertible Debt

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bonds, at least when they are first signed into existence, are still debts by nature. When VC funds hold on to convertible bonds, they do not have the full suite of rights and powers held by preferred shareholders, such as special governance rights. As a result of these distinct entitlements and powers (or lack thereof), convertible bond holders experience a greater divergence of interests from existing shareholders than preferred shareholders, leading to a higher possibility of conflicts of interest. Beyond the differences in rights, there is further problem as the interim interest payments that have to be made by issuing companies could take a financial toll on start-ups with negative cash flow, limiting their appeal to portfolio companies. Moreover, convertible bonds are seldom issued and the market for convertible bonds is far from established in China.244 The first issuances of convertible bonds for non-listed companies occurred only in 1998.245 Since then, very few companies have taken up convertible bonds as an option, be it on the private or public markets.246 The underuse of convertible bonds as a financing instrument is largely attributable to defective institutional design. Only two groups of companies are currently allowed to issue convertible bonds, but only in compliance with additional strict regulatory controls. The first group are public listed companies, who have to fulfil a long list of prerequisites stipulated in the PRC Company Law and the PRC Securities Law.247

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versus Convertible Preferred Stock’, The Quarterly Review of Economics and Finance, 39 (4) (1999), 547. L. Lin, supra note 15, at p. 118. See ‘A Serious Look at Convertible Bonds for the New Third Board’ (2017), online: JRJ. com, http://bond.jrj.com.cn/2017/11/08150823357314.shtml (last visited 3 July 2019). ‘Recommendations for Reform in Light of the Low Take-up Rate of Convertible Preferred Stock and Convertible Bonds on the New Third Board’ (2019), online: Yicai www.yicai.com/news/100132401.html (last visited 3 July 2019). Article 161 of the PRC Company Law provides that a listed company may, upon a resolution of the shareholders’ assembly, issue corporate bonds that may be converted into stock and shall work out concrete conversion measures in the corporate bond issuance plan. Further, Article 16 of the PRC Securities Law provides that a public issuance of corporate bonds shall meet the following requirements: (1) The net asset of a joint stock limited company is no less than RMB 30 million and the net asset of a limited liability company is no less than RMB 60 million; (2) The accumulated bond balance constitutes no more than 40 per cent of the net asset of a company; (3) The average distributable profits over the latest three years are sufficient to pay the one-year interests of corporate bonds; (4) The investment of raised funds complies with the industrial policies of the state; (5) The yield rate of bonds does not surpass the level of interest rate as set by the State Council; and (6) Any other requirements as prescribed by the State Council.

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These requirements include meeting net asset thresholds of RMB 30 million for JSCs and RMB 60 million for LLCs respectively, and recording average annual profits over the last three years that are sufficient to pay off the interests accruable on the issued bonds for the first year. Additionally, all convertible bond issuances by listed companies have to be approved by the CSRC. The second group involves nonlisted public companies, as permitted by the CSRC.248 The CSRC’s permission is not easily obtained; among the criteria that a company must meet are that it must be innovative and a start-up.249 This effectively disqualifies many companies even if they are on the NEEQ, and convertible bonds remain out of reach as a tool for non-listed public companies. A further obstacle is the requirement that the issuing company cannot have more than 200 shareholders before the issuance, further narrowing the range of eligible companies. Finally, even if a company meets all these requirements, it may still be deterred by the costs incurred in navigating the red tape required to obtain approval as the process involves cross-institutional regulation by the supervising bodies for both the issuance of bonds and the transfer of shares upon conversion.

3.3.2.3 Legal Obstacles against Contractual Protection While VC funds in China are able to negotiate other forms of contractual protection aside from the VAM, the common covenants used in such transactions, including liquidation preferences250 and as prescribed in the NVCA documents,251 are not readily recognised and enforceable

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Measures of Corporate Bond Issuance and Operation (CSRC Order No. 113), effected on 5 January 2015, Shanghai Stock Exchange (2015), online: www.sse.com.cn/lawandrules/ regulations/csrcorder/c/3976177.pdf, where Article 12 provides that corporate bonds issued by a listed company or by an unlisted public company whose stock is transferred publicly may be attached with terms on warrants or convertible equity. . . The issue of corporate bonds under terms on warrants or convertible equity by a listed company shall comply with relevant provisions of the Measures for the Securities Offering of Listed Companies and the Interim Measures for the Administration of Securities Offering by Companies Listed on the Growth Enterprise Market. The provisions governing the issue of corporate bonds under terms on warrants or convertible equity by an unlisted public company whose stock is transferred publicly shall be separately developed by the CSRC. Rules For Private Placement Of Convertible Bonds By Innovative Companies And Start-ups (For Trial Implementation) Promulgated By SZSE, NEEQ And CSDC (2017), online: SZSE News: http://www.szse.cn/English/about/news/szse/t20170926_558241.html Discussed previously in this chapter. See text accompanying notes 25–54. See text accompanying notes 181–193.

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under the PRC Company Law. Legislation thus becomes an impediment to the adoption of alternative forms of contractual protection.

3.3.2.4 Insufficient Legal Protection of Investors The lack of effective legal protection for minority shareholders is also a contributing factor to the prevalence of VAM in China’s VC market. This can be traced to the lack of comprehensive fiduciary duties owed by directors in a corporation, and the defective private enforcement of these duties by shareholders.252 First, the duty of loyalty (pinyin: zhongshi yiwu) and the duty of due diligence (pinyin: qinmian yiwu) were introduced under the revised PRC Company Law 2006.253 Article 147 of the PRC Company Law generally states that the directors, supervisors (in the supervisory board), and senior executives of a company shall ‘ . . . bear the duties of loyalty and due diligence towards the company’.254 The law provides a short list of prohibited activities. These prohibited activities include: (1) misappropriation of company funds; (2) opening accounts with the company capital in a name other than the company’s; (3) providing capital to other parties with the company’s capital or providing security to third parties with the company’s assets without authorisation from the constitution, or obtaining consent from the shareholders’ general meeting or the Board of Directors; (4) conclusion of contracts or conducting selfdealing transaction with the company without consent from shareholders; (5) expropriation of company opportunities for self-interests or for the interests of other parties without consent from shareholders; (6) conducting a business that competes with the company; (7) misappropriation of company commissions; (8) disclosure of company’s secrets; and (9) other behaviours that are in breach of the duty of loyalty.255 The duty of diligence is not defined clearly under the PRC Company Law.256 The PRC Company Law is silent on the tests of skill 252 253 254

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Supra note 200, at 91. L. Lin, supra note 15, at p. 120. L. Lin, ‘Regulating Executive Compensation in China: Problems and Solutions’, Journal of Law and Commerce, 32(2) (2014), 238–239. Article 148 of the PRC Company Law. To help the public have a better understanding of the duty, Article 98 of the CSRC Guidelines for Articles of Association of Listed Companies 2006 specifies that directors’ duty of diligence includes: (1) treating all shareholders equally; (2) understanding the business operations of the company; (3) endorsement on the regular reports of the company in written form and ensuring that the disclosed information is true, accurate, and complete; and (4) providing information and materials to the supervisory board.

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and diligence, making the duty of care difficult to apply in judicial practice.257 Second, aside from duties owed by the directors, minority shareholders in other jurisdictions are also protected by a separate fiduciary duty to act with fairness, which is owed by the majority shareholders to the minority shareholders. This is found in the US and features prominently in the context of VC investments where it is increasingly common for venture capitalists to wield control under contractual arrangements despite holding a minority of the total share capital.258 English law may also impose directors’ duties on a person who is not formally a director by regarding him as a shadow director if he acts like one. In this way, a controlling shareholder who is very much involved in the company’s business and decision-making may have his behaviour regulated by the law as if he were a director.259 However, there is no equivalent duty specified by the PRC Company Law. Functionally, the closest duty is found in Article 20 of the PRC Company Law,260 which provides that controlling shareholders shall not abuse their power to the detriment of the company and other shareholders. Controlling shareholders who do so and result in harm to the company and other shareholders are liable for compensation. On its face, this duty appears to be similar to fiduciary duties owed by controlling shareholders under American company law

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Chinese courts use different tests in judging directors’ duties in judicial practice. See J. Wang, ‘Enforcing Fiduciary Duties as Tort Liability in Chinese Courts’ in R. Huang and N. Howson (eds.), Enforcement of Corporate and Securities Law: China and the World (Cambridge University Press, 2017), at pp. 185–206. For fiduciary duties in China, see also N. Howson, ‘Fiduciary Principles in Chinese Law’ in E. J. Criddle, P. B. Miller, and R. H. Sitkoff (eds.), The Oxford Handbook of Fiduciary Law (Oxford: Oxford University Press, 2019), at p. 603–622. W. Bratton and M. L. Wachter, supra note 57, at p. 1876. UK Companies Act 2006, section 251. Article 20 of the PRC Company Law states that ‘the shareholders of a company shall abide by the laws, administrative regulations, and bylaw, and shall exercise the shareholder’s rights under the law. None of them may injure any of the interests of the company or of other shareholders by abusing the shareholder’s rights, or injure the interests of any creditor of the company by abusing the independent status of legal person or the shareholder’s limited liabilities. Where any of the shareholders of a company causes any loss to the company or to other shareholders by abusing the shareholder’s rights, it shall be liable for compensation. Where any of the shareholders of a company evades the payment of its debts by abusing the independent status of legal person or the shareholder’s limited liabilities, if it seriously injures the interests of any creditor, it shall bear several and joint liabilities for the debts of the company.’

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and may provide some remedy against their abuse. However, although this provision can be enforced and might be a useful tool to hold controllers responsible, it is nevertheless too general and simplistic to shed any meaningful light on the law’s substantive expectations of controlling shareholders’ conduct. Further, there is also no procedural guidance as to how Article 20 can be invoked. Despite the lack of a duty under the PRC Company Law, the Code of Corporate Governance for Listed Companies (the Code) and the Guidelines on the Bylaws of Listed Companies issued by the CSRC provide that the controlling shareholders of listed companies owe duties of good faith to the company.261 The Code states that ‘a controlling shareholder or actual controller owes fiduciary duty to the listed company and other shareholders.262 A controlling shareholder shall exercise the rights of shareholders and perform the obligations of shareholders according to the law for the listed company controlled by it. No controlling shareholder or actual controller shall utilise its controlling power to damage the lawful rights or interests of any listed company or other shareholders, or utilise its control over the listed company to seek illicit interests.’

Nevertheless, it should be noted that the Code is soft law that is not legally binding and cannot be enforced by the court.263 Third, there are several problems with the derivative action regime under PRC Company Law. These problems include the high thresholds required to bring a derivative action, the free-rider problem, and the high cost of litigation.264 For example, the notice requirement is stricter than the counterpart action in the US in the sense that it can be waived only in cases of emergency.265 Also, contingency fee arrangements are not recognised in China, adding on to the free-rider problem. Moreover, there is naturally no common law derivative action as China is a civil law jurisdiction. Furthermore, the oppression action available in other 261 262 263

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L. Lin, supra note 15, at p. 121. Article 63 of the PRC Code of Corporate Governance. See L. Lin, ‘Code of Corporate Governance: Lessons from Singapore to China’, The Company Lawyer, 40(7) (2019), 227. Article 151 of the PRC Company Law. See also Huang, (Robin) Hui, ‘The Statutory Derivative Action in China: Critical Analysis and Recommendations for Reform’, Berkley Business Law Journal, 4(2) (2008), 239; D. C. Clarke and N. C. Howson, Pathway to Minority Shareholder Protection: Derivative Actions in the People’s Republic of China, in D. W. Puchniak, H. Baum, and M. E. Chow, The Derivative Action in Asia: A Comparative and Functional Approach, 1st ed. (Cambridge University Press, 2012), at pp. 243–295. Ibid.

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jurisdictions (which allows shareholders who have been personally prejudiced in the running of a company to bring a personal claim against the corporate controllers) is not available in China.266 Finally, venture capitalists are generally in a better bargaining position, especially in China where there is a serious capital gap problem for startups who are unable to raise financing from IPOs, Chinese banks, and bond markets.267 Thus, if venture capitalists wish to impose VAMs on portfolio companies out of the fears outlined earlier,268 entrepreneurs in need of cash may have little choice other than to accept these terms and ‘bet’.269

3.3.2.5 Providing an Alternative Exit for Investors VAMs that provide for the VC fund to be bought out also provide an alternative exit option.270 When the performance of the portfolio company is unsatisfactory, other exit methods such as IPOs, M&As, and trade sales are often impractical. At the same time, liquidation is unlikely to adequately compensate the VC fund.271 A failure of investment is also not a situation prescribed by the PRC Company Law as warranting the redemption of shares by the company.272 Even if a redemption were to be done through capital reduction, the PRC Company Law provides that any distribution back to shareholders upon an equity reduction shall take into account the necessary payments needed to satisfy creditors.273 Thus, the only realistic exit when an investment turns out to be unprofitable is for the founders of the portfolio companies to purchase shares from the 266 267 268 269

270

271 272

273

L. Lin, supra note 15, at p. 121. See L. Lin, supra note 18 at p. 170. See text accompanying notes 254–264 in this chapter. Telephone interview with Ms Yin, Associate, Han Kun Law Offices (Shanghai office); telephone interview with Ms Jia Qi, Associate, King & Wood Mallesons Law Office (Beijing office), 26 March 2019. For the exits of VC-backed companies in China, see L. Lin, ‘Venture Capital Exits and the Structure of Stock Markets: Lessons from China’, Asian Journal of Comparative Law, 12 (1) (2017), 1. L. Lin, supra note 15, at p. 122. Article 142 provides that a company shall not purchase its own shares except under any of the following circumstances: (1) to reduce the registered capital of the company; (2) to merge with another company that holds its shares; (3) to use shares for employee stock ownership plan or equity incentives; (4) a shareholder requests the company to purchase the shares held by him since he objects to a resolution of the shareholders’ meeting on the combination or division of the company; (5) to use shares for converting convertible corporate bonds issued by the listed company; (6) it is necessary for a listed company to protect the corporate value and the rights and interests of shareholders. Article 177 of the PRC Company Law.

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venture capitalists.274 This does not mean that this solution is waterproof from the perspective of concerned investors – it may often be the case that entrepreneurs have no other personal assets apart from their stake in the company, such that the contractual remedy is practically unenforceable.275 However, the mere presence of an alternative exit method is generally advantageous.

3.3.3 Are VAMs a Desirable Contractual Innovation? 3.3.3.1 Complexity and Negative Spillover Effects The widespread use of VAMs does not necessarily mean that they are an easy term to use. Various theoretical and practical difficulties haunt the drafting, negotiations, and enforcement of VAMs. This section shall start by considering the complexity of reducing VAMs to contractual language and some of the negative spillover effects of regrettable drafting on parties’ behaviour and dynamics. First, it is difficult and costly for parties to choose and define the targeted condition in the VAM. When non-financial target conditions are chosen, such as the number of active users or the average profit of a particular product of a tech company, there can be two points of contention.276 On the one hand, the agreed condition may be rendered irrelevant by changing circumstances. Considerable time is usually required before start-ups can pin down with certainty their products and strategies, possibly rendering business-related targets identified at the point of contracting anachronistic.277 On the other hand, there is a considerable risk of data manipulation by the portfolio company when it comes to assessing such targets. This is due to the fact that the company has possession of relevant business-sensitive data, which may not be verifiable by any existing independent standard. As proof of these concerns, interesting examples of such forms of manipulation have emerged in the Chinese market in the recent years, including the practice of paying people to purchase products so as to create an appearance of popularity (shuadan).278 If a financial target condition is chosen, such as the portfolio company’s profit margins or revenue, defining the target becomes even 274 275 276 277 278

L. Lin, supra note 15, at p. 121. Ibid. Ibid., at p. 123. Ibid. Ibid.

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trickier.279 On the one hand, it is necessary to be numerically precise in defining the target so as to allow an uncontroversial judgment of whether the target has been attained. However, the downside to objective numerical definitions is that they can be overly complex and specialised, such that the portfolio company may find it hard to coordinate its corporate strategies so as to work towards meeting the target while also developing meaningfully.280 Furthermore, the growth and potential of a company is properly reflected by a holistic analysis of various indicators and not a single numerical figure.281 This is especially for start-ups that tend to experience prolonged loss-making periods.282 Indeed, for many tech start-ups, the bigger their customer base is, the less profitable they are likely to be in the short term, so that growth and profitability become (initially at least) incongruous goals.283 Finally, financial measures may just as well be subject to the same risks of data manipulation and practices discussed earlier.284 Some interviewed venture capitalists have thus observed that it is nearly impossible to design a perfect indicator of success.285 Moreover, how do parties meaningfully agree on the standards of success or failure? As mentioned earlier, the VAM terms are likely to be determined by the balance of the parties’ relative bargaining power. In this scenario, the final agreed position may have little to do with what is the optimal balance of interests as between both parties. Instead, it is more likely to represent the best position for the stronger party. If the venture capitalist is in a strong position, it may push for an overly high standard of success to pressurise the management and maximise its own benefits; if the portfolio company is in a strong position, it may also volunteer for or accept a high standard of success in order to demonstrate confidence, trading risk for greater prospects of equity investments in future. In these circumstances, VAM targets are often inflated, resulting in a high number of failures, which defeats the purpose of venture financing. Another consideration is that the prospects of future corporate affairs are always subject to, and sometimes overridden by, factors extraneous to the portfolio company’s performance itself. For example, 279 280 281 282 283 284 285

Ibid. Ibid. Ibid. Ibid. Ibid., at pp. 123–124. Ibid., at p. 124. Telephone interview Mr Tian, Partner, iVision Ventures, 26 March 2019.

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negative changes in the general economic environment and suspensions of IPOs due to changes in regulatory policies286 can be fatal to the agreed VAM targets, regardless of how hard the management tries to meet them. Further, it is difficult for parties to account for the potential negative spillover effects that VAM terms may have on their future incentives and working relationship at large. VAMs by nature alter the incentive structure of management by artificially breaking down the company’s lifespan into pre-VAM and post-VAM stages. Before VAM targets are assessed,287 managers are naturally incentivised to adopt a short-term mentality. For example, they may prize possibly irrational expansion over internal stabilisation if the VAM target touches on revenue. After VAM targets have been reached, there can be an abrupt loss of continuity as management loses the driving force to produce consistent corporate performance.288 Finally, it is costly and time-consuming to negotiate and structure the amount, period, targets, and outcome of a VAM.289 VAMs envisage thresholds and targets in a very uncertain future, which can be hard to pin down in precise contractual language.290 ‘The costly contracting theory predicts that negotiation and enforcement of explicit provisions are costly.’291 ‘Covenants are included only when the benefits of restricting activity are greater than the costs.’292 The incomplete contract theory293 has also exposed a primary weakness of the contract as a governing paradigm of a commercial relationship - incompleteness, thus leading to potentially inhibitive costs of perfecting that contract in future.294

286 287

288 289 290 291

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See supra note 270. See also the case of Southern Beauty, infra note 298. The author’s hand-collected private agreements show that most of the VAMs specify that the period of VAM lasts for three years. Some VAMs only last for one year. L. Lin, supra note 15, at p. 124. Ibid. Ibid. Paul Alan Gompers and Joshua Lerner, The Venture Capital Cycle (MIT Press 2004), at p. 66. Ibid.; O. E. Williamson, The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting (New York: Free Press, 1985). See for example, S. J Grossman and O. D Hart, ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94(4) (1986), 691. L. Lin, supra note 15, at p. 125.

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3.3.3.2 Reducing Mutual Trust between the Parties Since VAMs are result-oriented and bifurcate party interests, the use of VAMs would result in an inherent tendency to sow distrust among the parties and distort their working relationship.295 For example, when the VAM provides for the dilution of controlling rights of the management upon an event of failure, this could thwart the confidence of the management team and breed defensiveness among them, which may adversely affect the future performance of the company. In fact, the running thread in all the design difficulties enumerated in the subsection earlier is that the form of VAMs, being apparently concerned with investor protection, is actually predisposed to introduce scepticism and distrust into the investor–entrepreneur relationship by waterproofing an investment at all costs.296 Some interviewees also revealed that apart from the VAM, some VC funds even asked the entrepreneurs to provide additional personal guarantees with their personal assets, which have commonly led to the bankruptcies of entrepreneurs when an investment goes south.297 In their fixation on transferring risks from themselves to entrepreneurs, Chinese VC funds seem to have adopted a mentality of waterproof profitearning instead of calculated risk-taking, even though the latter is more properly in line with the nature of VC investments. In addition, there is strong public disapprobation against VAMs in China, which are seen as a calculated move by VC funds to take advantage of portfolio companies. The public’s disapprobation of VAMs was compounded by the highprofile case of Southern Beauty. In 2008, CDH Investment offered to invest in Southern Beauty, on the condition that the company had to succeed in going public within five years or else it would be obliged to buy back all the shares issued to CDH at a premium. The IPO attempts failed and the founder, Zhang Lan, was forced to give up her controlling rights in Southern Beauty.298 295 296 297 298

Ibid. Ibid. Interview with Shao Jun, Partner, Yuantai Law Offices (Shanghai), 20 April 2019. See Southern Beauty, the Fiasco, Su Longfei (2016), online: www.p5w.net/xcf/201607/ t20160707_1510312.htm. In 2008, CDH Investment offered to invest in Southern Beauty, on the condition that a VAM agreement be installed in the investment agreement with the company. The VAM agreement was a one-way clause, which stipulated that the company had to succeed in applying for IPO in five years or else it would be obliged to buy back all CDH’s shares at a premium. The IPO attempts failed, and Zhang Lan was forced to give up her controlling rights in South Beauty.

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3.3.3.3 Legal Problems under Chinese Law There is no codified law regarding the definition and legality of VAMs. Instead, the existing legal material on VAMs arises from challenges in the Chinese courts and arbitration institutions, including a series of judicial decisions.299 The key case is the landmark Supreme People’s Court case of Haifu.300 In the Haifu case, Haifu Investment Co. (Haifu), a PE firm, entered into a Capital Increase Agreement with (1) Gansu Shiheng Nonferrous Resources Recycle Co., (Shiheng), which was wholly owned by Hong Kong Diya Co. (Diya’); (2) Diya; and (3) Ms Lu Bo, the general manager and legal representative of Shiheng in 2007. As a result of Haifu’s investment, Shiheng was converted into an Equity Joint Venture (EJV), which is subject to the PRC EJV Law. Haifu and Diya subsequently entered into an EJV Agreement. There was a cash-based VAM provision in the Capital Increase Agreement (clause 7.2). Under the agreement, Haifu would receive cash compensation from Shiheng if its net profit for 2008 was less than RMB 30 million. If Shiheng failed to pay such compensation, Haifu could then demand that Diya pay the same compensation.301 When Shiheng failed to meet the prescribed performance target, Shiheng and Diya both refused to honour the cash compensation obligation and Haifu sued.302 The Supreme People’s Court held that the claim against Shiheng, the portfolio company, and based on the VAM was unenforceable, as it effectively guaranteed a fixed return to Haifu irrespective of Shiheng’s actual business performance and profits. Such a guaranteed return violated Article 8 of the Sino-foreign EJV Law,303 under which shareholders

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301 302 303

See L. Lin, supra note 15, at 110, Figure 1. Small and Medium-sized Enterprises (Tianjin) Venture Capital Fund Partnership LLP v. Lu Shihai (dispute over a contract) (2014) E Wu Han Zhong Min Shang Wai Chu Zi No. 00304 (中小企业(天津)创业投资基金合伙企 业(有限合伙)与卢士海合同纠纷案(2014)鄂武汉中民商外初字第00304号). Haifu Investment Co., Ltd. of Suzhou Industrial Park v. Gansu Non-ferrous Metal Resources Recycling Co., Ltd., Hong Kong Diya Co., Ltd., Lubo (dispute over capital increase) (2012) Min Ti Zi No. 11 (苏州工业园区海富投资有限公司与甘肃世恒有 色资源再利用有限公司、香港迪亚有限公司、陆波增资纠纷案(2012)民提字第 11号). This provision was not triggered as the investment deal broke down the next year. L. Lin, supra note 15, at p. 126. Paragraph 1 of Article 8 of the PRC Sino-foreign Equity Joint Venture Law provides that ‘after payment of equity joint venture income tax on an enterprise’s gross profit, pursuant to the tax laws of the People’s Republic of China, and after deductions therefrom as stipulated in its articles of association regarding reserve funds, employee bonus and welfare funds, and enterprise development funds, the net profit of an equity

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in an EJV are only entitled to share the net profits of the EJV pro rata to their respective equity interests in the EJV. Consequently, by entitling Haifu to directly obtain assets from the company without going through the statutory process of profit distribution, the VAM impaired the interests of Shiheng and its creditors and was an abuse of shareholder’s rights prohibited by Article 20 of the PRC Company Law.304 Finally, the VAM enabled Haifu to secure a return without bearing the risks of the company’s operation. Since the VAM agreement violated mandatory legal provisions, the contract was held to be invalid under Article 52 of the Contract Law.305 In contrast, the claim against the controlling shareholder, Diya, was enforceable.306 This was because Haifu’s claim did not harm the interests of Shiheng and its creditors, nor did it violate any provisions of law or regulation, as Diya would compensate the PE firm using its own assets and not out of assets belonging to the portfolio company, Shiheng. The true intention of the parties to provide compensation in the event the investment failed was recognised and the VAM clause was enforced.307 However, the grounds upon which the Court recognised the VAM agreement between the investor Haifu and the shareholder Diya was hardly convincing. There was only one VAM agreement. This agreement provided that the company would be obligated to pay cash. Upon, and

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joint venture shall be distributed between the equity joint venture partners in proportion to their investment contribution to the enterprise’s registered capital’. Article 20 of the PRC Company Law states that ‘shareholders of a company shall exercise shareholders’ rights in accordance with the provisions of laws and administrative regulations and the articles of association of the company and shall not abuse their shareholders’ rights to cause damage to the company or the interests of other shareholders or abuse the independent legal person status of the company and limited liability of the shareholders to cause damage to the interests of the creditors of the company’. Article 52 of the PRC Contract Law states that ‘in any one of the following situations, a contract shall be without effect: (1) one party concludes the contract through the use of fraudulent or coercive means, causing detriment to the interests of the State; (2) the contract involves a malicious conspiracy which is detrimental to the interests of the State, a collective, or a third party; (3) illegal intentions are concealed beneath an appearance of legality; (4) there is detriment to social and public interests; or (5) the mandatory provisions of laws and administrative regulations are violated.’ The deliberate attempt by the Court in validating the VAM agreement between the investor Haifu and the shareholder Diya was, however, hardly convincing. There was only one VAM agreement in this case (i.e. clause 7.2). The agreement provides that the company shall be obligated to pay the cash compensation. Upon (and only upon) the failure of the company in honouring the compensation obligation, the controlling shareholder, Diya, will be obliged to take over the liability. As a result, while the Court dismissed Haifu’s claim against the company and Ms Lu Bo, Diya was ordered to perform its obligation under the cash performance ratchet by paying a cash compensation of RMB 19,982,095 and court fees to Haifu.

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only upon, the failure of the company to honour the compensation obligation, the controlling shareholder, Diya, would be obliged to take over the liability. Thus, the agreement between Haifu and Diya was akin to an agreement creating a guarantee for the company’s liabilities. The corollary of this analysis was that if the main VAM agreement between Haifu and Shiheng was held to be invalid, the guarantee agreement between Haifu and Diya should accordingly also be void. Therefore, on a strict view of the law, the legal consequences (i.e. invalidity) of the main VAM agreement would diminish the validity of the corollary guarantee, in which case Diya should not be held responsible for compensating Haifu fully. On this account, it appears that the Court’s holding in this regard was motivated not by the operation of legal doctrine but more by the necessity to placate VC funds by safeguarding their investment interests. The Haifu judgment showed the then Supreme People’s Court’s position that an investor in a Sino-foreign EJV could enforce a cash-based VAM against the controlling shareholder of the EJV but not against the EJV itself.308 Subsequent decisions adopted a similar line of reasoning, holding that VAM agreements between portfolio companies and investors were invalid if there was a violation of creditor rights, but that VAM agreements between existing shareholders and investors were valid contractual expressions of party autonomy and equal bargaining. This has since become a key distinct feature of typical VAM clauses.309 However, this is not the final word on the status of VAMs. Although courts have been observed to follow the principles established in the Haifu decision, there is no general principle of stare decisis in China and it is unsafe to treat the decision as a black-letter rule in practice, as one might do in a common law jurisdiction. The case of Haifu also lacks even soft binding force, as it has not been designated as a guiding case by the Supreme People’s Court.310

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Although court decisions in China do not command precedential value, in practice, the decisions of the Supreme People’s Court of China are almost always deferred to by the lower courts. Ibid., note 6. A total of 107 out of the 165 investigated VAMs concluded after 2012 made the shareholders of the portfolio company liable under the VAM agreements. Only ten of the investigated VAMs stipulated that the portfolio company was to bear sole liability under the VAM agreement. The Haifu case is not a guiding case of the Court, as seen from a perusal of the guiding cases last published by the Court, online: Supreme People’s Court, www.court.gov.cn /fabu-gengduo-77.html?page=6.

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In fact, it might appear that the judicial attitude is shifting. Most notably, in the recent case of Qiang Jingyan v. Cao Wubo (Qiang Jingyan)311 and the case of Jiangsu Huagong,312 the Chinese courts took a different approach toward VAMs. In the case of Qiang Jingyan, the Court expressed a judicial attitude distinct from that in Haifu. In Qiang Jingyan, the VAM agreement provided for the right of Qiang Jingyan, the investor, to have his shares redeemed by Cao Wubo, the existing shareholder, with the portfolio company undertaking a guarantee with respect to Cao Wubo’s obligation on a joint and several basis. Unlike the judgment in Haifu, which was underpinned by considerations of creditor protection in accordance with Article 20 of the PRC Company Law, the court in Qiang Jingyan based its decision primarily on the requirements of contractual formation in determining whether to enforce the VAM. Most recently, the principles pronounced in Haifu were further reconsidered by the decision in Jiangsu Huagong, where the Higher People’s Court of Jiangsu Province ruled that it was Yangzhou Duanya Jichuang JSC (Yangzhou Duanya), the portfolio company, that bore liability for the share redemption, recognising that the VAM was entered into with the portfolio company instead of shareholders. The Court held that the Supplementary Agreement containing the VAM was valid and the share redemption provisions under which Yangzhou Duanya was liable did not contravene the mandatory requirements of any law or administrative regulation. The grounds for the decision were as follows: 1. At the time of signing the VAM, Yangzhou Duanya was an LLC, which is not prohibited from repurchasing its own shares under the PRC Company Law. 2. Share buybacks carried out by LLCs in accordance with legal requirements do not compromise the principle of capital maintenance or jeopardise creditor interests. 3. The fact that the investor became a shareholder of the company pursuant to the investment does not detract from the investor’s prior role as a creditor of the company under the VAM. 311

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Qiang Jinyan and Cao Wubo Equity Transfer Dispute (2016) Supreme Court Civil Appeals No. 128 (强静延与曹务波股权转让纠纷案 (2016) 最高法民再128号). Jiangsu Huagong Venture Capital Investment Company, Yangzhou Duanya Jichuang Joint Stock Company and Pan Yunhu Request for Share Redemption Dispute (2019) Suminzai No. 62, (江苏华工创业投资有限公司与扬州锻压机床股份有限公司、潘 云虎等请求公司收购股份纠纷案 (2019) 苏民再62号).

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4. The VAM was entered into to protect investors’ interests in view of the specific business risks involved; it was a truthful representation of parties’ intentions. 5. Although the returns promised to the investor under the agreement were relatively fixed, they were not substantially higher than the costs of financing during the relevant period. Thus, Yangzhou Duanya did not incur costs or conduct operations in a way that was out of the ordinary course of its business. As a result, the court concluded that the VAM in question did not contravene any mandatory laws or administrative regulations, nor did any ground for contractual invalidity under Article 52 of the Contract law apply. Thus, the VAM was deemed valid. In contrast, the laws cited by the Supreme People’s Court as grounds for decision in the Haifu case were provisions in the PRC Company Law and the PRC Sino-foreign EJV Law. The primary reason behind the ruling in Jiangsu Huagong is that the PRC Company Law allows share redemption for the purpose of reducing registered capital, provided that the capital reduction is carried out in accordance with legal requirements. Further, when the portfolio company is financially capable of fulfilling its redemption obligations, its assets would remain intact, and the claims of its creditors would not be adversely affected. In other words, the key ingredients for a valid share redemption agreement are, first, that it has the purpose of capital reduction, and second, that it does not compromise the claims of other creditors. In order to remove judicial uncertainty relating to the legal effectiveness of VAMs, the Supreme Court of China has recently published a conference summary to guide future judicial practice (pinyin: Jiumin Jiyao).313 The summary states that when the People’s court is adjudicating disputes involving VAMs, the court should take into account relevant regulations in the PRC Contract Law and the PRC Company Law. With regard to the VAMs concluded between the investors and the target company, ‘in the absence of any vitiating factors, when the target company alleges that the VAM is invalid due to share redemption or cash compensation, the People’s Court should not rule that such VAMs are invalid. The People’s Court should examine whether the rule against withdrawal of 313

The National Civil Commercial Trial Work Conference – Conference Summary or how the Supreme People’s Court guides the lower courts through issuing conference summaries that are available at: www.court.gov.cn/zixun-xiangqing-199691.html.

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v e n t u r e ca p i t a l l a w i n ch i n a capital by shareholders, as well as the rule on share redemption in the PRC Company Law are complied with. When the investor requests the target company to redeem shares, the People’s Court should examine its request according to the requirements listed in Article 35 of the Company Act on the rule against withdrawal of capital by shareholders, or Article 142 on share redemption. If it is found that the target company has failed to meet the relevant requirements, the People’s Court should reject such request. When the investor demands monetary compensation from the target company, the People’s Court should examine such demand according to the requirements listed in Article 35 of the PRC Company Law on the rule against withdrawal of capital by shareholders, as well as Article 166 on profit sharing. If it is found that the target company has failed to meet such requirements, the People’s Court should reject such demand from the investor. If the target company has gained profit subsequently, the investor could still initiate litigation against the target company.’

Nevertheless, these summaries do not have legal effect. The Supreme Court of China should issue judicial interpretations314 and select guiding cases315 to remove judicial uncertainty relating to the legal effectiveness of VAMs. Comparatively, Chinese arbitral tribunals seem more open to giving effect to VAMs. In 2014, the China International Economy and Trade Arbitration Commission (CIETAC) issued an arbitral award that deemed the VAM agreement between the investors and the portfolio company legally valid. In the reported summary of the case, the VAM stipulated that if the portfolio company did not reach a specified financial performance target within a certain period of time, it would have to compensate the investors by cash. Simultaneously, the investors also undertook to compensate the portfolio company by cash in the reverse scenario. The VAM agreement also provided for a separate set of targets, failing which investors would be entitled to have their shares purchased or redeemed by a significant shareholder or the portfolio company, as the case may be.316 It appears that this VAM is much fairer than the others, as 314

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The Supreme People’s Court has been issuing judicial interpretations to fill the legislative gap. On judicial interpretation, see further in Li Wei, supra note 154. In November 2010, the Supreme People’s Court of China established the Case Guidance System, a system in which certain Chinese court judgments are selected and re-issued as de facto binding Guiding Cases to guide the adjudication of similar subsequent cases and ensure the uniform application of law. An arbitral award made by the CIETAC in January 2014 ([2014] CIETAC 0056) recognised a VAM agreement between the investors and the portfolio company as valid. See Chen Fu and Zhang Wei, Arbitral Awards on VAMs, online: www.shui5.cn /article/69/73971.html.

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discussed previously317 in the sense that it provides for the company to receive benefits should it meet the prescribed targets. Notably, the CIETAC was of the view that such arrangements did not violate the principle of capital maintenance or any mandatory provision in Chinese laws and regulations and were thus regarded by the arbitrators as valid and enforceable.

3.4 The Future of VC Contracting Legal reform is needed to address the concerns discussed earlier and to facilitate VC contracting in China. This should be done by equipping investors with the appropriate sword and shield in their arsenal such that VAMs can be eventually replaced as the primary method by which their interests are protected. These include empowering venture capitalists by relaxing the restrictions in the PRC Company Law on the issuing of financial instruments such as convertible preferred stock and convertible bonds and providing additional protection for investors by introducing more legal remedies for minority investors, such as imposing fiduciary duties on controlling shareholders, introducing oppression remedies, expanding the scope of fiduciary duties of directors, as well as relaxing the requirements for derivative actions. Admittedly, across-the-board legal reform may be costlier than simply permitting the operation of VAMs, but the key advantages to legal reforms lie not in their short-term cost effectiveness, but their longterm potential to establish a healthier venture capitalist–entrepreneur relationship. Empirical studies show that convertible preferred stocks have long been the most common form of security issued in VC financing rounds. In a 2002 study conducted by Steven Kaplan and Per Stromberg, it was found that out of 213 VC financing rounds in 119 portfolio companies by 14 different VC firms, 170 of them comprised the issuance of convertible preferred stock only, and 202 of them were issuances of convertible preferred stock and some other security such as straight preferred stock and common stock.318 317

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Such as the VAM discussed in the Haifu case as discussed in supra text accompanying notes 300–310. S. N. Kaplan and P. Stromberg, ‘Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts’, Review of Economic Studies, 70 (2003), 281.

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Apart from the previous discussion on how convertible preferred stock responds to some of the concerns that investors seek to address using VAMs, economic literature has also showed that convertible preferred stock is an efficient tool that provides the following benefits: aligning the incentives of VC funds and entrepreneurs,319 allocating control between them, signalling the entrepreneur’s talent and motivation,320 and discouraging entrepreneurs from engaging in ‘window dressing’ in order to induce further rounds of financing.321 Depending on the particular jurisdiction in which the convertible preferred stock is used, there may be other unique advantages to this financing instrument, such as a reduction in the tax burden on managers’ incentive compensation under US tax law.322 The first function of convertible preferred stock is that it aligns the interests of VC funds and entrepreneurs. Schmidt notes in this regard that ‘the ultimate success of high-potential, entrepreneurial firms does not only depend on the quality of the project (but) also the effort provided by the entrepreneur (and) the commitment of the venture capitalists’.323 The problem, however, lies with devising a system of remuneration that properly aligns the interests of both parties. Many consider vanilla equity financing to be untenable as it leads to the ‘double moral hazard problem’, where each party contributes less and takes on more risks because they assume that the other party bears the costs of such actions.324 In this regard, theoretical models constructed by Gompers325 and Schmidt326 show that convertible preferred stock outshines straight debt or equity as the security of choice in VC financing. As explained by Gompers,327 ‘the convertible preferred security can act as 319

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322 323 324

325 326 327

K. M. Schmidt, ‘Convertible Securities and Venture Capital Finance’, The Journal of Finance, 58(3) (2003), 1139. R. J. Gilson and D. M. Schizer, ‘Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock’, Harvard Law Review, 70(2) (2003), 875. F. Cornelli and O. Yosha, ‘Stage Financing and the Role of Convertible Debt’, The Review of Economic Studies, 70(1) (2003), 1. Supra note 319. Ibid. Ibid., at 2. See also R. C. Green, ‘Investment Incentives, Debt, and Warrants’, Journal of Financial Economics, 13(1) (1984), 115; P. A. Gompers, ‘Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments’, (1999), online: www.hbs.edu/faculty/Pages/item.aspx?num=11203 (last visited on 3 July 2019). P. A. Gompers, ibid. K. M. Schmidt supra note 319. P. A. Gompers, supra note 324.

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both an incentive compensation system for the entrepreneur (because he shares substantially in the upside of the firm but does not benefit from increasing risk) and as a screening mechanism (because the downside discipline of the preferred debt portion makes the deal unattractive to low quality entrepreneurs)’. Another function of convertible preferred stock is reducing ‘window dressing’ by entrepreneurs. ‘Window dressing’ is a form of signal manipulation which may occur at the start of each new financing round.328 It includes attempts by an entrepreneur to improve shortterm financial performance at the expense of long-term value creation in order to ensure that the project will be refinanced by new or existing investors. Where convertible preferred stock is used, any attempt to engage in ‘window dressing’ simultaneously increases the possibility that existing investors may decide to exercise their options to convert, thus significantly reducing the equity stake of the entrepreneur. Hence, convertible preferred stock may effectively deter future attempts at window dressing. The model constructed by Corneli and Yosha shows that where convertible securities are adopted, the entrepreneur is less likely to engage in signal manipulation. As established earlier, convertible preferred stock establishes an investor–entrepreneur relationship with greater mutual trust, interest alignment, and sustainability. By using convertible preferred stock, Chinese VC funds will have access to alternative financing instruments to protect their interests, and would not be confined to VAMs. However, so long as Chinese law does not permit LLCs to issue preferred stock, any attempt to issue such stock becomes a purely contractual endeavour, making the characteristics and terms of such shares heavily dependent on private negotiations and provisions. This stands in contrast to the mechanisms and rights inherent to convertible preferred stock that guarantee a minimum standard of protection. Further, this means that provisions creating preferred stock need to be made consistent with prevailing regulation before such companies go public, resulting in a somewhat forced conversion into ordinary shares.329 The result of this is that all the potential benefits from the use of convertible preferred stock as analysed earlier would be heavily discounted in Chinese parties’ half-hearted 328

329

F. Cornelli and O. Yosha, ‘Stage Financing and the Role of Convertible Debt’, London Business School Working Paper No. 253–1997 (1998), online: https://ssrn.com /abstract=48581 or http://dx.doi.org/10.2139/ssrn.48581. Interview with Ms Zou Jing, Partner, Grandall Law Firm, 26 April 2019, Shanghai.

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endeavours to contractually ‘recreate’ convertible preferred stock while navigating the various legal obstacles under Chinese law. There are a few potential explanations regarding why Chinese law remains cautious about convertible preferred stock. First, preferred stock, if introduced, will be a new form of financing instrument in China. Given that Chinese investors are relatively inexperienced, any gaps in regulatory oversight may lead to disastrous consequences. Furthermore, legislators are concerned that the use of preferred stock would introduce potential conflicts of interest among different classes of shareholders. As the main participants of the Chinese stock markets are individual retail investors,330 there may be a worry that convertible preferred shareholders will compromise the interests of common shareholders. For example, the conversion of preferred stock into common stock may lead to a decrease in the price of common stock on secondary markets. Hence, these concerns caused a strong backlash against the introduction of convertible preferred stock when the Pilot Measures on Preferred Stock were rolled out in 2014.331 Such concerns may, however, have declined in relevance as the percentage of small retail investors in the A-share market has considerably decreased over the last few years.332 Furthermore, the need to conform with international best practices, facilitate VC financing, and meet the needs of start-up firms provides 330

331

332

The percentage of individual retail investors in the public float of the Chinese A-share market has reached 72 per cent in 2014. See China International Capital Corporation: Percentage of Retail Investors in A-share Market Showing Considerable Decrease, online: https://m.21jingji.com/article/20190702/herald/b39f0f661609f2353cdfafbb8d88b974.html. During the public consultation process leading to the promulgation of the State Council Opinions on Pilot Measures on Preferential Shares (国务院关于开展优先股试点的指导 意见), 429 comments were made in reference to Article 33 on convertible preferred stock in the draft Opinions. Among these, 427 were from retail investors, sharing the sentiment that convertible preferred stock may create the same problem as the non-tradable share reforms, squeezing out common shareholders and causing share prices in secondary markets to plummet. Some retail investors suggested a ban on conversion or a longer lock-out period during which conversion is prohibited. See Pilot Measures on Preferential Shares (CSRC Order No. 97), 优先股试点管理办法(2014年3月21日证监会令第97号), enacted on 21 March 2014, online: China Securities Regulatory Commission www.csrc.gov.cn/pub/ heilongjiang/xxfw/hljflfg/201602/t20160214_291252.htm. By estimation, the percentage of retail shareholding in the overall market capitalisation has decreased from 28 per cent in 2014 to 21 per cent in 2018. Further, the percentage of retail shareholding in the public float has decreased from 72 per cent in 2014 to 53 per cent in 2018. This change in shareholding profile demonstrates a considerable decrease in the ‘retailisation’ of A-share market. See Zhong Jin Corporation: Percentage of Retail Investors in A-share Market Showing Considerable Decrease, https://m .21jingji.com/article/20190702/herald/b39f0f661609f2353cdfafbb8d88b974.html.

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further strong justification for introducing the flexible and useful financing tool that is convertible preferred stock. As a preliminary test, it is suggested that regulators first consider allowing listed companies to issue convertible preference stock.333 The regime can then be adjusted to respond to any teething problems before it is expanded to a wider scope of companies. This is especially because regulators will very soon have to face market demands for the use of convertible preference stock from companies listing on China’s new National Association of Securities Dealers Automated Quotation (NASDAQ)-style tech innovation board (the Science and Technology Innovation Board (STAR Market)), with its focus on tech companies334 that are likely to use this class of stocks. The fact that regulators have begun to experiment with corporate governance solutions through the introduction of dual-class shares on the new board might suggest that there is some hope for reform in the near future. However, it has to be noted that the innovations thus far have been limited to how voting rights are viewed and the position with respect to conversion rights remains unknown.335 It is suggested that legislative measures be expedited to formally acknowledge convertible preferred stock to bring China in conformity with international standard practice. One of the principal issues that comes with the introduction of convertible preferred stock, as discussed,336 is the risk of abuse by a distinct group of corporate controllers, namely preferred shareholders or investors, and whether this group should owe fiduciary duties vis-à-vis other shareholders and/or the portfolio company. Case law in Delaware stands 333

334

335

336

Indeed, Chinese regulators have become more liberal on this issue. The CSRC has recently amended the old Guiding Opinions of the China Banking Regulatory Commission and the China Securities Regulatory Commission on Commercial Banks Offering Preferred Shares to Replenish Tier 1 Capital (No. 12 [2014] of the China Banking Regulatory Commission). Issued in 2019, the new Guiding Opinions of the China Banking Regulatory Commission and the China Securities Regulatory Commission on Commercial Banks Offering Preferred Shares to Replenish Tier 1 Capital (Amended) provides that non-listed banks can on their own motion issue preferred stock if certain conditions are met. ‘China Finalises Rules for New Technology Exchange in Shanghai’, Bloomberg News (2019), online: https://www.bloomberg.com/news/articles/2019-03-02/china-finalizesrules-for-new-technology-exchange-in-shanghai. ‘Why Shanghai’s New Nasdaq-style Tech Board May Be a Game Changer’, The Straits Times (2019), online: www.straitstimes.com/business/companies-markets/whyshanghais-new-nasdaq-style-tech-board-may-be-a-game-changer-0. W. Bratton and M. L. Wachter, supra note 57.

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for the proposition that such duties should be owed.337 However, no such duties are owed by major/controlling shareholders under Chinese law.338 Therefore, if China introduces convertible preferred stock, there may be a corresponding need to introduce fiduciary duties owed by controlling shareholders so as to prevent abuse of convertible preferred stock. However, this is not a simple direct transplantation process as the US law that imposes fiduciary duties on controlling shareholders cannot simply be transplanted to civil law China without analysing how such duties cohere with and are justified by the distinctive legal doctrines in China. First, introducing fiduciary duties owed by controlling shareholders into Chinese law would lead to a significant change to PRC Company Law and involve high legislative costs. Second, such a duty relies heavily on proper interpretation and enforcement by the courts. China is a civil law country where the doctrine of stare decisis does not apply, and it will be difficult to enforce such duties in practice unless the courts in all areas and at all levels are competent enough to appreciate the rationale, scope, and proper application of this fiduciary duty. Nevertheless, this is not an insurmountable problem and the Supreme Court of China may consider issuing judicial interpretations and guiding cases to solve this problem. 337 338

Supra note 57, at p. 1876. Although Article 20 of the PRC Company Law has a functional equivalent and Article 63 of the Code of Corporate Governance has provisions for the fiduciary duties that a controlling shareholder of a listed company owes to the company and other shareholders, the Code itself is not legally binding and cannot be enforced by the court. See also, L. Lin, ‘Code of Corporate Governance: Lessons from Singapore to China’, Company Lawyer, 40(7) (2019), 227–236.

4 Venture Capital Exits

4.1 Introduction The literature dealing with the law of venture capital (VC) has primarily dealt with the following three areas: government intervention and the development of VC markets; VC contracting; and VC exits, the last of which is particularly pertinent to the present chapter. As a preliminary point, five principal VC exit vehicles have been identified by scholars: (1) an initial public offering (IPO), in which a significant portion of the portfolio company is sold in the public market; (2) an acquisition exit, in which the entire firm is sold to a third party (through a sale of shares, merger, or sale of the firm’s assets);1 (3) a secondary sale, in which only the venture capitalist’s shares are sold to a third party (typically a strategic acquirer); (4) a buyback, in which the venture capitalist’s shares are purchased by the entrepreneurial firm itself; and (5) a write-off, in which the venture capitalist walks away from the investment.2 Venture capitalists and entrepreneurs are free to choose the appropriate exit strategy based on their business needs, the firm’s financial condition, and market conditions. Each form of exit has its corresponding advantages and disadvantages, such that a choice of one over another must be made according to an assessment of the particular circumstances in which the deal is made.3 1

2

3

D. J. Cumming and J. G. MacIntosh, ‘Venture-Capital Exits in Canada and the United States’, University of Toronto Law Journal, 53 (2003), 101, at p. 106. D. J. Cumming and J. G. MacIntosh, ‘A Cross-Country Comparison of Full and Partial Venture Capital Exits’, Journal of Banking and Finance, 27(3) (2003), 511, at p. 512. See D. J. Cumming and J. G. MacIntosh, supra note 1 (The paper provides a comprehensive study of the comparative advantages and disadvantages of all forms of VC exits).

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It has been variously established that the exit is of great importance in VC investments to all participants involved – venture capitalists, entrepreneurs, and investors alike.4 For venture capitalists, considering that VC investments are primarily equity investments,5 profit is made only when venture capitalists turn their illiquid stakes in the start-up company into realised returns. As many start-up firms are young and lack the cash flow and profits to pay their investors interest or dividends, most returns come through capital gains.6 Therefore, the means by which venture capitalists can cash out such gains is vital to the profitability of a VC investment.7 Further, apart from money, venture capitalists also invest their management expertise and assistance into portfolio companies, and exiting their investment is important for venture capitalists to be able to recycle their resources and skills into future projects. For entrepreneurs, the exit of venture capitalists may be crucial to regaining control of their companies – given that such control is almost always ceded to some extent to venture capitalists during the investment – or allowing them to reap the financial fruits of their hard work, depending on the exit mechanism in question. Finally, for investors or limited partners, exit events allow them to enjoy the proceeds of their investments or withdraw funds from failed investments for damage control, as the case may be, and perhaps more importantly, provide them with a benchmark against which the relevant venture capitalist’s capabilities and the desirability of VC investments in general can be measured. Among the various exit mechanisms, IPOs seem to receive the most academic attention, with widespread consensus on the strong correlation between a vibrant capital market and an active VC space.8 4

5 6 7 8

See generally B. S. Black and R. J. Gilson, ‘Does Venture Capital Require an Active Stock Market?’, Journal of Applied Corporate Finance, 11 (1999), 36. D. J. Cumming and J. G. MacIntosh, supra note 1, at p. 101. Ibid. Ibid. See B. S. Black and R. J. Gilson, supra note 4; E. B. Rock, ‘Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firms, and US Markets’, Theoretical Inquiries in Law, 2 (2001), 711; P. Gompers and J. Lerner, ‘The Venture Capital Revolution’, Journal of Economic Perspectives, 15 (2001), 145; C. Mayer, K. Schoors, and Y. Yafeh, ‘Sources of Funds and Investment Activities of Venture Capital Funds: Evidence from Germany, Israel, Japan and the UK’, Journal of Corporate Finance, 11 (2005), 586; M. O. Fiedler and T. Hellmann, ‘Against All Odds: The Late but Rapid Development of the German Venture Capital Industry’, The Journal of Private Equity, 39 (2001); L. A. Jeng and P. C. Wells, ‘The Determinants of Venture Capital Funding: Evidence Across Countries’ (1998), https://dx.doi.org/10.2139/ssrn.103948. (They analysed the determinants of VC

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More specifically, it has been theorised that the use of the IPO as an exit option is a necessary pre-requisite for the negotiation of an ‘incentive-compatible implicit contract’ at the time of the investment, under which the entrepreneur will be deemed sufficiently successful so as to regain control of the company, with the venture capitalist correspondingly agreeing to exit and hand back control, if a reputable third party (an underwriter) is willing to underwrite the IPO of the relevant company.9 Such a contract is not possible in private trade sales of venture capitalists’ shares to third parties since venture capitalists’ control simply passes to the acquirer. Acquisitions of the entire company, on the other hand, are a different species since entrepreneurs are willing to give up their companies in those cases and therefore the fundamental premise of the implicit contract (that entrepreneurs value their control) is absent. Thus, IPOs have been the most discussed and most exalted exit option in the VC space. This chapter corroborates and builds upon existing findings traversed above. By analysing the viability of the two broad categories of exit (via IPOs and mergers and acquisitions (M&As)) in China from a legal and regulatory perspective, this chapter affirms the prevailing view that a vibrant capital market is predominantly important for ensuring successful exit of VC investments and thus the overall development of the VC market. In view of this, it identifies several weak points in China’s current capital markets framework that may need to be addressed to further promote VC. This chapter critically evaluates the development of China’s stock markets and the evolving listing regimes, the new stock exchange – Science and Technology Innovation Board (the STAR Market), introduced in 2019 – as well as the recently introduced dual-class stock structure on the STAR Market. Private M&As, on the other hand, are not as popular an exit option (which is consistent with the prevailing view), but this is at least partially attributable to the overly restrictive regulations surrounding private M&As. Accordingly, this chapter argues that such restrictions should be appropriately relaxed to allow the VC market to avail itself of the full benefit of an active private M&A space.

9

for a sample of twenty-one countries and found that IPOs are the strongest driver of VC investing.) B. S. Black and R. J. Gilson, supra note 4.

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Finally, this chapter provides an interesting addition into the discussion of ‘exit’ in VC from the perspective of entrepreneurs by identifying the importance of personal bankruptcy laws in encouraging entrepreneurship, and advocates for the adoption of a debtor-friendly bankruptcy regime in China.

4.2 Exits via IPO 4.2.1 The Importance of Exits via IPO There have been many empirical and theoretical attempts to explore the importance of exits, especially exits via IPO, to the development of VC markets.10 As VC funds have a limited lifespan, successful exits are critical to ensuring attractive returns to venture capitalist investors, and in turn securing subsequent capital from the investors for future VC funds.11 A successful exit is also a key indicator of the venture capitalist’s success. The VC fund often insists on retaining control of the portfolio company to protect itself from the high risk that entrepreneurs may mismanage the company or pursue private benefits.12 Such an arrangement of control is typically reflected in an explicit contract between the VC fund and the portfolio company. For instance, contracts often provide that the fund invests in the portfolio company through convertible preferred stock and enjoys significant control over the company via disproportionate board representation and approval rights for important operating decisions.13 On the other hand, entrepreneurs have the opportunity to regain control from the VC fund by exercising their call options on control upon an IPO. The contract, which functions to transfer control rights, serves as an important performance incentive to the entrepreneurs.14 In order to regain control of the firm, the entrepreneurs

10

11 12 13

14

B. S. Black and R. J. Gilson, ‘Venture Capital and the Structure of Capital Markets’, Journal of Financial Economics, 47(3) (1998), 243; M. D. Rin, G. Nicodano, and A. Sembenelli, ‘Public Policy and the Creation of Active Venture Capital Markets’, Journal of Public Economics, 90 (2006), 1699. B. S. Black and R. J Gilson, ibid., at p. 257. Ibid., at pp. 258–259. Ibid., at pp. 259–261. Upon IPO, special control rights given to the VC fund would disappear, as the convertible preferred stocks held by the fund will be converted to common stock at the time of the IPO, as stipulated in the contract. B. S. Black and R. J Gilson, supra note 10, at pp. 259–260.

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need to prove their management skills and provide evidence that they can be trusted with the capital provided by the VC fund.15 The viability of this implicit contract in turn depends on the viability of an IPO exit strategy.16 Other exit strategies such as a trade sale of the whole portfolio company to another buyer or a secondary sale of a portion of the shares to a third party will not help the entrepreneur regain control of the firm, and thus do not incentivise the entrepreneurs in the same way. Further, IPO exits provide more incentive to entrepreneurs to ensure the firm succeeds, as compared to other exit vehicles. First, IPOs are potentially the most profitable option for a portfolio company.17 Empirical studies also show that innovative and profitable ventures are more likely to go public.18 Thus, entrepreneurs and their investors have good reasons to work towards IPOs. Second, unlike acquisitions or secondary sales, which are usually constrained by buyer availability, IPOs are typically always possible provided that the firm is sufficiently successful and profitable. Finally, such success requirements further encourage entrepreneurs to properly manage and grow the company. In contrast, secondary sales and write-offs do not necessarily require a firm to be successful or profitable. In short, the profitability of IPOs, and the fact that going public is contingent on the firm’s success, foster strong motivations for entrepreneurs and investors.

4.2.2 The Preference for IPOs in China As shown in Table 4.1, IPO has been the most popular exit channel for VC-backed firms in China. Share buybacks, for instance, are usually only opted for either when exits cannot be done via IPO or M&A, or when the portfolio company no longer wishes to be controlled by the venture capitalist.19 This is unsurprising given that share transfers and share buybacks usually mean relatively lower

15 16 17

18 19

Ibid., at p. 259. Ibid. Ibid., at p. 257; A. Schwienbacher, ‘Innovation and Venture Capital Exits’, The Economic Journal, 118 (2008), 1888, https://dx.doi.org/10.2139/ssrn.46909. Schwienbacher, supra note 17. Interview with Ms Shao, Legal Counsel, Gaorong Capital, 29 October 2015, Beijing; interview with Ms Kang, Partner, Global Law Firm, 29 October 2015, Beijing.

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Table 4.1 Number of exits via IPO, M&A, and share transfer for VCbacked companies, as well as the corresponding amount of new capital committed to VC funds in China (2006–2018)

Methods of exit Year

IPO22

M&A

Share transfer23

Total number of exits20

2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006

396 470 277 257 172 33 144 312 331 82 43 100 30

128 148 155 280 111 76 31 55 24 6 6 13 25

322 360 223 197 70 58 44 41 20 24 27 12

1,050 1,420 2,001 1,813 444 230 246 456 388 123 135 142 100

Amount of new capital committed to VC funds (in RMB billion)21 858.834 768.135 623.055 396.117 325.815 319.777 317.777 306.218 220.645 188.153 166.604 155.763 149.037

Source: Zero2IPO24 and ChinaVenture25

rates of return on the investments. Moreover, there are relatively more legal restrictions on share buybacks under Chinese law.26 Further, write-offs are naturally reserved as a method of last resort for VC funds. 20

21

22

23 24 25 26

This total figure includes management buyouts and share buybacks but excludes the NEEQ listings. Zero2IPO: Annual Research Reports on Venture Capital in China, https://m.pedaily.cn /news/440424. In this table, the IPO figure only refers to exits by VC-backed companies going public on the Chinese stock market. It does not include IPO exits via overseas markets. ‘Share transfer’ excludes management buyouts and share buybacks. For the data from 2008 to 2018. For the data from 2006 to 2007. Article 142 of the Companies Law of the People’s Republic of China provides the situations under which a company can buy back their own shares. Also, in practice, it is difficult for unlisted companies to obtain bank loans for share buybacks.

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Table 4.2 Number of exits via IPO and M&A for VC-backed companies, as well as the corresponding amount of new capital committed to VC funds in the United States (2004–2018) Methods of exit Year

IPO

M&A

Amount of new capital committed to VC funds (in USD billion)

2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004

85 58 43 79 125 87 62 44 41 11 12 90 60 58 81

779 827 845 941 953 813 813 694 663 469 475 533 473 446 402

53.8 34.3 41.1 39.0 35.5 20.6 24.4 26.3 19.9 11.9 31.5 34.9 33.4 23.0 17.4

Source: National Venture Capital Association27

However, in the US, a greater proportion of VC exits occur via an M&A than an IPO (See Table 4.2). In 2018, the US venture capital industry saw 85 exits via an IPO and 779 exits via an M&A. From 2006 to 2018, only 936 VC-backed IPOs took place – roughly one-tenth of the 10,126 VC-backed M&A exits in the same period. Two major reasons spanning the legal, economic, and cultural dimensions can be proffered to explain the investor preference for IPO over M&A as an exit option in China, particularly during 2011 and 2012.28

27

28

See National Venture Capital Association Yearbooks (2019), online: National Venture Capital Association, https://nvca.org/wp-content/uploads/2019/08/NVCA-2019Yearbook.pdf. L. Lin, ‘Venture Capital Exits and the Structure of Stock Markets: Lessons from China’, Asian Journal of Comparative Law, 12(1) (2017), 1, at pp. 11–14.

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First, exits of VC investments via IPOs tend to give high returns in China.29 As of 31 December 2015, the average price-to-earnings ratio (P/E ratio) of A-shares on the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) were 17.61 and 53.34, respectively – far higher than the average of 9.88 for shares listed on the Hong Kong Exchanges and Clearing Market (HKEx) Main Board.30 The P/E ratio for the SME Board and the ChiNext Board were even higher, at 68.0631 and 109.01,32 respectively. In fact, the SME Board’s highest P/E ratio in 2015 was 85.65,33 while the ChiNext Board’s was a staggering 146.57.34 In addition, a study of Chinese IPO initial returns found that the average IPO initial return was 66 per cent, with 14–22 per cent being attributed to under-pricing, and 44–53 per cent due to overvaluation.35 Thus, the high returns from selling shares after listing make IPOs an attractive option.36 Second, the preference for IPOs may be explained by cultural factors.37 Chinese entrepreneurs can frequently be very attached to their companies and therefore unwilling to relinquish control in an M&A.38 This is particularly prevalent in VC-backed start-ups with relatively concentrated shareholding structures (in contrast to the diversified shareholding of large public companies).39 It is thus more difficult for outsiders to acquire the whole start-up by a tender offer. Moreover, in acquisition situations, a strategic buyer would usually make the target company a wholly owned subsidiary or a separate division of the strategic buyer in order to produce synergistic gains,40 such as by integrating the target 29 30

31

32

33 34

35

36 37 38

39 40

Ibid., at p. 11. Hong Kong Stock Exchange, ‘Market Highlights’, (China Stock Markets Web, 2016), www.hkex.com.hk/Market-Data/Statistics/Consolidated-Reports/HKEX-MonthlyMarket-Highlights?sc_lang=en Shenzhen Stock Exchange, ‘Small and Medium Enterprise Board’ (Shenzhen Stock Exchange, 2015), http://sme.szse.cn/. Shenzhen Stock Exchange, ‘ChiNext’ (Shenzhen Stock Exchange, 2015), http://chinext .szse.cn. SZSE, ‘Small and Medium Enterprise Board’, supra note 31. SZSE, ‘ChiNext’, supra note 32. There are various reasons for high P/E ratios in China, including the merits-based system of IPO and speculation by the investors. S. Song, J. Tan, and Y. Yi, ‘IPO Initial Returns in China: Underpricing or Overvaluation?’, China Journal of Accounting Research, 31 (2014), 47. L. Lin, supra note 28, at p. 11. Ibid., at p. 13. Telephone interview with Mr Shao, Partner, Yuantai Law Firm, 22 December 2015, Shanghai. L. Lin, supra note 28, at p. 13. D. J. Cumming and J. G. MacIntosh, ‘Venture-Capital Exits in Canada and the United States’, supra note 1, at pp. 106–107.

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company’s products and technologies.41 In doing so, the strategic acquirer faces difficulties in reconciling the target company’s corporate culture with that of the parent company. The acquirer may also find it difficult to exert influence on the existing employees of the target company.42 Considering these difficulties, the number of strategic buyers who wish to acquire VC-backed companies in China is limited.43

4.2.3 Correlation between Stock Market and VC-Backed IPOs Extensive academic literature44 has found a strong correlation between the size and liquidity of a country’s stock market and the level of activity of its VC market.45 The connection between the two markets has also been observed empirically in Europe46 and more generally around the world.47 In particular, Black and Gilson contend that the vibrancy of the VC market is dependent on the presence of an active stock market through which the venture capitalists can exit from a successful portfolio company via IPO.48 Initial public offerings enable the venture capitalists to exit from the VC investment while leaving the entrepreneurs in control of the start-up.49 The option of an IPO exit is necessary for the negotiation of an incentive-compatible implicit contract at the time of the VC investment.50 Black and Gilson have also argued that the VC industry tends to be stronger and more vibrant in stock market-centred

41 42 43 44 45 46 47

48 49 50

Ibid. L. Lin, supra note 28, at p. 13. Telephone interview with Ms Kang, Partner, Global Law Firm, 22 December 2015. Supra note 8. L. Lin, supra note 28, at pp. 2–3. M. Da Rin, G. Nicodano, and A. Sembenelli, supra note 10, at p. 1699. Jeng and Wells find the strength of the IPO market to be an important fact in determining venture capital commitments. See L. A. Jeng, and P. C. Wells. ‘The Determinants of Venture Capital Funding: Evidence across Countries’, Journal of Corporate Finance, 6 (2000), 241–289. S. Bonini and S. Alkan, ‘The Political and Legal Determinants of Venture Capital Investments around the World’, Small Business Economics, 39 (2012), 997. This study analyses data from sixteen countries around the world using new statistical methods and has found evidence confirming La Porta, Lopez-de-Silanes, Shleifer, and Vishny’s (‘LLSV’) hypothesis. B. S. Black and R. J. Gilson, supra note 4. E. B. Rock, supra note 8, at p. 713; B.S. Black and R. J. Gilson, supra note 4, at p. 2. Ibid.

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systems like the US, relative to countries like Germany and Japan that are bank-centred.51 One of the author’s articles has also confirmed the correlation between the number of VC-backed IPOs and the liquidity of the stock market in China.52 On one hand, continuous regulatory improvements to China’s stock market since 2008 have contributed significantly to the growth of VC fundraising. For example, after the long-awaited secondary board – the ChiNext board – was finally established in October 2009, both the number of newly established VC funds and the amount VC funds raised doubled in 2011. On the other hand, numerous IPO suspensions have led to freeze-ups in China’s VC market.53

4.2.4 Understanding China’s Stock Markets Unlike the US where the stock market was developed since the 18th century,54 the Chinese stock market was established in 1990 after the two stock exchanges – SSE and SZSE – were established (See Figure 4.1 for the development of China’s stock markets). The establishment of the stock market offered new exit channels for VC investments in China. Since then, China’s stock market has rapidly grown in size and liquidity. As of March 2020, the two main stock exchanges, that is, the SSE and the SZSE, were worth more than USD 8.49 trillion, collectively, with the SSE being the second largest stock exchange in Asia and the fifth in the world by market capitalisation.55 In light of the difficulties SMEs face in being listed on the Main Boards, the SME Board was launched on 17 May 2004 to provide a new financing channel for the SMEs. However, its stringent listing requirements are almost the same as those of the Main Boards.56 In a bid to build a multi-layered capital market by setting up a new secondary board in China, the ‘ChiNext’ (a portmanteau of the phrase ‘China Next’, also known as the Growth Enterprise Board or chuang51 52 53 54

55

56

B. S. Black and R. J. Gilson, supra note 10, at p. 243. L. Lin, supra note 28. Ibid., at p. 3. S. Banner, ‘The Origin of the New York Stock Exchange, 1791–1860’, The Journal of Legal Studies, 27(1) (1998), 113. See data from the World Exchange Foundation (date as of March 2020): List of Exchanges, online: TradingHours.com, www.tradinghours.com/exchanges, accessed 27 March 2020. L. Lin, supra note 28, at p. 20.

Main Boards SME Board

Blue-Chip Enterprises Small and Mid-size Enterprises with Stable Growth

ChiNext STAR Market National Equities Exchange and Quotations

Technology Growth Enterprises Strategic High-Tech Innovative Enterprises

SZSE SZSE SSE

Innovative High-Growth Enterprises

Regional Equities Exchange Markets

Figure 4.1

SSE, SZSE

China’s multi-layered capital markets

Other Small and Medium Enterprises

Over-the-counter Markets

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yeban), was officially launched on 30 October 2009 on the SZSE.57 The ChiNext Board specifically aims to attract firms in the highgrowth and high-tech sectors and meet pent-up demands from SMEs facing difficulties in securing financing. The ChiNext Board provides more relaxed listing requirements compared to the Main Boards and the SME Board.58 The National Equities Exchange and Quotation (NEEQ) system, more commonly known as the New Third Board (xinsanban), is a national overthe-counter (OTC) market in China.59 The NEEQ differs from the other Chinese stock exchanges in terms of targeted companies, trading rules, and investor eligibility. In particular, the NEEQ is targeted at ‘innovationoriented, entrepreneurial, and growing medium, small and micro-sized businesses’, rather than more mature companies. Further, NEEQ has a much higher investor eligibility requirement – companies quoted on the NEEQ are unable to offer securities to the public, but only to specific qualified investors.60 Today, the concept of ‘stock market’ broadly includes the two Main Boards on SSE and SZSE, the SME Board, the ChiNext Board, the NEEQ,61 STAR Market, and other regional equity markets that feature in the multi-tiered capital market system in China (See Table 4.3). Given the increasing demands from a large number of SMEs, start-ups and entrepreneurs, the Chinese Securities Regulatory Commission (CSRC) has taken substantive steps to improve the regulatory environment of the stock market, particularly in creating a multi-layered capital market (duocengci ziben shichang) (see Figure 4.1). The launch of the

57 58 59

60 61

Ibid., at p. 20–21. See Table 4.3 of this chapter. The NEEQ’s origins can be traced back to 2001 when the ‘Proxy Equities Exchange and Quotation system’ (‘PEEQ’, also known as guquan daiban zhuanrang xitong) was set up in 2001. PEEQ was set up to provide a platform for companies delisted from the Main Boards as well as for former Securities Trading Automated Quotation (‘STAQ’) and National Exchange and Trading System (‘NET’) companies to transfer their equities. The PEEQ was called the ‘third’ board because it was the third stock exchange when it was developed in 2001, after the Main Boards (the SSE and the SZSE) and the SME Board. The PEEQ was named the ‘New Third Board’ in 2006 as part of a trial OTC programme involving only a few high-tech enterprises in Beijing’s Zhongguancun Science Park. In 2012, the pilot programme was expanded to include high-tech zones in Shanghai, Zhangjiang, Wuhan Donghu, and Tianjin Binhai. In 2013, the pilot programme was again expanded to cover all qualified companies nationwide and the NEEQ was officially launched. See L. Lin, supra note 21, at p. 24. L. Lin, supra note 28, at p. 28. NEEQ is not identical to a normal stock exchange like the SSE and the SZSE. See L. Lin, supra note 28 at Part VI(A) for detailed discussion.

Table 4.3 China’s stock markets: a comparison62 Main Boards

SME Board

ChiNext

NEEQ

STAR Market

Market Type Type of Entities Listed Listing Regime

Exchange Big mature companies Approval-based

Exchange Mid-sized companies Approval-based

Exchange High-growth innovative SMEs Registration-based63

OTC Non-listed companies

Duration

Three years

Three years

Two years

Profitability Requirement

Profitable for three consecutive accounting years with cumulated net profits exceeding 30 million RMB,

(1)

Three years (before registrationbased IPO) Cumulative revenue for the past two accounting years not lower than 10 million RMB except for those whose revenue is

Exchange High-tech innovative highgrowth companies Registration-based, where the SSE conducts review, and the CSRC decides whether to allow registration within twenty days Three years

62 63

Profitable for two consecutive years with cumulated net profits exceeding 50

Registration-based

5-tiered listing requirements based on market capitalisation for companies that fall within the objectives of the STAR Market, are not yet profitable

The table is made by the author based on the listing rules of China’s stock market as of July 2020. The registration-based IPO was introduced to the ChiNext Board on 27 April 2020.

Table 4.3 (cont.) Main Boards with the exemption of ‘Enterprises under the Pilot Programme’ identified by the CSRC or cumulated revenue exceeding 300 million RMB

SME Board

(2)

(3)

million RMB; for companies with a predicted market capitalisation not lower than one billion RMB, profitable for the past year with cumulative revenue exceeding 100 million RMB; for companies with a predicted market capitalisation not lower than five billion RMB,

ChiNext lower than 10 million RMB because of long research processes but whose net assets for the last financial period are nevertheless not lower than 30 million RMB

NEEQ or have uncovered deficits: (1) for companies with a predicted market capitalisation not lower than one billion RMB, profitable with cumulated net profits not lower than 50 million RMB for the last two years or profitable for the last year with revenue not lower than 100 million RMB; (2) for companies with a predicted market capitalisation not lower than 1.5 billion RMB, past year revenue not lower than 200 million RMB and total research

STAR Market

past year revenue not lower than 300 million (last limb only effective from 12 June 2021 onwards). Requirement modified for red-chip enterprises and companies with differential voting rights Cash Flow Requirement

Overall cash flow from business activities for the past three accounting years

Nil

(3)

Continuous operational records are kept with respect to business activities carried

(4)

expenditure constituting no less than 15 per cent of revenue for the last three years; for companies with a predicted market capitalisation not lower than two billion, past year revenue not lower than 300 million RMB and net cash flow arising from business activities for the past three years not lower than 300 million RMB; for companies with a predicted market capitalisation not

Table 4.3 (cont.) Main Boards exceeds 50 million RMB

SME Board

ChiNext

NEEQ

out in the relevant accounting year; no gratuitous transactions (5)

lower than three billion RMB, past year revenue not lower than 300 million RMB; for companies with a predicted market capitalisation not lower than four billion RMB, main business of the company approved by relevant authorities; company operates in a market with considerable potential and has achieved initial success; wellknown institutions have invested a certain amount in the company; for biomedical companies, at least one

STAR Market

Net Assets Requirement

Intangible assets constituting not more than 20 per cent of total net assets and no uncovered deficits over the last financial period, with the exemption of ‘Enterprises under the Pilot Programme’ identified by the CSRC

Net assets not less than 20 million RMB and no uncovered deficits for the last financial period, with the exemption of ‘Enterprises under the Pilot Programme’ identified by the CSRC

Net assets per share not lower than one RMB per share

approval for Phase II testing of Category I New Drug is obtained and other companies should possess equivalent technical strength and fulfil relevant criteria

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various new boards moved China’s stock market a step closer to the market-oriented model. It has greatly facilitated financing for VC-backed companies by offering them more exit channels via IPOs.

4.2.5 The Current State of IPO Reform China’s IPO regime has long been subject to tight administrative controls, which are commonly blamed for distorting the capital market and encouraging corruption among officials.64 Because of China’s unique political and institutional infrastructure, its two Main Boards (the SSE and the SZSE) are not state-independent and lack autonomy in selfregulation.65 Under the merit-based regulatory system, many aspects of securities offering are heavily regulated, thereby significantly hampering the efficiency of the capital market and the operation of market forces. Due to difficulties with listing on China’s Main Boards, many Chinese companies, especially high-growth and internet companies, have chosen to turn to overseas capital markets.66 To address these issues, China’s IPO system has undergone a series of reforms since the 1990s.67 The first system implemented in China was a strictly planned ‘Quota Management’ system (e du guanli)68 from 1993 to 1995, under which the issuer must first obtain share issue quotas from local governments or central ministries.69 The CSRC would review the 64

65

66 67 68

69

B. L. Liebman and C. J. Milhaupt, ‘Reputational Sanctions in China’s Securities Markets’, Columbia Law Review, 108 (2008), 929, at p. 931 and p. 939. (That Chinese Main Boards have long been blamed as underdeveloped and less functional because of weak investor protection, weak enforcement, inefficient pricing, accounting fraud, market manipulation, and poor disclosure.) Ibid., at 931–935. Since the two stock exchanges were established in 1990, the Chinese stock market has developed alongside economic reform and served specific political missions, such as the privatisation of SOE and the stimulation of investment sentiment amongst the public. L. Lin, supra note 28, at p. 19. For more information on the evolution of IPO in China, see L. Lin, supra note 28. On 25 April 1993, the State Council of the People’s Republic of China issued the Gupiao Faxing yu Jiaoyi Guanli Zanxing Tiaoli (股票发行与交易管理暂行条例) [Provisional Regulations on the Administration of Share Issuance and Trading] (promulgated by the China Securities Regulatory Commission, 22 April 1993, effective 22 April 1993), signaling the official establishment of the administrative approval system. People’s Governments of the province, autonomous regions, municipality directly under the Central Government, or municipality listed separately under the State plan (collectively referred to as the ‘local governments’).

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approved stock issuance application and decide the volume, issuing price, and other details of the shares to be issued.70 From 1996 to 2000,71 the IPO system transitioned into the ‘IPO Number Management’ (zhibiao guanli) system. The CSRC would set a quota for the number of IPOs for relevant local authorities to adhere to.72 These local bodies would then recommend pre-selected enterprises for listing, subject to review and approval by the CSRC and State Council Securities Committee (SCSC).73 In 2001, the ‘Channel System’ (tongdao zhidu) was established.74 Each securities firm could only recommend a certain number of companies to apply for IPOs, with the quota to be obtained from the CSRC. Only when a recommended issuer was approved, could the next recommendation be made. Therefore, the number of IPOs was still controlled. However, compared to the previous systems in which the issuers were administratively selected, underwriters were granted the right to recommend issuers and accordingly would bear the risks of an IPO’s success or failure to some extent.

70

71

72

73

74

CSRC, ‘Woguo Gupiao Faxing Shenhe Zhidu de Yanjinlicheng’ (我国股票发行审核制 度的演进历程) [The Evolution of the Approval System of Securities Issuance in China] (China Securities Regulatory Commission, 3 July 2013), www.csrc.gov.cn/pub/newsite/ ztzl/xgfxtzgg/xgfxbjcl/201307/t20130703_230251.html. In 1996, the SCSC published the ‘Guanyu 1996 nian Quanguo Zhengquan Qihuo Gongzuoanpai Yijian de Tongzhi’ (国务院证券委员会关于 1996 年全国证券期货工 作安排意见的通知) [Opinions on Work Arrangements for the National Securities and Futures Market in 1996] (promulgated by the State Council, 2 September 1996, effective 2 September 1996). CSRC, ‘The Evolution of the Approval System of Securities Issuance in China’, supra note 70. In 1999, the CSRC issued the ‘Guanyu Jinyibu Wanshan Gupiao Faxing Fangshi De Tongzhi’ (关于进一步完善股票发行方式的通知) [Circular on the Improvement of the Share Issuance Work] (promulgated by the China Securities Regulatory Commission, 28 July 1999, effective 28 July 1999), No 94, which implemented an additional administrative procedure to examine pre-selection materials for enterprises applying for an IPO. The CSRC would take over the role of pre-selecting enterprises recommended by local governments or departments in charge of central enterprises. This procedure in turn changed the simple old practice of local recommendations under the two-level administrative review system, and ushered in an examination mechanism prior to any formal selection. On 17 March 2001, the CSRC announced the abolition of the administrative approval system for stock issuance and the official implementation of the channel system, which was characteristic of the qualification approval system for stock issuances. On 29 March 2001, the Securities Association of China offered detailed explanations for the ‘Channel System’.

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From 2004 until now, the ‘Sponsorship System’ (baojian zhidu)75 has been used, under which certified sponsors may recommend companies for stock issuance and listing. Sponsors are required to instruct, assist, and guide companies on information disclosure, and to guarantee that all financial information provided in the IPO prospectus is true.76 The Sponsorship System reinforces the responsibility and accountability of the sponsors,77 though the power to approve IPO applications is still vested with the CSRC. The year 2015 saw a significant move in orienting China’s stock market towards market demands. On 20 April 2015, the draft bill of the Securities Law of the People’s Republic of China was published, which specified the new registration system for stock issuing and listing. On 27 December 2015, the Standing Committee of the National People’s Congress approved a proposal to revamp the IPO system, authorising the State Council to implement changes to the system in March 2016.78 The major feature and key objective of the new registration system is the shift away from an administrative regime towards a market-driven one in allocating resources. Presently, IPO applications are subject to the CSRC’s approval. Under the new system, however, financial intermediaries, instead of the CSRC, will be primarily responsible for the substantive verification of such applications.79 Under the registration system, the main role of the stock exchanges is to assess the ‘completeness, consistency, and intelligibility’ (qibeixing, yizhixing, kelijiexing) of application materials submitted by issuers. The completeness requirement mainly refers to whether the contents, scope,

75 76 77 78

79

Ibid. Ibid. Ibid. CSRC, supra note 70. Further, in the ‘Zhengjianhui Guanyu Jinyibu Tuijian Xingufaxing Tizhigaige de Yijian’ (证监会关于进一步推荐新股发行体制改革的意见) [Opinion on Further Promoting the IPO System Reform] (promulgated by the China Securities Regulatory Commission, 30 November 2013, effective 30 November 2013), the CSRC announced that, under the registration-based IPO system, it would focus on the compliance review of the new listing candidates without assessing the profitability of the IPO companies. The timing of new share issuances and the question of how to issue shares will be determined by the market, in the hope that the valuations of new share offerings will better reflect market demand and supply. Q. Q. Du, ‘Zhucezhi Hexinneirong Shoudu Gongkai: Xize yi Jiben Chengxing’ (注册制核心 内容首度公开 细则已‘基本成型’) [The Framework of the Registration System is Confirmed]’ First Financial Daily (29 June 2015), www.yicai.com/news/4638100.html.

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and degree to which the materials have satisfied disclosure rules and provided necessary and sufficient information for investors to make informed decisions.80 The consistency requirement concerns the reasonableness of the operating conditions of the enterprise as disclosed, the logicality of financial statements articulated, and the level of corroboration by financial and non-financial data.81 Finally, the intelligibility requirement requires that the language and expression of submitted materials be succinct and understandable.82 Upon completing the review of the application materials, if the stock exchange deems the application acceptable, it will issue a favourable opinion and submit this, with the application materials, to the CSRC for registration.83 The CSRC will then validate the registration within a prescribed timeframe unless a dissenting opinion is issued by the stock exchange.84 Since November 2016, IPO approvals by the CSRC have increased in frequency from twice per month, to four times every month. Importantly, IPO approvals have begun to emphasise stringent scrutiny of the completeness, authenticity, and effectiveness of IPO information. At the same time, less weight is being placed on the issuer’s substantive judgment on the value of the investment, which has significantly improved the efficiency of the audits, shortening the queuing time for an IPO from an average of 3 years to 1.5 years. This has been instrumental in solving the problem of a congested IPO market in China; and by raising the efficiency of IPOs, it has also lowered the cost of IPOs. This is one of the most tangible benefits of having a new registration system.85 However, as the registration system has not been fully implemented in all the stock markets in China as of 1 June 2020, it is still an open question whether the new registration system can fundamentally rid itself of administrative interference in the capital market, given that the degree of administrative intervention in China’s capital market has always been prominent.86

80 81 82 83 84 85

86

Ibid. Ibid. Ibid. Ibid. Ibid. D. X. Dong, ‘IPO Zhucezhi Gaige YizhiZaiLushang’ (IPO 注册制改革一直在路上) [IPO Registration Reform has been in continuous progress] (26 February 2018), Caixin Global, online: http://opinion.caixin.com/2018-02-26/101214025.html. On 24 February 2018, at the 33rd Meeting of the 12th Standing Committee of the National People’s Congress, it was decided that the deadline for reform and launch of registration-based IPOs would be extended by two years. When addressing the reasons

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4.2.6 Launch of the ‘STAR Market’ In May 2014, the State Council issued a statement regarding the development of the capital markets so as to accelerate the development of innovative start-up companies.87 In November 2018, President Xi Jinping announced that China would create the STAR Market for start-ups to raise capital.88 On 1 March 2019, the CSRC issued its Measures for the Administration of the Registration of IPO Stocks on the Science and Technology Innovation Board (for Trial Implementation) and Measures for the Continuous Supervision of Companies Listed on the Science and Technology Innovation Board (for Trial Implementation). The first batch of companies listed on the STAR Market started trading on 22 July 2019.89 The official purpose of the STAR Market is ‘to embrace global cuttingedge technology, to boost the mainstream economy and to answer to the fundamental needs of national development’. The STAR Market aims to serve technology enterprises that are, first, of strategic importance to the country; second, technologically advanced in key areas such as newgeneration information technology, materials, energy and biochemicals; and, third, well-received by the market.

4.2.6.1 Eligibility for Listing on the STAR Market For the first time in the history of Chinese capital markets, the STAR Market imposes no requirement on intangible assets and allows pre-

87

88

89

for proposing to extend the deadline, the CSRC stated that there are still many existing problems in China which make introducing a registration-based IPO system difficult. State Council, ‘Opinions of the State Council on Further Promoting the Sound Development of Capital Markets’ (No. 17 [2014] of the State Council ) (国务院关于进一步促进资本市 场健康发展的若干意见) (国发 [2014]17号). S. D. Zhang, ‘Shanghai to create a tech board for start-ups, unicorns to raise capital, upping the ante with Nasdaq and Hong Kong’, South China Morning Post (5 November 2018), www.scmp.com/business/companies/article/2171706/shanghai-create-tech-board -start-ups-unicorns-raise-capital. CSRC, ‘Kechuangban Shoucigongkai Faxing Gupiao Zhuce Guanlibanfa (Shixing) ‘ (《科 创板首次公开发行股票注册管理办法(试行)》(中国证监会第 153 号令)) [Measures for the Administration of the Registration of IPO Stocks on the Science and Technology Innovation Board (for Trial Implementation) Order No. 153 of the CSRC] (China, 1 March 2019), www. csrc.g ov. cn/pub/newsite/flb/flfg /bmgz/fxl/201906/ t20190627_358165.html, CSRC, ‘Kechuangban Shangshigongsi Chixujianguan Banfa’ (《科创板上市公司持续监管办法(试行)》(证监会令[第 154 号] )) [Measures for the Continual Supervision and Regulation of the Science and Technology Innovation Board (for Trial Implementation) Order 154 of the CSRC] (China, 1 March 2019), http://img .project.fdi.gov.cn//21/1800000121/File/201903/201903040937404447147.pdf.

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revenue companies and companies with uncovered deficits to be listed if certain conditions are met. As for specific listing requirements, the STAR Market adopts a five-tiered approach centred on predicted market valuation (See Table 4.3): the higher the market valuation is, the more relaxed other financial requirements are and vice versa. Notably, if one’s predicted market valuation is equal to or exceeds 4 billion RMB, it does not need to meet any minimum profit threshold to be listed; instead, the only requirements are that the main business of the company is approved by the relevant authorities, the company operates in a market with considerable potential and has achieved initial success, and well-known institutions have invested a certain amount in the company. These flexible indicia are beneficial for companies operating in industries that require substantial up-front capital investment but show slow returns. However, to the extent that there may be practical difficulties in interpreting terms like ‘predicted market valuation’ and ‘well-known institutions’, more clarification is required. Separately, based on the shareholding structure of companies that seek to get listed, different requirements are imposed on companies with an ordinary shareholding structure (single class shares), a special shareholding structure (shares with weighted voting rights), and red-chip companies that are not listed overseas. Additionally, any company that seeks to list on the STAR Market needs to fulfil the following four criteria: (1) continuous operations for at least three years; (2) a minimum post-IPO share capital of 30 million RMB; (3) new shares issued in the IPO consisting at least 25 per cent of the total share capital (if the share capital exceeds 400 million RMB, the proportion of IPO shares shall be at least 10 per cent); and (4) the legal representatives, directors, supervisors, and executives of the company must have acted lawfully and with integrity in the last three years. Many tech companies face serious difficulties in obtaining funding because of the nature of their life cycle – tapping on cutting-edge technology to support new business ideas, they require substantial funding at the initial stage of their life cycle, but may take significantly longer than companies in traditional industries to produce a workable product, earn profits, and access traditional capital markets. In this regard, the STAR Market has addressed a real need for financing among promising sci-tech companies.

4.2.6.2 Listing Procedures As compared to existing capital markets in China (See Figure 4.2 for the IPO review process of the Main Boards), the STAR Market adopts a more efficient listing regime (See Figure 4.3). Listings are reviewed by the SSE

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Receipt of Application

Feedback Committee

Preliminary Disclosure

Figure 4.2

Preliminary Review Committee

Feedback Issued

Issuance Appraisal Committee

Closing of Files

Opinion Issued (if any)

Approval for Listing

Submission of PostReview Required Documents (if any)

Current IPO review process

and registered by the CSRC. As of now, the review process is estimated to take about six to nine months; if approved by the SSE, the CSRC will complete the registration process within twenty working days thereafter. This timeline is considerably shorter than the one-year review period of other A-share markets. Further, the STAR Market is the first exchange to adopt a registration-based listing regime; in contrast,90 the Main Boards, and the SME Board are approval-based as of the date of the book. The purpose of the experimentation with a registration-based listing regime in the STAR Market is to de-bureaucratise the A-share primary markets. In contrast to the Main Boards, the STAR Market relies less on regulatory authorities to review and evaluate applicants and more on the market to make judgment calls. More emphasis is placed on the quality, consistency, and accessibility of information and documents disclosed by the issuers and intermediaries. As mentioned above, two steps are involved in the listing process. First, the issuer submits the required documents to the SSE for review. Second, after the SSE grants approval, it relays the submitted documents to the CSRC together with its opinion and review documents for CSRC registration. Whether the CSRC will nevertheless apply to some extent its logic of substantive review as practised in the approval-based regimes in the STAR Market process remains to be seen. Also, unlike the Main Boards, regulators will not issue administrative orders to suspend IPOs in the STAR Market. Considerable under-pricing can be observed in IPOs in the Chinese A-share market. This is attributable to the following reasons: high barriers to entry under the approval system; significant price differentials between primary and secondary markets; and post-IPO speculations. As prospective buyers tend to offer higher prices in order to be allotted shares in the IPO process, the price of IPO shares surged in 2009 when the CSRC first implemented market-based IPO pricing. Since 2014, IPO pricing has been once again restricted, with the benchmark price being 90

See Table 4.3 of this chapter.

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Preliminary Communication

Supplementary Materials

Submission of Application

No later than 30 days Review of Materials

Within 5 working days Application Rejected

Application Processing

Preliminary Disclosure

Same day

Within 20 working days Appeal

First Round of Inquiries

Subsequent Rounds of Inquiry

Within 10 working days of response

Review Request Issued

Review by Listing Committee

Opinion Issued

Application Rejected

Application Approved

Appeal

Handover to CSRC for Registration Review

Hearing

Within 3 months of application

Review

Within 20 days Registration Denied

Registration Allowed Within 6 months

Appeal

Figure 4.3

IPO

IPO process of the STAR market

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twenty-three times of the P/E ratio. In contrast, under the rules of the STAR Market, institutional investors play a major role in IPO pricing. Parties allowed to participate in the IPO book building process are limited to professional institutions falling within seven specific categories, including securities, companies, and fund companies. At the same time, information and risk disclosure of offline offers is strengthened in order to promote sufficient price discovery, increase the proportion of offline placements and lower online subscription. IPOs in the STAR Market do not face the upper price limit of twenty-three times of the P/ E ratio, nor are they subjected to administrative regulations pertaining to the scale of fundraising. The STAR Market has instituted a ‘co-investment’ regime for trial implementation, where sponsor subsidiaries utilise their own funds to co-invest in 2 per cent to 5 per cent of the IPO shares for a lock-up period of two years. By committing the assets of financial intermediaries to the IPO, the extent to which issuers’ interests and main underwriters’ interests overlap can be reduced, thus ameliorating the occurrence of overpricing. At the same time, co-investment incentivises securities service providers to be more cautious before making an underwriting decision, strengthen their financial, investigative, and regulatory compliance capabilities, and reduce short-termism. The STAR Market also encourages strategic investors and the relevant issuers’ management personnel and key employees to participate in strategic placements to inject additional stable streams of capital into the market. To this end, several rules are put in place: (1) the requirements in relation to strategic placements are relaxed; for example, placement to strategic investors is allowed for IPOs exceeding 100 million shares. (2) A green-shoe mechanism is introduced where the issuer and the main underwriter can adopt over-allotment options in their IPO proposal, as long as such over-allotment options, if exercised, do not exceed 15 per cent of the total number of shares issued. Such a mechanism serves to prevent any sharp decrease in share prices postIPO so as to preserve the confidence of primary market investors. (3) Finally, the relevant issuers’ management personnel and key employees are allowed to participate in strategic placements through a dedicated asset management programme. The STAR Market established a listing committee and a consultation committee for technological innovation. In particular, the listing committee, together with the listing review arm of the SSE, is in charge of reviewing listing applications to the STAR Market. The listing review arm

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of the SSE bears primary responsibility for the review and issues formal opinions, whereas the listing committee of the STAR Market plays a complementary supervisory role to evaluate and assess the review report issued by the SSE through mechanisms such as assessment meetings. The listing committee comprises thirty to forty non-SSE expert members and relevant SSE staff. The consultation committee, on the other hand, provides professional consultative opinions based on the prevailing needs of the SSE in relation to listing publicity and review. It comprises forty to sixty esteemed experts in the scientific and technological innovation sector, renowned entrepreneurs, and experienced investors. All committee members sit on a part-time basis. The two committees work closely in collaboration with the listing review arm of the SSE in their designated roles to complete the review process.

4.2.6.3 Investor Protection As loss-making companies are allowed to be listed, investors face greater risks trading in the STAR Market. To mitigate risks and protect retail investors, the STAR Market imposes two eligibility requirements on investors: (1) the average assets in the investor’s security and capital accounts shall be no less than 500 thousand RMB for twenty trading days before being given access to the STAR Market; and (2) the investor has experience in trading securities for more than twenty-four months (See Table 4.4 for comparison with the Main Boards and the ChiNext Board). Also, broker members should conduct a multi-faceted review on individual investors and engage in comprehensive risk disclosure. Particularly, the review focusses on ascertaining whether the individual investor understands the rules and procedures relating to the trading of shares in the STAR Market and appreciates the relevant risks. Such reviews are renewed periodically (at least once every two years) to ensure that information relating to individual investors’ risk appetite remains up to date. A more targeted approach is employed with regard to regulation over trading in the STAR Market. First, a default lock-up period of twelve months applies to all existing shareholders before IPO, with an extended period of three years in the case of controllers and shareholders with key roles in the development team. Second, specifically with reference to lossmaking companies, there is a general prohibition against sale of pre-IPO shares, which will be lifted only when the company remains listed for five years. Third, for sales made through call auctions on secondary markets or block trades, each shareholder may only dispose up to 1 per cent of his shareholding every year. Additionally, for shares held by private equity

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Table 4.4 Investor eligibility for China’s stock markets Main Boards

ChiNext

STAR Market Average assets in investor’s security and capital accounts are no less than 500 thousand RMB for twenty trading days before being given access to the STAR Market and investor has experience in trading securities for more than twentyfour months; investors who do not meet these criteria may participate in trading through other indirect means such as publicly raised funds Apart from ensuring that the investor fulfils the substantive criteria mentioned earlier, members are to conduct a multifaceted review of the investor based on asset level, knowledge, risk appetite, and creditworthiness. Such reviews are to be renewed at least

Substantive Criteria

No

Two years of trading experience with a cooling period of two trading days; for investors with trading experience less than two years, members are to provide guidance and impose a cooling period of five trading days

Member’s Obligations before Allowing Entry

Standard risk warnings

Investor to apply for entry in person and is given faceto-face risk warnings; investor to sign risk disclosure letters and transcribe relevant declarations; members are to review investors’ capacity to engage in trading,

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Table 4.4 (cont.) Main Boards

ChiNext continuously oversee trading activities, and conduct risk reviews at least once every two years

STAR Market once every two years to ensure that information relating to individual investors’ risk appetite remains up to date. Members are to engage in comprehensive risk disclosure to investors regarding the risks of trading on the STAR Market through appropriate means and require first-time investors to sign a paper or electronic risk disclosure letter, which discloses fully the main risk features of the STAR Market.

(PE) or VC investors, suggestions were made to encourage off-market disposals to institutional investors as long as existing sale restrictions are complied with. Compiling the investor eligibility requirements of the Main Boards, the ChiNext Board, and the STAR Market in the table above, it can be seen that the degree of investor accessibility gradually decreases.

4.2.6.4 Trading System The STAR Market has also introduced innovative changes to existing trading rules in order to facilitate its trading activities. For example, the daily price limit is for the first time raised to 20 per cent, with a no-pricelimit free trading period of five days after the IPO. Minimum price

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movements can also be set with greater flexibility, coupled with the introduction of after-hour trading at fixed prices. As a result, price movements are afforded greater flexibility, bid-ask spreads for cheaper stocks are reduced, and trading activities are more evenly distributed, leading to a potential increase in market liquidity. Separately, in order to encourage innovation, restrictions over share disposals by key personnel of the listed entity are relatively relaxed: (1) pre-IPO shares are locked up for twelve months after the IPO and six months upon leaving the company; (2) upon expiry of the lock-up periods for pre-IPO shares, a maximum proportion of 25 per cent of such shares can be disposed per year for a period of four years, with any unused proportion of the selling entitlement being carried over to the next year.

4.2.6.5 Information Disclosure First, the STAR Market adopts a more targeted approach regarding information disclosure. Apart from generic information disclosure requirements, unique characteristics of sci-tech companies are taken into account to craft specific disclosure obligations relating to industry information, core technology, business risks, corporate governance, and fluctuations in performance. Further, in order to preserve the competitiveness of sci-tech companies, more flexibility is built into the disclosure regime in respect of the quantitative indicators, timings and methods of disclosure, temporary exemptions from disclosure in case of businesssensitive information, and disclosure of critical information outside trading hours. In addition, more stringent rules apply for disclosures relating to key person disposals in addition to the prevailing regime. Specified shareholders are to disclose information regarding company performance to adequately inform the market of relevant risks before they are allowed to dispose of their pre-IPO shares. Controlling shareholders and de facto controllers are to actively participate in upholding the disclosure obligations of listed companies and shall not assist in withholding important information. Second, sponsors and securities service providers are to assume responsibility for the issuer’s compliance with information disclosure standards. The STAR Market imposes stricter continuous supervisory duties on sponsoring organisations. Specifically, more detailed responsibilities now attach to sponsors in relation to their supervision over issuers’ material adverse changes and their disclosure responsibilities. Sponsors are now required to monitor the daily operations and trading activities of issuers, urge issuers to disclose significant risks, render

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supervisory opinions regarding such risks, and conduct necessary on-site checks. In line with their ‘gatekeeping’ roles, sponsors shall conduct full checks over issuers’ IPO documentation against legal requirements and industry standards so as to ensure that the contents of such documentation are true, accurate, and complete. Third, the STAR Market will review disclosures made in IPO documentations based on the criteria of comprehensiveness, consistency, and accessibility so as to encourage issuers and sponsors/securities service providers to make truthful, accurate, and complete disclosures. As a brief comparison of disclosure requirements among the Main Boards, the ChiNext Board, and the STAR Market, the ChiNext Board imposes more stringent requirements than the Main Boards, focussing on eliciting disclosures regarding the potential adverse influence of issuers’ core technology changes. The STAR Market, in turn, imposes even stricter requirements, while at the same time making allowance for the unique characteristics of sci-tech companies by building more flexibility into the rules (See Table 4.5).

4.2.6.6 Delisting Regime Companies listed on Chinese A-share markets have always faced more difficulties in delisting as compared to their counterparts listed on mature markets overseas. Under the STAR Market regime, compulsory delisting is regulated by reference to its four primary bases: material regulatory breaches; subpar trading activities; failure to meet financial targets; and non-compliance, the last three of which have been the subject of more detailed regulatory guidance than under the prevailing system outside of the STAR Market regime. Different from the Main Boards, the SME Board, and the ChiNext Board, the STAR Market uses four market-based indicators to regulate delisting, including trading volume, price, the number of shareholders, and, for the first time, market capitalisation. Specifically, once (1) the trading volume of a listed company’s shares for a consecutive 120trading-day period falls below two million shares, (2) the closing price of a listed company’s shares falls below their face value for a consecutive 20trading-day period, (3) the total market capitalisation falls below 300 million dollars for a consecutive 20-trading-day period, or (4) the number of shareholders falls below 400 for a consecutive 20-trading-day period, delisting is due. Market-based indicators serve as more reliable indicators of the value of listed entities and, when reinforced by regulatory measures, strengthen market-based mechanisms.

Table 4.5 Information disclosure in China’s stock markets

Information disclosure

Main Boards

ChiNext

STAR Market

Standard information disclosure

Stricter information disclosure requirements than Main Boards. Ad hoc disclosures to be made on an as-andwhen basis. Periodic disclosures to take the form of company performance briefs to enhance the immediacy of information disclosure. Emphasis on disclosure of review report for internal controls system and special audit report for fundraising. To ensure compliance with the principle of fair information disclosure. With specific regard to the reliance of some tech companies on their core technology, emphasis is to be placed on full disclosure of core technology changes and the potential impact and risks thereof.

(1)

(2)

General principles of information disclosure based on five fundamental pillars of ‘truthfulness, accuracy, completeness, immediacy, and fairness’. Fulfilment of these principles is the pre-requisite to allowing convenience and expediency for the operations of sci-tech companies. Specialised, industry-specific information disclosure rules are given prominence. Disclosures are to be made on a periodic and ad hoc basis regarding key areas such as trends of industry development, operational models, core competitiveness, development team, and research input. Specifically, disclosures are to be made if the company enters into new business or changes its main area of business.

(3)

(4)

(5)

Disclosure standards regarding operational risks are enhanced. Specific disclosure requirements are imposed with regard to material operational risks that may arise in the daily operations of a sci-tech company. Disclosure standards regarding high-risk share pledges are enhanced. Shareholders with a high share pledge ratio are required to make full disclosures regarding the basic terms of such pledge(s), the use of the loan obtained, personal financials and, in the case of a pledge of controlling shares, any effect that the pledge(s) may have on the control rights of those shares. Disclosure standards and decisionmaking regarding material transactions and related-party transactions are improved. In consideration of the

Table 4.5 (cont.) Main Boards

ChiNext

STAR Market companies which are unprofitable at the time of listing, those companies are exempted from using profitrelated indicia for decisions on material transactions. Related-party transactions, on the other hand, receive stricter treatment with a broader definition of related parties combined with appropriate adjustments in the disclosure and review requirements of related-party transactions. The prevailing indicator of transaction value/net assets is replaced by that of transaction value/ total assets or market capitalisation.

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Additionally, the STAR Market has abolished the prevailing A-shares delisting regime of ‘suspension, de-suspension and re-listing’ and all its delistings are final. This has greatly enhanced the efficiency of the delisting process. To take the example of delistings due to failures to meet financial targets: once a listed company receives a warning about the prospect of delisting, which is not revoked in the subsequent accounting year, delisting will be affected immediately. Re-listing will no longer be possible, except to the extent that delisted entities (other than those who are delisted due to material regulatory breaches) may apply to get listed again in accordance with the registration and review rules applicable to new IPOs. In totality, this institutional arrangement, coupled with the registration system, evinces the STAR Market’s philosophy of ‘free entrance; strict exit’. Nevertheless, whether this delisting regime can be effectively enforced in tandem with the registration system so as to maintain the intricate balance between market entrance and exit remains to be tested by time.

4.2.6.7 Dual-Class Share Structure The STAR Market is the first Chinese stock market to allow companies with dual-class share (DCS) structures to get listed.91 Companies have begun to take advantage of this opportunity, with UCloud Technology Ltd. being the first company to list on the new board with a DCS structure in April 2019. The next part will analyse DCS in the context of VC. It will discuss the importance of DCS among VC-backed companies, and how the DCS structure can be used in China. Specifically, it will analyse in detail and provide suggestions for: (1) the limits on firms seeking to apply to list with DCS structures; and (2) how these limits have been and should be imposed on the manner in which the DCS company is structured. 4.2.7 DCS Structures in the Context of VC 4.2.7.1 The Popularity of DCS in the Tech Sector Dual-class share structures are typically characterised by one class of shares with only one vote per share, which are usually offered to public 91

The rules of the STAR Market included a provision permitting the use of DCS structures by listed companies. See Article 41 of the Measures for the Administration of the Registration of IPO Stocks on the Science and Technology Innovation Board (for Trial Implementation), supra note 89; Rules 4.5.1–4.5.14 of the Rules of the Shanghai Stock Exchange for the Listing of Stocks on the Science and Technology Innovation Board, CSRC, www.csrc.gov.cn/pub/shanxi/xxfw/gfxwj/201906/P020190627331176879777.pdf (‘STAR Market Rules’).

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investors, and another class of shares with multiple votes per share which are usually issued to founders.92 Dual-class share structures are commonly used in VC-backed firms as they enable entrepreneurs to maintain control of the firm even after listing.93 This structure has proven especially popular among companies in the technology sector. Between 2012 and 2016, about 15 per cent of all technology companies that listed in the United States (US), including Facebook Inc., Fitbit Inc., and Twilio Inc., adopted the DCS structure.94 This trend can be attributed to three main factors. First, many companies in the technology sector have been expanding aggressively and, in the course of doing so, expending large amounts of capital in the short-term. Attempts to raise this capital through the equity capital markets means that the founder’s equity, and resulting control of the firm, is diluted. Given that many of these companies are start-ups in the nascent stage of development, they are not able to turn to the debt markets. Hence, their reliance on the capital markets is almost inevitable. Consequently, it makes sense that they turn to the DCS structure to allow the company to raise funds while keeping the founder in control of the company. Second, as compared to other companies in the traditional industrial sectors, companies in the technology sector are much more dependent on the technical brilliance of individual key persons, especially their founders, and it is key to their success that these founders remain in control. This may be attributable to the need for unique insights, ideas, and innovative skills that these founders have contributed since the inception of the firm. Aside from being the main driving engine, they may also provide directory foresight, which is sometimes coupled with idealism (e.g. Alphabet, which believes that Google’s search services facilitate basic human rights) and a view on growth in the super long term (e.g. Tesla). These factors enable technology companies to build a strong culture of innovation, with the view to conducing long-term growth. In view of this, managerial stability is a key 92

93

94

D. C. Ashton, ‘Revisiting Dual-Class Stock’, St John’s Law Review, 69(4) (1994), 863, 866; F. H. Easterbrook and D. R. Fischel, ‘Voting in Corporate Law’, Journal of Law and Economics, 26 (1983) 395. Examples of this scenario include, for instance, the Facebook founder, Mark Zuckerberg. In declarations filed on 1 February 2012 by Facebook with the United States’ Securities and Exchange Commission, Zuckerberg would, after Facebook’s Initial Public Offering, hold a 22 per cent equity stake in Facebook. Through the use of ‘Class B stocks’ which entitled him to 10 votes per share, Zuckerberg would also control 57 per cent of the shareholder vote. J. Ritter, ‘Initial Public Offerings: Dual Class IPOs’, Financial Review, 50(4) (2015), 481.

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factor to the success of these companies. Hence, a change in the managerial team would be exceptionally disruptive to the future prospects and longterm development of the company. Given the importance of the founder and company stability in the pursuit of the company’s business and development of its culture, the DCS structure is viewed as an essential tool for protecting the company’s long-term interests. Third, given the importance of stability and the continued presence of the company’s founding members, technology firms are particularly aware of the threat of hostile takeovers. These threats might also induce the company’s founders to ditch their long-term plans in order to service the shortterm goals of shareholders. In mature securities markets, such as the US, institutional investors control a large proportion of the available capital, and they often demand that the company produce measurable financial results in the short term.95 As a result, the company may adopt plans that are satisfactory to short term investors but do not promote the interests of the company in the long-term.96 In other words, the net effect is that pressure on the company’s directors once it lists on the stock exchange might result in a change of course that hurts the long-term interests of the company. Hence, the DCS structure is helpful as it protects the stability of the firm’s management in two ways. First, giving founders control of the shareholder vote through DCS, the DCS structure protects these founders from being replaced in a hostile takeover. Second, and consequently, this assurance ensures that the founder’s managers can maintain their innovative, idealistic, super-long-term frame of mind in directing the company as they are effectively shielded from the demands of market investors for financial results in the short term. This protection against short termism may help the company to better develop in the long term.

4.2.7.2 The Arguments for DCS in China This section argues for the need for DCS in China. First, the DCS structure is important to many high-growth and high-potential companies in China. Hence, allowing for the DCS structure will increase the attractiveness of China’s domestic stock exchanges, especially since a DCS structure allows founders of companies to raise capital while still preserving controlling 95

96

P. L. Simmons, ‘Dual Class Recapitalization and Shareholder Voting Rights’, Columbia Law Review, 87(1) (1987), 112. D. J. Berger, ‘Multi-class Stock and the Modern Corporation: A View from the Left (Coast) on Governance Misalignment and the Public Company’, Meeting of the Securities and Exchange Commission Investor Advisory Committee (9 March 2017), www.sec.gov /spotlight/investor-advisory-committee-2012/berger-remarks-iac-030917.pdf, at pp. 7–8.

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interests. Second, there are various benefits of listing with a DCS structure, such as allowing the shareholder-director to maintain control of both board and shareholder decisions and allowing the company’s directors to plan for the long term with greater certainty of the future. Finally, although the DCS structure has been rejected by some jurisdictions, it is suitable for the conditions of China. The DCS structure has proven exceptionally popular among VCbacked companies.97 Due to the lack of DCS in Chinese stock exchanges, many of the Chinese IT and e-commerce giants such as Alibaba, Baidu, and JD.com have chosen to list their shares on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotation system (NASDAQ),98 instead of the local exchanges. In particular, Alibaba has brought the world’s biggest IPO to the US.99 In doing so, the firm cited the inflexibility of the HKEx in disallowing a listing with DCS structures.100 In 2014, the HKEx noted that 20.2 per cent (34 of 168) of Chinese firms that were listed on NYSE or NASDAQ had done so with DCS structures. Of these, 70 per cent were from the technology sector and they collectively represented 90 per cent of the value of all Chinese firms listed in the US at that time, with a valuation totalling USD 136 billion. More strikingly, more than two-thirds (11 out of 15) of the firms that had listed in America in 2014 had done so with DCS structures.101 This is a trend that has continued into 2018 where 33 Chinese companies went public in the US, raising USD 9.2 billion.102 Of these, 64 per cent were 97

98

99

100

101 102

D. Klausner, ‘Dual class IPOs are on the rise: Tech unicorns jump on board this new trend’, PricewaterhouseCoopers (18 July 2018), http://usblogs.pwc.com/deals/dual-classipos-are-on-the-rise-tech-unicorns-jump-on-board-this-new-trend/. ‘Concept Paper: Weighted Voting Rights’ (August 2014), Hong Kong Exchanges and Clearing Limited (‘2014 HKEx Paper’), at Appendix II. Data obtained from filings with the American SEC, E. Barreto, ‘Alibaba IPO ranks as world’s biggest after additional shares sold’, Reuters (22 September 2014), www .reuters.com/article/us-alibaba-ipo-value-idUSKCN0HH0A620140922. This is until Saudi Aramco, the Saudi Arabian state-owned oil giant, raised US $25.6 billion in its recent IPO and superseded Alibaba, see M. Martin, ‘Saudi Aramco Raises $25.6 Billion in World’s Biggest IPO’, Bloomberg (6 December 2019), www.bloomberg.com/news/art icles/2019-12-05/saudi-aramco-raises-25-6-billion-in-world-s-biggest-ipo. E. Barreto, D. Thomas, ‘U.S. to get coveted Alibaba IPO after Hong Kong talks founder’, Reuters (25 September 2013), www.reuters.com/article/us-alibaba-ipo/u-s-to-getcoveted-alibaba-ipo-after-hong-kong-talks-founder-idUSBRE98O19R20130926. 2014 HKEx Paper, supra note 98, at pp. 29–36. K. Hu, ‘Chinese companies flooded into the US IPO market in 2018’, Yahoo! Finance (29 December 2018), https://finance.yahoo.com/news/chinese-companies-floodedu-ipo-183408925.html; An alternate report by CNBC, citing BakerMckenzie, states

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technology companies, including major companies such as iQiyi Inc., Pinduoduo Inc., NIO Inc., and Tencent Music.103 These four companies listed with DCS structures and they represent over 60 per cent of the capital raised by Chinese companies in the NYSE and NASDAQ in 2018.104 Table 4.6 is the selected list of Chinese companies105 which are listed with DCS structures on NYSE or NASDAQ. Table 4.6 Key Chinese IPOs in NYSE or NASDAQ in 2018 Firm

Amount raised (USD)

Vote ratio

iQIYI, Inc.106

2.4 billion

10–1

Pinduoduo Inc.107 NIO Inc.108

1.6 billion

4–1

1.15 billion

10–1 8–1

Tencent Music109

1.1 billion

10–1

103 104 105

106

107

108

109

Holder Controlling shareholder (Baidu) Founder Chairman Major investor (Tencent) Parent company (Tencent)

Stock exchange NASDAQ

NASDAQ NYSE

NYSE

there were 37 IPOs: Y. N. Lee, ‘Trade war hasn’t stopped Chinese Companies from listing in the US: Nasdaq’, CNBC (11 December 2018), www.cnbc.com/2018/12/12/trade-warchinese-companies-still-seeking-ipos-in-the-us-nasdaq-says.html. Ibid. Ibid. These companies are designated as ‘Chinese companies’ for present purposes because their founders are Chinese and/or their principal place of business and primary market is China. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, iQIYI, Inc.’, (27 February 2018), www.sec.gov /Archives/edgar/data/1722608/000119312518060890/d487167df1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Pinduoduo Inc.’, (24 July 2018), http:// investor.pinduoduo.com/node/6341/html. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, NIO Inc.’, (13 August 2018), www.sec.gov /Archives/edgar/data/1736541/000119312518247401/d560276df1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Tencent Music Entertainment Group’, (2 October 2018), www.sec.gov/Archives/edgar/data/1744676/000119312518290581/ d624633df1.htm.

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Table 4.6 (cont.) Firm Uxin Ltd.110 Sunlands Online Education Group111 111, Inc.112 Qutuotiao Inc.113 Aurora Mobile114 CooTek (Cayman) Inc.115

Amount raised (USD)

Vote ratio

225 million 150 million

10–1 7–1 10–1

100.5 million 84 million 77 million 57 million

15–1 10–1 10–1 25–1

Holder Founder Major investor CEO and other directors Founders Co-founder Founder Co-founder

Stock exchange NASDAQ NYSE

NASDAQ NASDAQ NASDAQ NYSE

Nevertheless, unlike in the US where DCS structures are permissible, companies incorporated in China are generally not allowed to offer shares with multiple voting rights. The Chinese stock market has long been constrained by the ‘one share one vote’ system.116 Arguably, this has led a sizeable number of Chinese enterprises to list on overseas stock exchanges instead. 110

111

112

113

114

115

116

US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Uxin Limited’, (29 May 2018), www.sec.gov /Archives/edgar/data/1729173/000104746918004128/a2235772zf-1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Sunlands Online Education Group’, (23 February 2018), www.sec.gov/Archives/edgar/data/1723935/000119312518056029/ d494072df1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, 111, Inc.’, (15 August 2018), www.sec.gov /Archives/edgar/data/1738906/000104746918005629/a2236354zf-1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Qutuotiao Inc.’, (17 August 2018), www .sec.gov/Archives/edgar/data/1733298/000119312518251751/d545022df1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, Aurora Mobile Limited’, (29 June 2018), www .sec.gov/Archives/edgar/data/1737339/000119312518209561/d567445df1.htm. US Securities and Exchange Commission, ‘FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, CooTek (Cayman) Inc.’, (16 August 2018), www .sec.gov/Archives/edgar/data/1734262/000104746918005651/a2236299zf-1.htm. The ‘one share, one vote’ principle is specified under Article 126 of the Companies Law of the People’s Republic of China. In Chinese academia, there are arguments that while nonlisted limited liability companies are theoretically not prevented from issuing dual-class shares, in practice, these companies are unable to issue dual-class shares.

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With the overseas listing of these high-growth and high-potential companies, China’s stock markets have lost these IT giants as valuable potential applicants. This reduces the attractiveness of China’s domestic stock exchanges, as many domestic investors would miss out on the considerable investment returns that could be brought about by the rapid growth of these companies. Meanwhile, with improving IT infrastructure, a considerable number of high-tech companies in China have emerged. For instance, the ‘Chinese Silicon Valley’ – Zhongguancun – birthed forty-nine start-ups daily in 2014.117 With the expansion and urgent financing needs of these high-growth start-ups, there is demand from the founders of these firms for a DCS structure that would allow them to raise capital while still preserving controlling interests. Further, China’s digital economy has been booming, reaching a total capitalisation of RMB 29.91 trillion, contributing to a third of China’s total GDP.118 Arguably, adopting a DCS structure in China would give domestic entrepreneurial firms greater flexibility in terms of capital structures and provide domestic investors with a wider range of investment opportunities.119 In April 2018, the HKEx decided to allow companies to list their shares with DCS structures.120 This was a move made with the express intention to ‘attract more good quality, high growth, and innovative companies to list in Hong Kong’.121 To achieve this aim, the DCS structure was made

117

118

119

120

121

‘Science and Technology Minister Wan Gang answers reporters’ questions China.com.cn (China, 11 March 2015), www.china.com.cn/zhibo/zhuanti/2015lianghui/2015-03/11/ content_34996059.htm. Tencent Research Institute, ‘Shuzi Zhongguo Zhishu Baogao (2019)’ (数字中国指数报告 (2019)) [The Digitalisation Index of China (2019)], China Big Data Industrial Observation (23 May 2019), www.cbdio.com/BigData/2019-05/23/content_6123836.htm. While the dual-class share structure is beneficial to entrepreneurial management, numerous problems could also arise, such as the potential risk of corporate abuse by the management. Since listed companies in China typically have a concentrated shareholding structure, a dual-class structure may exacerbate a major corporate governance issue, that is the conflict between the controlling shareholder and the minority shareholders. ‘Hong Kong’s Listing Regime Enters New Era, Featuring Emerging and Innovative Firms’, Hong Kong Exchange (24 April 2018), www.hkex.com.hk/News/News-Release /2018/180424news?sc_lang=en. ‘A Listing Regime for Companies from Emerging and Innovative Sectors’, Hong Kong Exchanges and Clearing Limited (February 2018), (‘HKEx 2018 Paper’) at 30.

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available only to ‘innovative’ companies.122 Since then, Xiaomi Corp and Meituan-Dianping have chosen to do so, raising USD 5.4 billion and USD 4.9 billion respectively.123 This helped Hong Kong to become the top IPO market in the world in 2018.124 While the Singapore Exchange (SGX) has also launched rules to allow the listing of DCS companies,125 there have not been any IPOs using this share structure as of 1 June 2020. While it is conceded that allowing listings with DCS structures alone may be insufficient to attract Chinese funds to the Chinese stock markets, there can be little doubt that doing so would possibly retain these high-value firms, and possibly lure some back from the US. Should it fail to do so, the Chinese market would miss out on opportunities to further develop the local securities market by attracting listings from both local firms that can compete on an international scale and foreign firms that are looking to tap into the wider Asian market. As the HKEx has recognised,126 the US has been a very attractive option, especially for many up-and-coming Chinese firms. It would certainly be beneficial to the Chinese market should these companies list locally. Aside from attracting companies, a further consideration that Chinese regulators would have in mind is whether the DCS structure would be beneficial to the companies which choose to list with it. The rest of this section considers the manner in which a company might benefit from listing with a DCS structure. As mentioned earlier, the DCS structure allows incumbent shareholders to raise money from the equity markets without losing control of the shareholder meeting. This allows the shareholder-director to maintain control of both board and shareholder decisions. Hence, as Google executives describe it, a DCS structure allows a public company to ‘retain many of the positive

122 123

124 125

126

Hong Kong Exchange Listing Rules (‘HKEx Rules’), Rule 8A.04. E. Yiu, ‘Hong Kong Regains Global IPO Crown from New York in 2018 Thanks to Its Listing Reforms’, South China Morning Post (24 December 2018), https://www.scmp .com/business/companies/article/2179283/hong-kong-easily-regains-2018-global-ipocrown-new-york-thanks. Ibid. ‘SGX launches rules for listing of dual class shares companies’, Market Screener (26 June 2018), www.marketscreener.com/SINGAPORE-EXCHANGE-LIMITE-6491511/news/ Singapore-Exchange-SGX-launches-rules-for-listing-of-dual-class-shares-companies -26825827/. 2014 HKEx Paper, supra note 98, at pp. 30–37.

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aspects of being private’.127 By retaining control over voting rights, the shareholder-directors cannot be removed by the other shareholders, who only control a minority vote and are shielded from pressure exerted by other shareholders.128 Consequentially, the DCS structure has been described as ‘arguably the most effective anti-takeover device ever invented’.129 The entrenchment of the shareholder-director allows the company’s directors to plan for the long term with greater certainty of the future.130 As they cannot be removed by a shareholder vote, they will not have to worry about demands by shareholders for short-term growth. As potential buyers will not be able to engage in a proxy war with the shareholderdirector who has control of shareholder decisions, they also do not have to worry about keeping the share price high so as to prevent a takeover bid.131 This allows directors to ‘act in the long-term best interest of the firm’, such as by investing in research and development, human capital, or potentially controversial acquisitions and ensuring that these plans are carried to fruition.132 Empirically, firms with DCS structures invest more heavily in research and have higher sales growth.133 Without such a structure, the directors may have to be more profit-focussed than is beneficial so as to satisfy the short-term demands of shareholders and/or to ensure that the company’s share price is high enough to deter takeover bids. This could prove sub-optimal to the company’s performance, especially in the case of companies in the technology sector who are still in the early stages and need to spend cash on development instead of focussing on turning a profit. Companies such as Spotify,134 Uber,135 127

128

129 130

131 132

133 134

135

US Securities and Exchange Commission, ‘Form F-1 Registration Statement Under the Securities Act of 1933, Google Inc.’, (29 April 2004), www.sec.gov/Archives/edgar/data/ 1288776/000119312504073639/ds1.htm. V. Baulkaran, ‘Management Entrenchment and the Valuation Discount of Dual Class Firms’, The Quarterly Review of Economics and Finance, 54 (2010), 70(‘Baulkaran’). Ibid. B. Jordan, S. Y. Kim, and M. Liu, ‘Growth Opportunities, Short-term Market Pressure, and Dual-class Share Structure’, Journal of Corporate Finance, 41 (2016), 304(‘Jordan’). Ibid. See Jason W. Howell, ‘The survival of the U.S. dual class share structure’ Journal of Corporate Finance, 44(C) (2017) 440. Jordan, supra note 130. E. Auchardand and O. Swahnberg, ‘Spotify faults itself for marginal gains; stock hits new lows’, Reuters (1 November 2018), www.reuters.com/article/us-spotify-tech-results/spot ify-faults-itself-for-margin-gains-stock-hits-new-lows-idUSKCN1N64JE. H. Somerville, ‘Uber Narrows Loss but Still A Long Way From Profitability’, Reuters (16 August 2018), www.reuters.com/article/uber-results/uber-narrows-loss-but-still -a-long-way-from-profitability-idUSL1N1V611I.

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and Tesla136 are all prominent examples that despite having established themselves, continue to have to sacrifice short-term profits for long-term growth. The positive effect of entrenchment is especially pronounced when there is a key directing personality within the company that has a special role in determining the success of the company. Examples of such personalities include Facebook’s Mark Zuckerberg and Alibaba’s Jack Ma. Where the founder or existing managers are key to ensuring the success of the company, the DCS structure ensures that the use of equity fundraising does not excessively dilute their influence within the company, allowing them to continue to run the company as they see fit. This appears to be a key feature in many modern technology start-ups and further suggests that the availability of the DCS structure will strongly influence a choice of listing jurisdiction.137 A survey of the global capital markets further suggests that the availability of DCS structures is a significant consideration for firms seeking listings and exchanges have responded accordingly to attract listings. As of August 2019, twelve of the world’s twenty largest markets by market capitalisation allow listed companies to have shares with different rights. These markets include Hong Kong and Singapore, who have only recently changed their rules to allow DCS, as well as the US, Canada, and Sweden, where the practice is more established. However, it is important to note that this is not a ubiquitous practice globally.138 The London Stock Exchange (LSE) maintains its ban on the DCS structure.139 Similarly, corporate law in Germany, Spain, South Korea, and China continues to prohibit the use of variable voting rights in all companies, public or private. This might suggest that the jury is still out as to the desirability of a company with a DCS structure. Another plausible reading of the situation 136

137

138

139

I. S. Jasmine, ‘Tesla Third-Quarter Profit Quiets Critics, Shares Surge’, Reuters (25 October 2018), www.reuters.com/article/us-tesla-results-stocks/tesla-third-quarterprofit-quiets-critics-shares-surge-idUSKCN1MZ1YZ. See F. Gao and L. Zhou, ‘Shangshigongsi Shuangceng Guquan Jiegou: Chuangxin yu Jianguan’ (上市公司双层股权结构: 创新与监管) [Listed Companies with Dual Class Share Structures: Innovation and Oversight], Journal of Sun Yat-Sen University (Social Science Edition), 57(3) (2017), 186, www.cnki.com.cn/Article/CJFDTotalZSDS201703021.htm. F. Huang, ‘Dual Class Shares around the Top Global Financial Centres’, Journal of Business Law, 2 (2017), 137. London Stock Exchange Rules, Listing Rule 7.2.1AR.

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would be to attribute it to path dependence stemming from existing legal thought and commercial practice. This was the situation in Hong Kong and Singapore where the DCS structure was initially banned, and only changed when regulators felt the need to give in to the demands of competition. Given that the use of DCS in listed companies is not a uniform practice among global markets, it would be apposite to highlight the factors that should be considered when considering whether to allow listings with DCS structures. Aside from the need to continue competing with other jurisdictions, regulators should also take into consideration the structure and theory of the local legal system, existing political goals, and the receptiveness of local stakeholders, especially given the possibility of resistance due to path dependence. Applying these considerations to the context of China, the presence of the policy of Mass Entrepreneurship and Innovation140 suggests that it is appropriate for the DCS structure to be introduced to the Chinese markets as it has the potential to provide benefits for all stakeholders involved – investors, listing companies, and the Chinese capital market and its regulators. This move is exceptionally apt for Chinese technology markets as the use of DCS to retain control can increase investment in innovation and development, allowing the company to achieve better long-term prospects which investors can then share through the issue of dividends. When these capital gains are reinvested into the market, more financing is made available to start-ups looking to list, creating a beneficial cycle of growth. The net result of such a move is that more high-quality companies can succeed and grow while remaining in China, helping to promote the development of China’s capital market.

4.2.7.3 DCS and Investor Protection While securing the position of the incumbent director-shareholders through the use of DCS structures has the potential to benefit the company, it has long been recognised that the use of this share structure may introduce agency problems.141 For example, the recent decision by the SGX and the HKEx to allow firms to list with DCS structures sparked concerns among market participants. In Singapore, some respondents to 140

141

L. Lin, ‘Engineering a Venture Capital Market: Lessons from China’, Columbia Journal of Asian Law, 30(1) (2017), 160. Baulkaran, supra note 128.

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SGX’s consultation paper believed that DCS structures were ‘detrimental to shareholder value creation and the rights of minority shareholders’ and the apparent relaxation of standards may cause investors to ‘view (the SGX’s) governance standards negatively’, resulting in the market’s valuation being lowered.142 Similar concerns were expressed by stakeholders in Hong Kong.143 As the following discussion will take place in the context of the Chinese market, it is primarily important to grasp the profile of the typical Chinese investor. A large proportion of the Chinese market is represented by retail investors.144 While the empirical evidence suggests that the market applies a valuation discount to shares in dualclass companies so as to account for the lack of control,145 retail shareholders may not be as well placed to appreciate the risks and limitations that come with being an investor in a dual-class company. As a result, undue reliance may be placed on the potential for higher growth and returns. They may then find themselves without legal recourse. If investors are unable to factor this into their investment decisions, the regulators may have to design a framework to step in to save the unknowing investors from themselves. Turning to structural issues, the use of weighted shares allows the founder to control shareholder resolutions despite holding a small fraction of shares. This separates ownership of the firm’s equity (e.g. share value and dividends) from control in a disproportionate manner. Hence, there is a potential for the abuse of control and conflicts of interest, which may manifest as excessive executive pay, or the use of the company’s resources to fund private interests or endeavours.146

142

143

144

145 146

Singapore Exchange Limited, Responses to Comments on Consultation Paper, ‘Possible Listing Framework for Dual Class Share Structures’ (28 March 2018) (‘SGX 2018 Responses’), 1. Hong Kong Exchanges and Clearing Limited, Consultation Conclusions, ‘Concept Paper on Weighted Voting Rights’ (June 2015), www.hkex.com.hk/news/news-release/2015/ 150619news?sc_lang=en (‘HKEx 2015 Responses’) at pp. 16–27. Sina Finance, ‘Touzizhe 2018 Xinzouxiang: Agu ‘qusanhuhua’ jinxingshi’ (投资者2018 新走向：A股‘去散户化’进行时) [2018 Trends for Investors: Ongoing Decrease in Retail Investments in A-share markets], (29 December 2017), http://finance .sina.com.cn/stock/marketresearch/2017-12-29/doc-ifyqcwaq5426599.shtml. Baulkaran, supra note 128. Ibid. Sanford J. Grossman and Oliver D. Hart, ‘One share-one vote and the market for corporate control’, Journal of Financial Economics, 20 (1988) 175–202.

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While the entrenchment of the founder’s position in the company has the potential to benefit the company,147 it remains a double-edged sword that can harm the interests of the shareholders. Protecting the founder from the influence of the market for corporate control is only beneficial to the extent that the founder remains efficient and continues to act in the best interests of the company.148 However, the founder is ultimately human and no amount of charisma can make up for this fact. Bebchuk and Kastiel state that even the most talented entrepreneurs will struggle to constantly keep up with the passage of time and emergence of new market developments in the long term.149 In the same vein, mistakes are likely to emerge over time and there is no guarantee that the company’s directors will be able to keep the company on the intended path of longterm growth which was charted when the company first listed with DCS.150 Given that a wedge has been driven between the managerial team’s economic interests and those of the company, it appears reasonable to conclude that the control afforded by the DCS structure might also have the result of encouraging inefficiency and complacency within the managers of the company.151 These potential pitfalls manifest in empirical studies which show that while companies with DCS structures are able to maintain their valuations at the time of IPO, and for a subsequent period, their valuations tend to decrease over time.152 Should the company’s management fail, the shareholders will then have to look to corporate governance mechanisms to protect their interests. However, there may be insufficient safeguards to protect shareholder interests as the DCS structure negates the company’s external and internal supervision mechanisms. In this context, the external mechanism refers to the market mechanism of the hostile takeover while the internal mechanism refers to internal corporate governance such as the proper execution of directors’ duties and the disciplining of directors by shareholders. The use of the DCS structure places shareholder power in the hands of the founder, precluding hostile takeovers, such that the threat of one is no 147 148 149

150 151 152

Discussed earlier in Chapter 4, Section 4.2.7.1. Grossman & Hart, supra note 146; Baulkaran, supra note 128. L. A. Bebchuk, K. Kastiel, ‘The Untenable Case for Perpetual Dual-Class Stock’, Virginia Law Review, 103(4) (2017), 604, at pp. 609–610. Ibid., at pp. 610–611. Grossman & Hart, supra note 146; Baulkaran, supra note 128. M. Cremer, B. Lauterbach, and A. Pajuste, ‘The Life Cycle of Dual Class Firms’, European Corporate Governance Institute (ECGI) – Finance Working Paper No. 550/2018, (2018), https://dx.doi.org/10.2139/ssrn.3062895, at pp. 39–40.

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longer a viable disciplinary option.153 As regards the internal mechanism, it is rendered ineffective by the level of control wielded by the founder, who possesses higher voting rights. At shareholder meetings, the use of DCS allows the founder to control shareholder resolutions. Furthermore, most minority shareholders are indifferent to issues of corporate governance while the lack of a Stewardship Code and shareholder activism means that institutional investors also play a similarly limited role in corporate governance.154 At board meetings, the directors are incentivised to vote in line with the founders. This incentive has two sources: first, by controlling the shareholder vote, the founders hold the power to appoint and replace directors; second, the identity of the company’s founder as an irreplaceable visionary is overwhelming.155 While Chinese companies also have other parties involved in corporate governance, namely the supervisory board and independent directors, it is not safe to rely on these parties to zealously guard the interests of shareholders.156

4.2.7.4 Analysis of the DCS in the Context of China In view of the potential dangers to investors arising from the use of the DCS structure, the Chinese regulators would wish to implement a robust framework to help ensure that the DCS works as intended and minimise the possibility of incumbent controllers abusing the DCS structure to take advantage of general investors. This would sustain confidence in the market and ensure a continued supply of equity finance. This in turn attracts companies to list their shares to conduct fundraising. However, regulatory authorities will also have to be careful to ensure that the regulations surrounding DCS structures are not so onerous as to scare potential issuers away. The SGX and the HKEx are the two latest major exchanges to introduce comprehensive regulatory frameworks and rules regulating the listing of companies, having done so in 2018. In conceptualising an appropriate 153

154

155 156

D. P. Cipollone, ‘Risky Business: A Review of Dual Class Share Structures in Canada and a Proposal for Reform’, Dalhousie Journal of Legal Studies, 21 (2012), 77–79; T. Wen, ‘You Can’t Sell Your Firm and Own It Too: Disallowing Dual-Class Stock Companies from Listing on the Securities Exchange’, University of Pennsylvania Law Review, 162 (2014), 1501. L. Lin, ‘Code of Corporate Governance: Lessons from Singapore to China’, Company Lawyer, 40(7) (2019), 227. As discussed previously in Chapter 4, Section 4.2.7.1. L. Lin, ‘Regulating Executive Compensation in China: Problems and Solutions’, Journal of Law and Commerce, 32(2) (2014), 207.

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regulatory framework governing DCS listings in China, the Chinese regulators might look to the Singapore and Hong Kong experience with the DCS structure. Aside from the fact that these are the newest frameworks, the Chinese regulators would also wish to note the similarities between the Chinese, Singapore, and Hong Kong markets. Unlike, for example, the American market where most companies have dispersed shareholdings, the Singapore and Hong Kong markets are populated with controlled companies.157 This mirrors the structure of many Chinese firms.158 Furthermore, these rules have been formulated by regulators that are already familiar with the needs and preferences of Chinese firms, as shown by the fact that Chinese companies represent a significant proportion of companies listed on both exchanges.159 Indeed, the listing rules for the STAR Market appear to differ from the SGX and HKEx only in minor respects. The following analysis considers how the current rules seek to protect investors. a Listing Requirements This section explores the limits placed on firms which seek to apply to list with DCS structures. (1) Qualifying Company The use of the DCS structure is limited only to companies that the regulator deems to be suitable. This is a requirement imposed by both the SGX and the HKEx, as well as the STAR Market.160 Not all companies are suited to the use of a DCS structure161 and controllers seeking to list with one should demonstrate their suitability. Different criteria have been imposed by the aforementioned exchanges as regards requirements as to the type of company. The SGX has adopted a looser definition, simply stating that the business model of the company will be considered.162 In contrast, the HKEx has explicitly required the 157

158 159 160

161

162

W. Y. Wan, C. Chen, C. W. Xia, and H. Goo, ‘Managing the Risks of Corporate Fraud: the Evidence from Hong Kong and Singapore’, Hong Kong Law Journal, 48 (2018), 125. L. Lin, supra note 156. W. Y. Wan, C. Chen, C. W. Xia, and H. Goo, supra note 157, at p. 125. SGX Mainboard Rules, Rule 210(10)(b), Hong Kong Exchange Mainboard Rules, Rule 8A.04; STAR Market Rules, Rule 3. Grossman and Hart, supra note 146; Hong Kong Exchange Mainboard Rules, Introduction to Chapter 8A. Singapore Exchange Limited, Consultation Paper, ‘Proposed Listing Framework for Dual Class Share Structures’ (28 March 2018), https://api2.sgx.com/sites/default/files/ public-consultations/migration/Consultation%2BPaper%2Bon%2BProposed% 2BListing%2BFramework%2Bfor%2BDual%2BClass%2BShare%2BStructures.pdf.

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company to be an ‘innovative’ company.163 The STAR Market requires that the company should be an innovative company that has a sustainable business model with strong potential, market recognition, and a positive social image.164 The innovative company requirement is a positive inclusion. This would ensure that the DCS structure will only be available to companies that will likely benefit from a DCS listing. These are generally innovative start-ups that require equity funding without a dilution of management control. Insulating the management of such companies from the shortterm demands of the market allows them to focus on investment and long-term growth. It is unlikely that other types of companies will be able to demonstrate a potential benefit from the use of a DCS structure and it is likely that these companies would better benefit from the disciplining effect of a ‘one share one vote’ structure.165 In the absence of proof of these potential benefits, the regulators should be extremely wary of authorising a DCS listing. Furthermore, using innovation as a touchstone would send a clear signal to the market as to the limited and specialised manner in which the market regulators intend the DCS structure to be used. Companies looking to list on the HKEx must also prove their status by securing the investment of at least one major investor. This investor must have provided, at the time of listing, a significant amount of investment, making up at least half of the company’s capital, and have committed to maintaining the investment for a further six months after listing.166 However, the requirement of a significant major investor imposed by the HKEx appears to be unnecessary. First, it does not help to ensure that the company is financially viable. There are already other conditions imposed to ensure the financial viability of the company. Furthermore, it is very unlikely that a start-up would be able to reach the IPO stage without the involvement of major investors. Second, and more 163

164 165 166

Hong Kong Exchange, ‘Suitability for Listing with a WVR Structure’ (Guidance Letter, April 2018), www.hkex.com.hk/-/media/HKEX-Market/Listing/Rules-and-Guidance /Interpretation-and-Guidance-Contingency/Guidance-Letters/Guidance-Letters-forNew-Applicants/gl93_18.pdf?la=en. STAR Market Rules, supra note 91, at Rule 3. Grossman and Hart, supra note 146. D. Polk, ‘Hong Kong Stock Exchange Launches New Rules for Dual Class and Biotech Listings’, Davis Polk (25 April 2018), www.davispolk.com/files/2018-04-25_hk_stock_ex change_launches_new_rules_dual_class_biotech_listings.pdf.

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importantly, requiring the major investor to commit to maintaining its investment in the company for a further period of six months may discourage companies that have VC investors, who commonly choose the IPO as an exit option, from seeking a listing. (2) Financial Requirements The regulators also require some proof that the company seeking a listing meets certain financial standards so as to ensure that only financially viable companies are eligible for listing. Given that many companies with DCS may be seeking a listing even before they have turned a profit, the regulators have had to focus on other factors. The SGX states that the company’s track record will be considered in determining whether the company is suitable for listing with DCS.167 The HKEx is more specific, measuring the companies based on market capitalisation of HKD 40 billion. It also allows for a lower capitalisation of HKD 10 billion if the company collected HKD 1 billion in revenue in the last financial year.168 Like the HKEx, the STAR Market provides two alternative qualifying financial criteria: either having an estimated market value of RMB 10 billion or having an estimated market value of RMB 5 billion and an annual revenue of RMB 500 million in the last financial year.169 While the requirements are similar in all three jurisdictions, the difference in magnitude between the HKEx’s and the STAR Market’s requirements raises the question of extent. Is it possible to guarantee that the company will be financially viable if a reduced threshold is applied? In the past, fraudulent companies such as Xintai Electric 170 and Jinya Technology171 were able to gain listing status despite the presence of strict reviews by the CSRC. Furthermore, while the imposition of a financial limit to filter out eligible companies can help to reduce risks, 167 168 169

170

171

SGX Mainboard Rules, Rule 210(b), read with SGX 2017 paper, supra note 162. Hong Kong Exchange Mainboard Rules, Rule 8A.06. ‘Shanghai Zhengjuanjiaoyisuo Kechuangban Gupiao Faxing Shangshi Shenhe Guize’ (上 海证券交易所科创板股票发行上市审核规则) [Rules of the Shanghai Stock Exchange Governing Review of the Issuance and Listing of Stocks on the Sci-tech Innovation Board], Article 24. Dandong Xintai Electric Co., Ltd was the first company that was compulsorily delisted for fraudulent activities during IPO; see generally ‘Xintai—First to be Delisted for Fraud’ (欣泰电气成欺诈发行退市第一股), http://topic.eastmoney.com/xtts/. Jinya Technology was compulsorily delisted after its fraudulent activities during IPO were unearthed, even though by then nine years has already passed since its listing. See generally ‘Nine Years of Fraud in the A-share Market and the Inevitable Fate of Delisting: Jinya Technology’ (金亚科技A股行骗九年:上市后造假续命难逃退市命运), http:// stock.jrj.com.cn/2018/06/28195424742371.shtml.

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this has little to do with the corporate governance issues that arise in the DCS structure where investor power and supervision of founders are more prominent issues.172 (3) Only Fresh Listings A common rule is that only companies seeking a fresh listing are allowed to adopt the DCS structure. In essence, this means that companies that have already been listed should not be offered the option of ‘converting’ to DCS structures without first de-listing the company. This rule has been adopted by all three exchanges173 and can be rationalised on the basis of fairness to existing shareholders. It would be unfair to trap them in a DCS structure and dilute their voting rights as shareholders by issuing weighted voting shares to key managers. Even if compensation is arranged, it would be almost impossible to determine the appropriate level of compensation. In these circumstances, the better arrangement would be for all ordinary shareholders to have entered the bargain with full knowledge that the company in which they are seeking shareholding has a DCS structure. b Limits on the DCS Structure This section explores how limits have been and should be imposed on the manner in which the DCS company is structured. It will explore and explain why there is a need for (1) a maximum vote ratio; (2) a minimum economic interest of shareholders; (3) requirements concerning the corporate governance of these listed companies; (4) enhanced disclosure requirements; and (5) situations where the DCS structure may be terminated. (1) Maximum Vote Ratio The separation of equity from control rights provides an incentive for managers to misbehave.174 By limiting the extent to which a wedge can be driven between equity and control, the extent to which the manager’s interests are misaligned from those of the company can be limited. This will also help to alleviate any concerns 172

173

174

L. Guo and Y. C. Peng, ‘Thoughts and Lessons from International Regulations on DCS’, Journal of Peking University (Philosophy and Social Sciences), 56(2) (2019), 140. The SGX listing rules does not provide for any other manner of establishing a listed company with a dual-class share structure; Hong Kong Exchange Mainboard Rules, Rule 8A.05; STAR Market Rules, supra note 91, at Rule 4.5.2. Discussed earlier under Section 4.2.7.3 ‘DCS and investor protection’ in this chapter.

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about unfairness arising from the enhanced voting rights that weighted votes give. All three exchanges have limited the vote differential to ten votes per share.175 This appears to be an acceptable standard to Chinese companies, as evidenced by the listing of Xiaomi Corp. in July 2018176 and Meituan-Dianping177 in September 2018 under the HKEx rules. Furthermore, even listings on American exchanges generally keep within this limit.178 Beyond this initial limitation, further measures will also be required to ensure that the initial level of protection is maintained throughout the period the company is listed. Hence, there should additionally be a limitation on any corporate actions that increase the proportion of votes represented by weighted voting shares.179 (2) Minimum Economic Interest Requiring shareholders holding on to weighted voting shares to have a minimum economic interest is another means of limiting the extent to which the economic interest of shareholder-directors can be separated from that of the company. This is enforced by the HKEx and the STAR Market, both of which require a minimum 10 per cent equity holding.180 While helpful, this may not necessarily be required given that there is already a cap on the maximum voting differential. Even if the company adopts the maximum voting differential of 10:1, the shareholder-directors will need to hold around 10 per cent of the equity to hold 50 per cent of the vote share (See Table 4.7). While the HKEx also places a maximum cap on the number of shares at 50 per cent,181 this might not be useful since a larger shareholding would result in the founders having interests that are better aligned with those of the other shareholders.

175

176 177

178 179

180 181

SGX Mainboard Rules, Rule 210(10)(d) Hong Kong Exchange Mainboard Rules, Rule 8A.10; STAR Market Rules, supra note 91, at Rules 4.5.4–4.5.5. Xiaomi is a Chinese electronics company founded in 2010 and headquartered in Beijing. Meituan-Dianping is a Chinese group buying website for locally found food delivery services, consumer products, and retail services. It is the youngest company on the Fortune Global 500 List for 2019. See Table 4.1. SGX Mainboard Rules, Rule 803A(3) Hong Kong Exchange Mainboard Rules, Rule 8A.13; STAR Market Rules, supra note 91, Rule 4.5.6. Hong Kong Exchange Mainboard Rules 8A.12; STAR Market Rules, ibid., Rule 4.5.3. Hong Kong Exchange Mainboard Rules, Rule 8A.12.

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Table 4.7 Illustration of relative shareholding and voting power Number of shares Weighted shares (10 votes/share) Normal shares (1 vote/share)

Equity share

Vote share

50

9.1 per cent

50 per cent

500

90.9 per cent

50 per cent

(3) Corporate Governance Measures This section explores the additional continuing requirements concerning corporate governance that are imposed on listed companies adopting the DCS structure. (a) Qualified Director-Shareholders Google’s executives have described an investment in a company listed with a DCS structure as a ‘bet’ on the management team.182 This is an appropriate metaphor, which highlights the faith that investors place in the management of a company listed with a DCS structure. Given that benefits of the DCS structure are contingent on the presence of a competent management team, it is important that only key members of the management are allowed to hold on to shares with multiple voting rights. Singapore achieves this by only permitting appointed directors to hold on to these shares.183 Hong Kong allows any director to hold on to these shares.184 Both schemes require the share to be converted to an ordinary share if it is transferred to any other party185 or if the shareholder is no longer qualified by the listing rules to hold on to these shares.186 The HKEx also requires these directors to undergo training so as to ensure they understand the concept and the use of the DCS structure.187 While the STAR Market imposes similar rules restricting the transfer of weighted shares,188 it differs from the Singapore and Hong Kong exchanges in also allowing a non-director to hold on to shares with 182 183 184 185

186

187 188

Google Inc’s file with the Securities and Exchange Commission, supra note 127. SGX Mainboard Rules, Rule 210(10)(c) and (e). Hong Kong Exchange Mainboard Rules, Rule 8A.11 SGX Mainboard Rules, Rule 210(10)(f)(i); Hong Kong Exchange Mainboard Rules, Rule 8A.18; See also SGX Mainboard Rules, Rule 752. SGX Mainboard Rules, Rule 210(10)(f)(ii); Hong Kong Exchange Mainboard Rules, Rule 8A.17; STAR Market Rules, supra note 91, Rule 4.5.8. Hong Kong Exchange Mainboard Rules, Rule 8A36. STAR Market Rules, supra note 91, Rules 4.5.9 and 4.5.10.

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multiple voting rights. The STAR Market rules state that the party holding on to shares with multiple voting rights must continue to contribute to the development of the company by remaining as a director or maintaining actual control of the company after the IPO.189 This significantly expands the scope of qualifying shareholders and opens up a further problem: while directors are subject to the director’s duty of loyalty towards the company,190 non-directors holding on to shares with multiple voting rights are not subject to similar duties. The closest proxy that can be found in Chinese law is the stipulation that shareholders shall abide by the law, applicable regulations, and the company’s articles of association, and shall not abuse their rights as shareholders to cause loss to the company.191 While this creates some basis on which holders of shares with multiple voting rights can be held accountable, it appears to be much less effective than a stricter duty of loyalty. Hence, the STAR Market should seriously consider either limiting the class of individuals that can hold on to shares with multiple voting rights or imposing stricter duties beyond those of an ordinary shareholder. The STAR Market might also wish to consider introducing powers of oversight by which a party can be disqualified from holding on to a share with multiple voting rights. Not only does the HKEx limit the class of persons who can hold on to shares with multiple voting rights, but also retains the discretion to disqualify these parties if: (1) he has been convicted of an offence involving fraud or dishonesty; (2) he has been disqualified from being a director by a court with competent jurisdiction; or (3) he has caused the company to fail to comply with the rules regarding the use of multiple voting rights at a shareholder meeting.192 While Singapore’s courts also have the power to disqualify a director from holding office,193 which would also result in the relevant director being disqualified from holding on to shares with multiple voting rights, the SGX does not have a comparably broad jurisdiction to discipline wrongdoing directors.194 Notably, a failure to comply with the requirements surrounding the use of multiple voting rights at a shareholder

189 190 191 192 193 194

STAR Market Rules, ibid., Rule 4.5.3. Article 147, PRC Company Law. Article 20, PRC Company Law. Hong Kong Exchange Rules, Rule 8A.17. See, for example, Companies Act ss 147, 154. However, a soft enforcement mechanism which the SGX utilises is ‘public reprimands’.

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meeting only appears to result in the resolution being invalid.195 Unlike these jurisdictions, the STAR Market does not provide for disqualification powers. While the Chinese courts can disqualify a director, supervisor, or senior manager of the company from holding office,196 these powers do not apply to mere shareholders. Hence, the STAR Market should also re-consider whether it requires disqualification rules analogous to those in the other jurisdictions. A further measure that may be considered is a moratorium on the disposal of all the shares held by the managing team, a requirement that is currently only imposed by the SGX.197 However, this borders on superfluity, given that such a moratorium only lasts for a pre-defined period in the short term; after all, it is extremely unlikely that the controlling shareholder would want to part with control of the company in the short term, especially after having gone through the trouble of obtaining approval to IPO with a DCS structure. Hence, this may not be particularly useful as an enforcement mechanism. Furthermore, any such transfer would also result in the termination of the DCS structure and, consequently, the usual safeguards applied to any listed company would be sufficient. Nevertheless, this may be a desirable measure insofar as the presence of such a moratorium will send a strong signal to the market of their commitment to the company and provide some certainty to investors. (b) Independent Directors In a listed company, independent directors play a significant role as a check on the executive directors.198 Given that the company’s managers are shielded from pressure through the shareholder meeting, the role of the independent directors assumes greater importance. Hence, the regulatory framework should provide minimum requirements as to the appointment of independent directors. In recognition of this, the exchange regulators in Singapore199 and Hong Kong200 require the company’s supervisory boards and committees to mainly comprise, and be headed by, independent directors.

195 196 197 198

199 200

SGX Mainboard Rules, Rule 730B. Article 146, PRC Company Law. SGX Mainboa Rules, Rules 225, 229A. See generally, W. Y. Wan, C. Chen, C. W. Xia, and H. Goo, supra note 157; see also D. W. Puchniak et al. (eds.), Independent Directors in Asia: A Historical, Contextual and Comparative Approach (Cambridge: Cambridge University Press, 2017). SGX Mainboard Rules, Rule 210(10)(i). Hong Kong Exchange Mainboard Rules, Rules 8A.26–8A.31.

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(c) Shareholder’s Meetings As the main purpose of the DCS structure is to enable the managerial team to act free of external pressure, ordinary shareholders should still have a say on other matters related to corporate governance. Regulatory frameworks should therefore allow ordinary shareholders to call a general meeting and be sufficiently represented. Both Singapore and Hong Kong allow ordinary shareholders representing 10 per cent of all shares to be able to call a general meeting.201 To ensure that these shareholders are sufficiently represented, ordinary shareholders must comprise 10 per cent of the total vote at a shareholder meeting as a prerequisite for the shareholder meeting to be convened.202 Furthermore, to ensure a minimum standard of corporate governance, some matters should be subject to a separate voting process on a one vote per share basis. An example would be the appointment of independent directors, where the key to ensuring an effective check is to safeguard their independent operation and insulate them from pressure from the management team.203 This can be done by ensuring that these directors are appointed with the mandate of the ordinary shareholders. Hence, the appointment of independent directors and auditors should be subject to this voting process. Other matters that affect the rights of the shareholders and are not managerial decisions, such as the variation of shareholder rights and the reverse takeover, winding up, or delisting of the company, should also be subject to this process.204 The STAR Market rules provide similar restrictions205 and appear to provide sufficient protection where it comes to the use of the DCS structure at the shareholder meeting. (4) Enhanced Disclosure Requirements To counter concerns about self-trading and the misdirection of corporate opportunities, a more robust framework requiring disclosure of interested person transactions must be instituted. This would have a two-fold effect: first, it would deter managers from taking advantage of their controlling position; second, it would make it easier for ordinary shareholders to monitor the state of their investment in the company and to make an exit decision should they lose faith in the company’s management. 201 202 203 204

205

SGX Mainboard Rules, Rule 210(10)(g) 8A.23. SGX Mainboard Rules, Rule 210(10)(h) 8A.09. W. Y. Wan, C. Chen, C. W. Xia, and H. Goo, supra note 157, at p. 157. SGX Mainboard Rules, Rule 210(10)(a), 730B Hong Kong Exchange Mainboard Rules, Rules 8A.24 and 8A.2. STAR Market Rules, Rule 4.5.10.

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First, subscribing shareholders need to be aware that they are purchasing shares in a company utilising a DCS structure. Hence, the listing documents should highlight the fact that the company is seeking a listing with a DCS structure and disclose, among other things, the relevant rationale behind this, the details of the controlling shareholders, and associated risks.206 To ensure that future potential shareholders are also aware of this fact, information about the company’s shareholding and control should be published in relevant circulars or annual reports.207 This would alert prospective shareholders who may then have the opportunity to obtain more information from the company’s listing documents. The HKEx goes a step further, requiring a corporate governance committee, comprising only independent directors, to be established.208 This committee is then required to publish a corporate governance report on a half-yearly basis.209 It also requires the appointment of a Compliance Adviser who, among other things, advises the board and shareholders on conflicts of interests that may arise and helps to ensure compliance with the relevant listing rules.210 These requirements give the ordinary shareholders some assurance that the company continues to comply with the relevant regulations and that the regulatory protections are working as intended. It also gives significant bite to the role of independent directors. The STAR Market rules have adopted a different approach, preferring instead to impose a broader disclosure regime over the use of advisers.211 It requires annual disclosures of all changes in company structure, and accompanying measures implemented to protect the rights and interests of investors. Where the changes are major, they should instead be disclosed in a timely manner. The rules also make use of the existence of a supervisory board under PRC Company Law, requiring it to issue special opinions on whether the company continues to comply with the relevant rules and whether the shareholders’ interests have been protected. However, these disclosures in the form 206

207

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SGX Mainboard Rules, Rule 610; Hong Kong Exchange Mainboard Rules, Rules 8A.35, 8A.37, 8A.38. SGX Mainboard Rules, Rule 1206, 1207; Hong Kong Exchange Mainboard Rules, Rules 8A.35, 8A.37, 8A.38; STAR Market, supra note 91, Rule 4.5.12. Hong Kong Exchange Mainboard Rules, Rule 8A.30. Ibid., Rules 8A.31, 8A.32. Ibid., Rule 8A.33 and Rule 8A.34. See generally, STAR Market Rules, supra note 91, Rule 4.5.12.

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of warnings about risk appear to be insufficient as it is likely that companies will treat the process of disclosure as a mere formality. Furthermore, insofar as concerns general retail investors, the demographic comprising the majority of the Chinese capital market, these disclosures tend to be inaccessible. It has been well documented that prospectus requirements do not directly protect shareholder interests, as they tend to be long, inaccessible, and ignored by shareholders.212 Similar concerns can be raised where the relevant disclosures merely require statements saying that the listing regime has been complied with. It is suggested that the disclosure regime is best suited instead to situations where there are conflicts of interests, targeting the specific situation in which investors can recognise the risk of self-dealing, which is inherent in the DCS structure. This would be most aptly complemented by the use of enquiry letters issued by the SSE. In summary, it is suggested that the STAR Market reconsider the specific type of disclosures that are required so as to best leverage their advantages. As regards mere compliance with listing rules, it is suggested that investors are not the most appropriate party to provide monitoring and oversight. It would instead be preferable to create a special office, similar to the Hong Kong Compliance Adviser, who is properly empowered to provide active internal monitoring. (5) Termination of the DCS Structure This section considers the situations in which the regulators may require the DCS structure to be terminated, namely where there is a breach of restrictions on the transfer of weighted shares and in the presence of sunset clauses, which may be required to be in the company’s constitution. (a) Transfer of Weighted Shares As weighted shares should only be held by the appropriate directors of the company, the regulatory framework should naturally provide for restrictions on their transfer. This prevents new managers, who may not yet have earned the faith of the shareholders, from taking over control of the company. However, it would be too onerous to impose a blanket prohibition on the transfer of weighted shares, as this would effectively prevent directors from leaving the company. This also 212

J. Armour et.al, Principles of Financial Regulation (Oxford University Press, 2016); H. Tjio, Principles and Practice of Securities Regulations in Singapore (LexisNexis Singapore, 2017); See generally, O. Ben-Shahaand C. E. Schneider, More Than You Wanted to Know: The Failure of Mandated Disclosure (Princeton University Press, 2014).

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results in ambiguity if the director is unable to continue in his position due to infirmity, death, or regulatory censure. Hence, a suitable compromise can be found in the solution employed by the SGX and the HKEx – requiring that the weighted share be transformed into an ordinary share upon transfer.213 This gradual conversion from a DCS structure only takes place where the party holding on to the weighted shares with multiple voting rights gives up control. (b) Sunset Clauses Sunset clauses are arguably necessary, and thus regulators may wish to require sunset provisions to be added to the constitution of companies with DCS structures. Sunset clauses have the effect of converting the firm’s corporate structure from a DCS structure to a ‘one share one vote’ structure. Such conversion may occur at a pre-agreed time or upon the occurrence of a specified event, subject to the agreement of shareholders to extend the validity of the DCS structure. These provisions are distinguished from the conversion of shares upon their transfer, as they are not dependent on an action initiated by the holder of shares with multiple votes. It has been argued that sunset provisions are necessary because the DCS structure is useful only at the firm’s inception.214 Indeed, the short-term pressures that the DCS structure protects against are in fact the default manner by which the market, through the market for corporate control, disciplines a company’s managers and are generally seen as essential to maintain the company’s efficiency.215 In the long run, once the company has amassed enough capital and development, it may be valid to consider the company’s managers as no longer needing insulation from the market’s demands, such that the DCS structure has expended its usefulness. This analysis is in line with research by Professors Lucian Bebchuk and Kobi Kastiel that showed companies which list with DCS structures as being able to generate a premium on their share price at the time of IPO, corresponding with the beneficial effect of having an entrenched management. This benefit dissipates over time, demonstrating the gradual ineffectiveness of the DCS structure in promoting shareholder 213

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SGX Mainboard Rules, Rule 210(10)(f); Hong Kong Exchange Mainboard Rules, Rules 8A.17–8A.19; STAR Market Rules, Rule 4.5.9. V. Govindarajan, S. Rajgopal, A. Srivastava, and L. Enache, ‘Should Dual-Class Shares Be Banned?’, Harvard Business Review (3 December 2018), https://hbr.org/2018/12/shoulddual-class-shares-be-banned. Grossman and Hart, supra note 146.

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interests.216 Indeed, research by Professor Martijn Cremers et al. suggests that the premium generated from the use of the DCS structure dissipates by the ninth year after IPO.217 Given these findings, the presence of a sunset clause might make a company that lists with a DCS structure a more attractive investment in the long run. Market practice has shown some consistency with this point. Research by the US Securities and Exchange Commission’s Jackson Committee showed that just less than half of a sample group of companies, or 71 out of 157 companies, that conducted an IPO with a DCS structure over the past 15 years ending in 2018 preferred using sunset clauses over a perpetual DCS structure.218 In the long term, firms that had sunset clauses traded at a premium when compared to those that had perpetual DCS structures.219 However, such provisions should be approached with caution. Deciding on an arbitrary point in time at which the DCS structure would expire would ultimately be an exercise in speculation. Placing a hard cap on the longevity of the share structure may spell uncertainty and volatility if the company does not develop as envisioned. Hence, it appears that defining a suitable sunset clause is, in and of itself, an imprecise art that depends on a combination of astute analysis of the company’s condition and learned guesswork as to what the future holds for the company. Perhaps a suitable method of doing so would be to require that all companies seeking a listing with DCS structures should include a sunset clause, out of a list of prescribed forms, in its articles of association, which may then be subject to periodic renewal by the agreement of shareholders voting on a ‘one share one vote’ basis.

4.2.8 Future Suggestions to Encourage VC-Based IPO 4.2.8.1 Suggestions for VC-backed IPOs There are five major suggestions to facilitate VC-backed IPOs in China. First, it is submitted that the proposed IPO reform implementing a registration-based system should be carried out to improve the 216

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L. A. Bebchuk and K. Kastiel, ‘The Untenable Case for Dual-Class Stock’, Virginia Law Review, 103 (2017), 585. M. Cremers et al., ‘The Life-Cycle of Dual Class Firm Valuation’, European Corporate Governance Institute (ECGI) – Finance Working Paper 550/2018. R. J. Jackson, ‘Perpetual Dual-Class Stock: The Case against Corporate Royalty’, US Securities and Exchange Commission (Speech, 15 February 2018), online: www.sec.gov /news/speech/perpetual-dual-class-stock-case-against-corporate-royalty. M. Cremers et al., supra note 217.

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regulatory environment of VC-backed IPOs. The shift from an administrative merit-based regulatory system to a registration-based one would greatly simplify the IPO process and substantially reduce transaction costs for VC-backed IPOs. Under the new system, entrepreneurial firms would not need to wait for months or years before they can raise capital. Neither would they need to worry about suspensions of the IPO process during periods when the market is weak. Thus, the shift would fundamentally eliminate the negative impact caused by IPO suspensions. Reducing the CSRC’s control over the IPO process would also ameliorate the existing corruption and price distortion problems. The shift would as well likely impact Chinese VC firms’ choice of portfolio companies and investment timings. Under the current system, the regulator rather than the market decides the price of an issuer’s shares. Investors are likely to presume that a successfully listed company is financially strong and has high potential, having survived the tedious and burdensome approval process by the CSRC. This has partially contributed to the extremely high P/E ratios of companies on China’s stock market.220 Therefore, in the past few years, a number of VC firms, which traditionally invested in early-stage start-ups, have changed their investment strategy to invest in pre-IPO, later-stage projects so as to reap faster and higher returns.221 After the impending IPO system reform, the market will presumably play a more decisive role in capital allocation and price setting. The preference of VC funds for investing in pre-IPO projects is likely to diminish. VC funds may shift back to investing in early-stage portfolio companies, as they traditionally did, thus providing more funding for nascent companies that are in greater need of financing to fuel their growth. Second, existing listing rules and requirements must be revisited and revised. As discussed earlier,222 profitability is a major listing requirement of the Main Boards, the SME Board, and the ChiNext Board. However, many entrepreneurial firms are young firms lacking the necessary cash flow and profits. In this respect, it is not an international practice for secondary boards targetted at high-growth companies to have requirements pertaining to profitability or tracking record. 220 221

222

See supra text accompanying notes 23–27. M. Zhou, ‘The Investment Stage for PE and VC was Extended’ (PE与VC投资“双双后 移”) [PE yu VC Touzi Shuangshuang Houyi] China Securities Journal (China, 17 March 2008), http://tech.qq.com/a/20080317/000116.htm. See Table 4.3 in this chapter.

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Since the ChiNext Board was initially launched to encourage innovation and entrepreneurship by facilitating capital financing for high-tech and high-growth entrepreneurial firms, ChiNext should remove or reduce the profitability requirement and focus on the ‘growth’ and ‘innovation’ ability of issuers instead. For example, the ChiNext Board may consider following the approach adopted by the Hong Kong Growth Enterprise Board (GEM), which requires a listing applicant to: Have a trading record of at least 2 full financial years with substantially the same management throughout the 2 years, and a continuity of ownership and control throughout the full financial year immediately preceding the issue of the listing document.223

Moreover, the issuer is required to disclose in detail its past business track records and future business plans and innovation models, and make them the key components of the listing documents. The issuer is also required to publish quarterly accounts and make half-yearly comparisons of its business progress and innovation models with the business plan and models of the first two financial years. Third, the role played by investment intermediaries in an IPO exit has been empirically documented.224 The more reputable the investment banker, the less extreme the short-term underpricing of the issuance.225 Similarly, ‘the better the reputation of the firm’s accountants, the less extreme the underpricing’.226 In China, the underwriter’s reputation is positively correlated with the post-IPO performance of the issuers that are not state-owned enterprises (SOEs). This indicates that prestigious underwriters can incrementally improve the issuer’s post-IPO performance.227 Under the new registration-based IPO system, the accountability and role of underwriters, lawyers, and accounting firms will be increased, as the CSRC will not scrutinise the substantive aspects of the listing documents. Therefore, increasing the sophistication of financial intermediaries is crucial to the implementation of the IPO reform. Arguably, this can be achieved by (1) imposing criminal liability for any fraud or improper information disclosure during a listing, (2) appointing internal control experts to improve the internal control 223 224

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GEM Listing Rules (HKeX), Rule 11.12A(3). D. J. Cumming and J. G. MacIntosh, ‘Venture-Capital Exits in Canada and the United States’, supra note 1, at p. 115. Ibid. Ibid. C. Chen, H. Shi, and H. P. Xu, ‘Underwriter Reputation, Issuer Ownership, and Pre-IPO Earnings Management: Evidence from China’, Financial Management, 42(3) (2013), 647.

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within underwriters, and (3) introducing a comprehensive credit rating system for the underwriters. Fourth, an effective implementation of the new IPO system also depends on building greater investor sophistication in the Chinese stock market. One major feature of the Chinese stock market is the large proportion of retail investors.228 A survey conducted by the SZSE showed that in 2019, the average trading assets of the securities accounts of 75.1 per cent of investors were below RMB 50,000.229 As of September 2014, individual investors accounted for 64.4 per cent of the total share capital of the ChiNext Board, in contrast to 35.6 per cent held by institutional investors.230 Studies have also found a positive correlation between heightened investor sentiments and the phenomenon of overvaluation.231 Many of these retail investors are more likely to speculate and be influenced by investor sentiments. Arguably, without greater participation from institutional and sophisticated investors, the Chinese stock market will continue its extreme susceptibility to retail investors who are less risk tolerant and correspondingly more inclined to invest based on fear or greed.232 Under the current system, as the supply of IPOs is artificially constrained by the CSRC, retail investors with little clue on how to properly invest will always be seeking the ‘next best thing’ that is listed on the stock exchanges, driving up the share prices of newly listed companies. 228

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Shenzhen Stock Exchange Main, ‘Shenjiaosuo 2019 nian Geren Touzizhe Zhuangkuang Diaocha Baogao’ (深交所 2019 年个人投资者状况调查报告) [2019 Report of Individual Investors], http://investor.szse.cn/institute/bookshelf/report/index.html. Ibid. ‘Five Year Anniversary of ChiNext – Composition of Investors and Investment Behaviour Report’, cited in Liu Wei, ‘ChiNext’ ‘Chuangyeban Geren Touzizhe Hujun Yingli 5.5 Wan Jiegou Rengyou Buzu’ (创业板个人投资者户均盈利 5.5 万结构仍有不 足) [The average profit of GEM individual investors is 55,000. The structure remains inadequate], Shanghai Securities News [shanghai zhengquanbao], (China, 30 October 2014) http://finance.people.com.cn/stock/n/2014/1030/c67815-25936954 .html. Song, J. Tan, and Y. Yi, supra note 35, at p. 47. E. Teo, ‘China’s Stock Market Casino and the Real Economy’ Straits Times, (Beijing, 13 January 2016), www.straitstimes.com/opinion/chinas-stock-market-casino-and-thereal-economy, accessed 17 April 2016; See also N. C. Howson and V. S. Hanna, ‘The Development of Modern Corporate Governance in China and India’ in Muthucumaraswamy Sornarajah and Jiangyu Wang (eds.), China, India, and the International Economic Order (Cambridge University Press, 2010), 543 (noting that China’s stock market has been unfavourably compared to a ‘casino’).

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However, the proposed IPO registration system will be more objective and market-driven, in terms of approval and pricing. Accordingly, investors will increasingly need to make investment judgments themselves. Therefore, improving the sophistication of investors on the stock exchange is of crucial importance. This can be achieved by continuous investor education and relaxing restrictions on institutional investors making equity investments.233 Fifth, many auxiliary legal reforms and institutional improvements are needed to facilitate the implementation of the registration system. As alluded to earlier, these include building and attracting more sophisticated investors, promulgating a well-designed delisting mechanism, and establishing a competent regulatory body with effective public enforcement. Additionally, given the large number of reported cases of corruption by CSRC officials in relation to IPOs,234 party and regulatory discipline should be enhanced.235

4.2.8.2 Amendments to the DCS Rules This part has sought to tease out the main considerations involved in designing the regulation of DCS structures on the public equity market. First, there is a need for efficient markets. Regulators need to empower companies to structure themselves in such a manner that they will be able to set themselves up for long-term success. This is particularly pertinent in the case of unicorn start-ups seeking a listing. Despite their size in terms of revenue or market capitalisation, the businesses of these companies tend to still be in the early stages and, consequently, some shielding of the 233

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Institutional investors such as the NSSF and insurance companies were prohibited from making equity investments due to past policy constraints. While relaxations have been made in recent years to allow institutional investors to make equity investments, many are subject to restrictions on investment ratios. For example, public pension funds are allowed to make investment in stocks, equity funds, and bond funds up to 30 per cent of their investible assets only under Art. 37(3) of the Guowuyuan guanyu Yinfa Jiben Yanglao Baoxianjijin Touzi Guanlibanfa de Tongzhi (国务院关于印发基本养老保险 基金投资管理办法的通知) [Guideline on the Investment for the Pension Fund] (promulgated by the State Council, 17 August 2015, effective 17 August 2015), No. 48. S. Wang, ‘Zhengjie Zhengjianhui Ruhe Zhenggai ‘fashenfubai’ ’ (政解证监会如何整改’ 发审腐败’?) [How Does CSRC Reform Solve the Problem of IPO Corruption?], The Beijing News (Beijing, 26 April 2016), www.bjnews.com.cn/news/2016/04/26/401393 .html. The Chinese Communist Party’s Central Commission for Discipline Inspection has been conducting investigations on CSRC officials for violations of discipline. Three officials from CSRC who were in charge of the approval of IPOs were investigated since 2015, including the Vice Chairman Yao Gang. See ibid.

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management from the short-term demands of the market may be appropriate. At the same time, efficient markets also need to ensure that investors are provided with all the relevant information required for them to make an accurate evaluation of the value of the firm. This would then guide them in their decisions on whether to purchase the shares, be it at IPO or subsequently, and whether they should sell their shares and exit their investment, especially if they disagree with the direction that the managing team is bringing the company. This point brings us to the second consideration, the need for investor protection. Aside from the ability to walk away from the investment, investors should also be able to have re-course to legal protection in a timely and affordable manner where the abuses of corporate powers or the DCS structure has taken place. The contextual circumstances of the Chinese legal system and the Chinese market also pose unique problems. Understanding the profile of the typical Chinese investor and the Chinese market is key. Since institutional investors in the Chinese market are comparatively passive, the market is mainly composed of retail investors. In 2018, a total of 80 per cent of the investors in the Chinese markets had invested less than RMB 500,000 while investors that had put in less than RMB 100,000 accounted for 40.9 per cent of the market.236 At the same time, most new investors are relatively young, with 56.2 per cent of new investors in 2018 being less than 30 years of age, and the average age of new investors in 2018 being 31 years old. Correspondingly, they tend to be younger, less experienced, and have a higher propensity for errors when making investment decisions. Furthermore, the Chinese market still lags behind more established markets in terms of information disclosure, self-regulation, class litigation, and other shareholder protection measures. Hence, it is imperative that regulators be more cautious and design a relatively strict regulatory framework. The STAR Market in devising its rules has adopted two general strategies to further the aim of shareholder protection. First, by relying on the supervisory board to provide internal oversight and protect investors. Second, by the external supervision of corporate activities by the exchange. Relying solely on the supervisory board is an unsafe and unreliable strategy that does not ensure investor protection. The board of supervisors is elected at the shareholder meeting, over which the founder of the 236

Shenzhen Stock Exchange Main, ‘Shenjiaosuo 2018 nian Geren Touzizhe Zhuangkuang Diaocha Baogao’ (深交所 2018 年个人投资者状况调查报告) [2018 Report of Individual Investors], http://investor.szse.cn/institute/bookshelf/report/.

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company has control due to the use of the DCS structure. Hence, the board of supervisors is susceptible to the influence of the controlling shareholders. The same problem also arises at the board of directors. Hence, it can be seen that the use of the DCS structure results in potential deficiencies in the company’s internal governance system. Turning to the powers of the exchange, the STAR Market rules only stipulate that the exchange may require compensation where the DCS structure has been abused by the controlling shareholder. It may not be immediately clear if a specific action is an abuse of the DCS structure. The manner in which harm and causation will be determined also means that much more has to be clarified before this power can be effectively put to use. It is suggested that the STAR Market rules can be amended in the following ways to improve investor protection during the period where the DCS structure is in place. First, the nomination of the board of supervisors can be made subject to a ‘one share one vote’ process, giving supervisors the same protection from influence that independent directors enjoy. Second, more can be done to improve shareholders’ access to justice through the courts by making it easier to bring a derivative action and a class action. The Chinese derivative action suffers from high thresholds, uncertainty, and inconsistent enforcement.237 Attempts at collective class action suits also tend to be unsuccessful despite the best efforts of lawyers to gather plaintiffs. Moreover, the handling of these cases tends to result in cases being split, increasing the co-ordination and legal fees faced by the plaintiffs and preventing them from pursuing an action to the fullest extent. The inefficient collective action system in China can be directly compared to the well-developed class action system in the US. It is not inconceivable that the threat of class action suits can act as a disciplinary tool to curtail potential bad behaviour by listed companies. Coupled with the use of contingency fees and civil procedure rules that allow the plaintiffs and their lawyers to recover costs should they succeed in proving wrongdoing on the part of defendants, investors are correspondingly better able to monitor their portfolio companies and enforce their rights at lower cost. By comparison, Chinese law merely allows shareholders the right to recovery where there is an abuse leading to loss. However, it does not provide any clear, effective mechanism by which this right may be enforced. Future law reform exploring the possibility of group litigation and clearer 237

D. C. Clarke and N. C. Howson, ‘Pathway to Minority Shareholder Protection: Derivative Actions in the People’s Republic of China’, in Dan W. Puchniak, Harald Baum and Michael Ewing-Chow (eds.), The Derivative Action in Asia: A Comparative and Functional Approach (Cambridge University Press, 2012).

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civil procedure rules would be a step in the right direction. Policymakers may also wish to consider how market institutions such as the Chinese Small and Medium Investor Service Centre may assist investors in their claims against the company and controlling shareholders.238 Third, given that the STAR Market rules permit a non-director to hold on to weighted voting shares, more has to be done to impose duties upon controlling shareholders. While directors owe duties of loyalty to the company, controlling shareholders in China do not. In this respect, a clearer fiduciary duty imposed on controlling shareholders would help to curb misbehaviour in terms of preventing controlling shareholders from sacrificing the interests of the company and other shareholders in the pursuit of their own interests. Alternatively, the scope of parties who may hold on to these shares should be restricted only to directors, resulting in a corresponding duty of loyalty in favour of the company being imposed. Should this step be taken, more should be done to reinforce the duty of loyalty owed by company directors under Chinese law. Finally, the independence of the board of directors of listed companies can be further improved. This can be done by requiring the establishment of independent nomination, audit, and remuneration committees chaired by independent directors. The appointment and dismissal of independent directors should also be subject to a shareholder vote on ‘one share one vote’ terms. The increased independence of the board leads to better internal oversight and governance, in turn ensuring that the board as a whole is better placed to fulfil its duty of loyalty owed to the company. Furthermore, unlike Singapore and Hong Kong, the Chinese Code of Corporate Governance does not stipulate that independent directors should form a majority of the board where the chairman is not independent.239 Adopting these measures will bring the Chinese code closer to international best practices and could greatly increase investor protection. Despite these measures, the presence and influence of the founder as a controlling shareholder continue to loom large. Hence, it is not certain that these systematic changes will be able to achieve the aim of increasing board independence and good internal corporate governance. In this context, the STAR Market may wish to seriously consider limiting the 238

239

See, for example: Xin Hua Net, ‘Zhongzheng Toufu Zhongxin: Wei Guangda Zhongxiao Touzizhe ‘Daiyan’’ (中证投服中心：为广大中小投资者‘代言’) [Index China Investment Service Center: ‘Endorsement’ for SMEs] (13 March 2019), www.gov.cn /xinwen/2019-03/13/content_5373424.htm. L. Lin, supra note 154, at 230.

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period in which harm can occur by mandating the inclusion of sunset clauses in the company’s articles of association. At the same time, serious thought should also be put into not only imposing but also enforcing a duty of loyalty on the founder in this specific instance.

4.3 Exits via M&A An acquisition exit, in which the entire firm is sold to a third party (an acquisition exit includes a sale of shares, a merger, and also a sale of the firm’s assets), is one of the principal VC exit vehicles.240 As shown in Table 4.1 (See Section 4.2.2 in this chapter), though being a popular exit channel for VC-backed firms, M&As are less feasible alternative exit options as compared to IPOs in China. There are five possible reasons for this situation. First, regulatory approval is required for M&A activities. Listed241 and non-listed242 public companies must seek approval from relevant authorities when the acquisition and/or relevant equity changes pertain to issues such as national industrial policies, industry access, transfer of state-owned shares, and foreign investments. Therefore, M&A activities and corporate reorganisations are uncertain and risky. A prolonged approval timeline also compromises M&A efficiency, resulting in negative implications including employee brain drain and variations in acquisition pricing. Second, local governments have been known to use their administrative powers to obstruct M&A activities, especially those involving SOEs.243 In addition, there are tight regulations over foreign M&A activities. Under the Provisions on Foreign Investors’ Merger and Acquisition of Domestic Enterprises,244 any M&A activity by foreign-invested enterprises requires approval from the Ministry of Commerce (MOFCOM) or a provincial department in charge of commerce.245 Faced with these institutional 240 241

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D. J. Cumming and J. G. MacIntosh, supra note 1, at p. 106. Article 4, Measures for the Administration of Takeover of Listed Companies [Shangshi Gongsi Shougou Guanli Banfa] (上市公司收购管理办法), China Securities Regulatory Commission (effective 1 September 2006, amended 23 October 2014). See Article 4, Measures for the Administration of Takeover of Non-listed Public Companies [Feishangshi Gongzhong Gongsi Shougou Guanli Banfa] (非上市公众公司 收购管理办法), China Securities Regulatory Commission (effective 23 July 2014). Telephone interview with Mr Yu Huaming, Senior Associate, Zhong Lun Law Firm (Shenzhen office), 28 February 2016. Provisions on Foreign Investors’ Merger and Acquisition of Domestic Enterprises [Shangwubu Guanyu Touzizhe Binggou Jingnei Qiye de Guiding] (商务部关于投资者 并购境内企业的规定), Ministry of Commerce (effective 22 June 2009). Ibid., Art. 10.

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obstacles, it is unsurprising that the scale of the M&A and corporate reorganisation businesses in the investment banking arms of Chinese securities companies is very small. In 2011, M&A and corporate reorganisation work took up only 5 per cent of the investment banking businesses of securities companies. In 2012, this increased only slightly to 5.7 per cent.246 In addition, the Chinese government has exerted stringent control over debt financing. Banks in China have very conservative lending practices, making it difficult to finance both VC and M&A deals with debt. According to Article 20(3) of the General Rules for Loans issued by the People’s Bank of China in 1996, a borrower is not permitted to use bank loans to fund equity investments. This is an enormous obstacle for VC firms seeking debt financing in M&A activities. To remedy this, the China Banking Regulatory Commission (CBRC) issued a Notice on the Risk Management of M&A Loans of Commercial Banks in December 2008 (2008 Guideline),247 allowing commercial banks to provide acquisition finance to certain companies. The 2008 Guideline was later replaced by a new guideline, issued in February 2015,248 which expanded the potential sources of funding by allowing policy banks and branches of foreign banks to provide acquisition finance.249 However, although this guideline allows PRC-incorporated banks to provide acquisition financing to an onshore enterprise to acquire 246

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X. B. Zheng, ‘Zhongguo Binggou Langchao Heshi Daolai Bu Queding’ (中国并购浪潮 何时到来不确定) [It Is Uncertain When the Chinese M&A Wave Is Going to Arrive], Securities Times [ZhengquanShibao], (27 May 2013), http://epaper.stcn.com/paper/zqsb/ html/2013-05/27/content_473491.htm. ‘Zhongguo Yinjianhui Guanyu Yinfa Shangye Yinhang Binggou Daikuan Fengxianguanli Zhiyin de Tongzhi’ (中国银监会关于印发商业银行并购贷款风险管 理指引的通知) [Notice of the China Banking Regulatory Commission on Issuing the Guidelines on the Risk Management of M&A Loans of Commercial Banks], China Banking Regulatory Commission (effective 6 December 2008). ‘Zhongguo Yinjianhui Guanyu Yinfa Shangye Yinhang Binggou Daikuan Fengxianguanli Zhiyin de Tongzhi’ (中国银监会关于印发商业银行并购贷款风险管 理指引的通知) [Notice of the China Banking Regulatory Commission on Issuing the Guidelines on the Risk Management of M&A Loans of Commercial Banks], China Banking Regulatory Commission (effective 10 February 2015), No 5. Notable changes include: (1) extending the guidelines to policy banks, PRC branches of foreign banks, or finance companies of business groups, (2) extending the term of the loan to not exceed seven years, (3) increasing the cap of the loan, such that it now cannot account for more than 60 per cent of the acquisition value, and (4) relaxing the security requirements for M&A loans. See King & Wood Mallesons, ‘CBRC Amends Guidelines for Risk Management of M&A Loans Granted by Commercial Banks’, (24 March 2015), www.kwm.com/en/knowledge/insights/cbrc-amends-mergers-and-acquisitions-loansguidelines-20150324.

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a target,250 this is subject to various limitations.251 First, the loan should not exceed 60 per cent of the total acquisition price252 and the loan term should not exceed seven years.253 Comparatively, in the US and Europe, a debt proportion of 70 per cent is commonplace,254 and may well run up to 90 per cent.255 Indeed, the average equity component in the top five UK leveraged buyouts (LBOs) in 2006 was a mere 21 per cent.256 Second, banks are required to ensure that there is a high degree of strategic relevance between the acquirer and the target (e.g. the acquisition would improve the acquirer’s competitiveness by obtaining strategic resources such as technology and intellectual property rights).257 This poses obstacles to PE funds, which are ‘financial’ as opposed to ‘strategic’ buyers who extract synergies from the acquisition.258 Third, banks must impose rigorous loan covenants,259 extract stringent securities, and closely monitor the performance of the loan obligations.260 This is in contrast to the practice in the US and Europe, where covenant-lite loans261 have become more commonplace. Ultimately, such regulatory restrictions have created a situation where PE funds in China typically do not use highly leveraged debt financing.262 In practice, acquisition loans are generally not available 250

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CBRC, ‘Guidelines on Risk Management of Merger and Acquisition Loans granted by Commercial Banks’, (2015), No.5 (‘CBRC Guidelines’). Y. Ye, ‘Value Creation in Private Equity Funds: Practices in China’, DBA Thesis, Arizona State University (May 2016), 21. Article 21, CBRC Guidelines, supra note 250. Ibid., Article 22. L. Gullifer and J. Payne, Corporate Finance Law (Hart Publishing, 2011) at p. 657. S. N. Kaplan and P. Stromberg, ‘Leveraged Buyouts and Private Equity’, Journal of Economic Perspectives, 22(4) (2008), 124; H. K. Baker, G. Filbeck and H. Kiymaz, Private Equity: Opportunities and Risks (Oxford University Press, 2015) at p. 90 (‘Baker, Filbeck and Kiymaz, Private Equity: Opportunities and Risks’). Financial Services Authority, ‘Discussion Paper 06/6; Private equity: a discussion of risk and regulatory engagement’, www.treasurers.org/ACTmedia/dp06%5F06.pdf (November 2006), 35. Article 26(3), CBRC Guidelines, supra note 250. D. P. Stowell, Investment Banks, Hedge Funds, and Private Equity, 2nd ed. (Academic Press, 2012) at p. 92; Baker, Filbeck and Kiymaz, Private Equity: Opportunities and Risks, supra note 255, at p. 204. Articles 31–33, CBRC Guidelines, supra note 250. Ibid., Articles 34–36. A covenant-lite loan is a loan which does not include stringent maintenance covenants (which typically requires the borrower to meet various financial tests on a quarterly basis). See UK House of Commons Treasury Committee, Private Equity (Tenth Report of Session 2006-07) (2007), 25–26 (‘UK Treasury Committee, Private Equity Report’). L. Lin, ‘Private Equity Investor Protection’, Berkeley Business Law Journal, 15(1) (2018), 11 (noting that due to regulatory restrictions on using bank loans to fund acquisition transactions, a Chinese PE fund does not usually conduct LBOs); see also K. P. Yong,

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to PE funds263 due to a strong credit preference towards SOEs.264 Hence, PE funds’ access to leverage remains limited.265 Third, LBOs by foreign funds also attract scrutiny by the MOFCOM, as evident in the failed LBO of state-owned construction company Xugong by Carlyle.266 The deal raised political concerns that the Chinese government was selling state assets to foreigners too cheaply,267 and despite Carlyle reducing its offer from 85 per cent to 50 per cent and subsequently 45 per cent equity, it could not secure approval by the MOFCOM for the LBO.268 China’s negative attitude towards LBOs may be understood with reference to their historical and political background. The 2015 stock market crash was widely attributed to excessive leverage by stock market investors,269 which led to a campaign of

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Private Equity in China: Challenges and Opportunities (Wiley, 2012), 61 (noting that due to the Chinese government’s strict regulation of the market, LBOs are tedious and fraught with regulatory hurdles). L. Gong and D. Xu, China: Private Equity 2019 (Global Legal Group, 2019), https://iclg .com/practice-areas/private-equity/private-equity-2017/china#chaptercontent8 (noting that while the CBRC guidelines do not prohibit acquisition loans to PE funds, the loans are usually provided to conglomerates and industrial companies). X. H. Liu, ‘How to Improve M&A Loans in China: a comparison and risk management angle’, Thesis: S.M. in Management Studies, Massachusetts Institute of Technology, Sloan School of Management (2017), at pp. 22–23 (noting that commercial banks generally require borrowers to provide sufficient guarantees to cover the risk of acquisition financing, which creates a bias towards SOEs, which have the backing of the government); Xiao, ‘From growth equity to leveraged buyout: Making Private Equity Investments in China’, Thesis: S.M. in Management Studies, Massachusetts Institute of Technology, Sloan School of Management (2013), at p. 59 (noting that the bank loan policies in China are inclined towards SOEs, and are mainly provided to strategic investors. Thus, the chance of LBO financing to PE firms remains low). A. Zhang et al, ‘A New Chapter for Private Equity in China’, Siguler Guff Advisers, LLC (2014) at p. 10 (noting that there is increasing, but still limited access to leverage for PE funds). D. Cumming and G. Fleming, ‘Taking China Private: The Carlyle Group, Leveraged Buyouts, and Financial Capitalism in Greater China’, Business History, 58(3) (2016), at pp. 351–353. P. Yong, supra note 262, at p. 94 (noting that the deal faced social pressure from competitors who used nationalism to stir up public outcry, and faced hostile reporting by domestic media). D. Cumming and G. Fleming, supra note 266, at pp. 351–353; see also Reuters, ‘China’s Xugong says Carlyle investment deal dead’, Reuters (22 July 2008), www.reuters.com /article/carlyle-xugong/chinas-xugong-says-carlyle-investment-deal-deadidUSSHA32313820080722. S. Shen and E. Tham, ‘In China, stocks-for-loans under stress as market slides’, Reuters (9 June 2017), www.reuters.com/article/us-china-collateral-stocks-insight/in-china-

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‘deleveraging’.270 Indeed, political rhetoric against the use of leverage reached a high-water mark in 2016 where the CSRC chairman condemned LBOs financed by high-risk insurance products as ‘barbaric’ and such asset managers as ‘robbers.’271 Recent consultation documents for banking and asset management regulation have also focussed on limiting leverage.272 Fourth, in acquisition situations, a strategic buyer would usually make the target company a wholly owned subsidiary or a separate division of the strategic buyer in order to produce synergistic gains,273 such as by integrating the target company’s products and technologies.274 In doing so, the strategic acquirer faces difficulties in reconciling the target company’s corporate culture with that of the parent company. The acquirer may also find it difficult to exert influence on the existing employees of the target company. Considering these challenges, it has been opined that the number of strategic buyers who wish to acquire VC-backed companies in China is limited.275 Fifth, the institutional infrastructure for M&As is underdeveloped. In an M&A-exit, a potential buyer faces difficulties getting direct access to the information of non-listed target start-up companies. M&A transac-

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stocks-for-loans-under-stress-as-markets-slide-idUSKBN1900TA; see also generally J. Bian et al., ‘Leverage-Induced Fire Sales and Stock Market Crashes’, (2017), https://dx .doi.org/10.2139/ssrn.3047460. A. Yao, ‘Two reasons not to fear China’s deleveraging campaign’, South China Morning Post (24 May 2017), www.scmp.com/business/global-economy/article/2095449/opin ion-two-reasons-not-fear-chinas-deleveraging-campaign; see also Zhixin, ‘Yingjie Zhenziguan Shidai’ (迎接真资管时代) [Welcoming the Era of Asset Management], Fund Management Cloud (资管云), (29 March 2018), http://mp.weixin.qq.com/s/ Y2BteSvSbkHIPcSuWBD5Ig; G. N. Li, ‘Jinrongquganggan jiang ruhejixu?’ (金融去杠 杆将如何继续?) [How will financial deleveraging continue?], (8 January 2018), http:// finance.sina.com.cn/zl/2018-01-08/zl-ifyqkarr7944256.shtml. X. Yu, ‘Regulator Suspends Product Sales of Insurers Branded ‘Barbarians’ for Hostile Buyouts’, South China Morning Post (6 December 2016), www.scmp.com/business/ banking-finance/article/2052267/regulator-suspends-product-sales-insurers-branded. See People’s Bank of China, ‘Regulation of Asset Management Business of Financial Institutions (Consultation Draft)’, People’s Bank of China (2017), www.pbc.gov.cn/gou tongjiaoliu/113456/113469/3420451/index.html; see also CSRC, ‘Interim Regulations on Securities and Futures Institutions Private Equity Asset Management Business Operation and Management’, CSRC (2016), www.csrc.gov.cn/shanghai/xxfw/gfxwj/ 201612/P020161202574865079353.pdf. D. J. Cumming and J. G. MacIntosh, supra note 1, at p. 106–107. Ibid. Telephone interview with Ms Kang, Partner, Global Law Firm, 22 December 2015.

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tions thus require a high level of professional assistance. However, statistics show that in China, there is a shortage of sophisticated financial intermediaries who possess the relevant expertise, due to the short history of China’s capital market.276 Given the limited domestic talent pool, banks have struggled to find enough talent to sustain their operations.277 Therefore, historically, few M&A transactions have been entered into and these deals often do not succeed.278 Nonetheless, the occurrence of M&A exits seems to be experiencing an upward trend in recent years, especially in the VC industry. The quantity of VC-backed M&A transactions has increased significantly from 76 in 2013 to 111 in 2014 (See Table 4.1). The total value of M&A exits in China doubled from USD 34,660 million in 2013 to USD 68,829 million in 2014.279 The number of M&A exits doubled again to 280 in 2015, making 2015 the first year since 2006 where M&A exits exceeded VC-backed IPOs (257) (excluding 2013, when the IPO window was suspended for the year). Arguably, the suspension of the IPO market in 2013 contributed to the increased popularity of M&As by introducing greater uncertainty 276

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See T. Chan and others, ‘The 2012 BCG 50 Chinese Global Challengers: End of Easy Growth’, The Boston Consulting Group, (11 September 2012), www.bcgperspectives.com /content/articles/globalization_2012_chinese_global_challengers_end_of_easy_ growth/?chapter=4 (that ‘few Chinese companies have developed a mastery of the M&A and post-merger integration processes . . . for many Chinese executives, deal making and deal integration are still foreign concepts. Their deals frequently fall short of their original goals. . . . they [Chinese companies] suffer from a lack of experience. Many Western companies have spent thirty or more years developing capabilities in evaluating, executing, and integrating deals.’). See PricewaterhouseCoopers, ‘Foreign Banks in China’, PricewaterhouseCoopers China (2012), at p. 28 www.pwc.com/gr/en/surveys/assets/foreign-banks-china-jul2012.pdf, (‘Nearly all foreign banks struggle to find and retain sufficient talent to support the continued growth of their mainland operation. Most foreign banks in China said their staffs were overwhelmingly Chinese, but given the limited number of years of reform, the existing domestic talent supply is still limited’). In a 2010 survey done by KPMG on Chinese companies, ‘fifty-six percent of survey respondents cited failure to identify important financial, operational and management issues in due diligence as a key reason for the failure of a deal and this is one particular area where the experience of external advisors can help’. See KPMG, ‘World class aspirations: The perceptions and the reality of China outbound investment’, KPMG (2010) at p. 12 https://home.kpmg/cn/en/home/insights/2010/10/china-outboundinvestment-201010.html. Zero2IPO Research Centre, ‘Qingke Zhongguo Guquan Touzi Shichang 2014 Nian Quannian Huigu’ (清科中国股权投资市场 2014 年全年回顾) [China Equity Investment Market Year-in-Review 2014], Zero2IPO Publisher (2015), at p. 42 http:// research.pedaily.cn/researchreport/2015/20150209378364.shtml.

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and risk into the IPO process. The riskiness of IPO exits has been further exacerbated by the volatility of stock markets in recent years.280 Additionally, the growing experience and improving attitudes of investors have contributed to a smoother M&A exit channel for VC investments. Deloitte has found that Chinese investors are increasingly more optimistic about market dynamics with respect to M&As and are developing an appetite for larger M&A transactions.281 With these heightened expectations, Chinese investors have become more willing to involve professional advisors in their transactions. Notably, this includes engaging professionals to resolve issues pertaining to postmerger integration – an aspect widely accepted in China as crucial to a successful M&A transaction.282 Furthermore, on 7 March 2014, the State Council promulgated a new Opinion on Further Optimising the Market Environment for the Merger and Restructuring of Enterprises (Opinion).283 It aimed to reduce the scope of projects that are subject to examination and approval, and to remove the pre-examination procedure for takeover reports of listed companies. Pursuant to the Opinion, the CSRC issued a new regulation to remove the examination and approval procedure for major purchases, sales, and replacement of assets by companies that do not constitute backdoor listings, and the prior examination and approval procedure for tender

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J. Noble, ‘Why Are China’s Stock Markets So Volatile?’ (2 July 2015), www.cnbc.com /2015/07/02/why-are-chinas-stock-markets-so-volatile.html. Deloitte, ‘More Experienced Buyers, Higher Return Expectations: 2014 Greater China Outbound M&A Spotlight’, (Deloitte 2014), at p.31 www2.deloitte.com/content/dam/ Deloitte/xe/Documents/About-Deloitte/me_csg_2014-china-outbound.pdf. Note though that this Deloitte study was conducted in relation to outbound M&A. (‘Respondents are more optimistic about the market dynamics in the coming year compared with those in the 2013 survey’; ‘Large M&A transactions will probably happen more frequently’. Chinese M&A investors expect middle and large-sized M&A transactions (USD 150 million-USD 500 million) to happen more frequently in the coming year. The expectations of small-sized M&A transactions (USD 5 million–USD 50 million) dropped significantly in the 2014 survey, showing Chinese investors were developing an appetite for larger transactions, especially for targets with higher valuations or with a leading position in their particular industry’.) Ibid. State Council, ‘Guowuyuan Guanyu Jinyibu Youhua Qiye Jianbing Chongzu Shichanghuanjing de Yijian’ (国务院关于进一步优化企业兼并重组市场环境的意 见) [Opinion on Further Optimising the Market Environment for the Merger and Restructuring of Enterprises], State Council (effective 24 March 2014), www.gov.cn /zhengce/content/2014-03/24/content_8721.htm.

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offers.284 In addition, a mandatory 75 per cent loan-to-deposit ratio has been abolished under the 2015 amendments to the Law of the People’s Republic of China on Commercial Banks,285 and this may encourage Chinese banks to lend more. This author believes that with the improvements of the regulatory environment in the M&A market, M&A will gradually evolve into a more widely used exit option for VC-backed companies. In January 2018, the National Development and Reform Commission (NDRC) issued the Notice on Specific Policy Issues concerning the Implementation of the Market-Oriented Debt-Equity Swaps of Banks,286 encouraging firms to conduct debt-to-equity swaps in a market-oriented manner through the raising of equity investment funds. Additionally, the scope of application will be expanded from simply SOEs to encompass non-SOEs. In light of this policy measure, the involvement of VC and PE firms in the M&A market will deepen. The LBO funds which predominantly invest in VC or PE firms will also develop further. In the first quarter of 2018, there were 102 PE-backed M&A exits, representing an increase of 112.50 per cent from the previous year.287 Overall, M&A as an exit channel is gradually gaining favour and increasingly being sought after by investors. Industrial consolidation and large enterprises 284

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‘Shangshi Gongsi Zhongda Zichan Chongzu Guanli Banfa’ (上市公司重大资产重组管 理办法) [Administrative Measures for the Material Asset Reorganization of Listed Companies], China Securities Regulatory Commission (effective 18 May 2008, amended in 2011), www.csrc.gov.cn/pub/newsite/flb/flfg/bmgz/ssl/201012/t20101231_189843 .html. superseded by ‘Measures for the Administration of the Material Asset Restructurings of Listed Companies’, China Securities Regulatory Commission (effective 23 November 2014). ‘Shangye Yinhangfa’ (商业银行法) [Law of the People’s Republic of China on Commercial Banks], promulgated by the 13th Meeting of the 8th Standing Committee of the National People’s Congress, effective 1 July 1995; amended 27 December 2003 by the 6th Meeting of the 10th Standing Committee of the National People’s Congress; amended 29 August 2015 by the 16th Meeting of the 12th Standing Committee of the National People’s Congress. ‘Guanyu Shichanghua Yinhang Zhaiquan Zhuanguquan Shishi Zhong Youguan Juti Zhengce Wenti De Tongzhi’ (关于市场化银行债权转股权实施中有关具体政策问题 的通知) [Notice on the Specific Policy Issues concerning the Implementation of the Market-Oriented Debt-Equity Swaps of Banks], National Development and Reform Commission, the People’s Bank of China, the Ministry of Finance and Other Ministries and Commissions (2018) No. 152. X. Wan, ‘Qingkejibao: 2018 Nian Q1 Binggou Shichang Pingwen Fazhan, Jingen Zhengce Dongxiang Yu Shichang Bianhua Wajue Touzi Jihui’ (清科季报: 2018年Q1 并购市场平稳发展，紧跟政策动向与市场变化挖掘投资机会) [Zero2IPO Report: The Q1 M&A market develops steadily in 2018, keeping pace with policy trends and market changes to tap investment opportunities], Zero2IPO Research Centre (2 May 2018), https://m.gelonghui.com/p/177293.

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absorbing smaller ones have become the current trend of development for many industries, with high-quality targets being in high demand, raising the certainty and profitability of investors relying on the M&A exit option.288

4.4 Bankruptcy Given the high-risk nature of venture capitalism, bankruptcy is a common exit strategy for individuals who have failed in their entrepreneurial venture. The availability of bankruptcy proceedings, as well as the regulations relating to such proceedings, is a rather controversial and politicised topic. Some people advocate for bankruptcy to be less entrepreneurfriendly, with higher exit barriers set for entrepreneurs to make bankruptcy less accessible and a longer bankruptcy period before dischargement. Others advocate for more flexible and forgiving bankruptcy proceedings. They believe that allowing these entrepreneurs a second chance at organising and recouping their finances is integral to the promotion of innovation and entrepreneurship. ‘Law and finance’ scholars have conducted empirical research on the links between bankruptcy law and VC finance. Two such scholars, Armour and Cumming, noted that a liberal personal bankruptcy regime has a positive impact on the success of a VC market.289 Conversely, a stricter bankruptcy regime discourages potential entrepreneurs from taking risks and failed entrepreneurs from re-establishing businesses.290 Armour and Cumming showed that countries with less liberal bankruptcy laws, measured by reference to the number of years before a bankrupt individual obtained a ‘fresh start’ (that is, a discharge from pre-bankruptcy indebtedness) while controlling for countries in which no ‘fresh start’ is available, have significantly lower demand for VC and PE.291 Such a theory highlights that there is a trade-off when deciding between a liberal and strict bankruptcy regime. A stricter regime allows for greater 288 289

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Ibid. J. Armour and D. Cumming, ‘The Legislative Road to Silicon Valley’, Oxford Economic Papers, 58(2006), 598, at Section 4, subsections 5.2., 5.4; J. Armour, ‘Personal Insolvency Law and the Demand for Venture Capital’, European Business Organization Law Review, 5(1) (2004), 87. Ibid., at Section 4 subsections 3.3. and 5.2. Ibid., Section 4, subsection 5.2.

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creditor protection, hence preserving incentives for entrepreneurs to succeed before bankruptcy, whereas a more forgiving bankruptcy regime maintains incentives for the entrepreneur to continue efforts even after bankruptcy. Ayotte analyses this trade-off using a principal-agent model and argues that ‘fresh start’ policies generate social gains by preserving an entrepreneur’s post-bankruptcy incentives.292

4.4.1 Speed up the Development of Bankruptcy Law in China The ‘fresh start’ policy in personal bankruptcy laws around the world has undergone some significant changes in the last twenty years. Jurisdictions including Singapore,293 England,294 Scotland,295 Germany,296 Austria,297 France,298 Israel,299 and Finland300 have abandoned their fixation with bankruptcy as a punitive mechanism against a defaulting debtor, or as a collection tool for creditors. Instead, these countries have opted for 292

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See F. M. Fossen, ‘Personal Bankruptcy Law, Wealth, and Entrepreneurship: Theory and Evidence from the Introduction of a ‘Fresh Start’’, American Law and Economics Review, 16(1) (2013), 269, https://doi.org/10.1093/aler/aht015. The theoretical model developed in this paper illustrates that a more forgiving personal bankruptcy law, which allows for a ‘fresh start’ for insolvent entrepreneurs, may have two contradictory effects on the attractiveness of entrepreneurial activity in comparison to wage work. On the one hand, forgiving personal bankruptcy proceedings provide insurance, as entrepreneurs enjoy a partial discharge from debt in case of misfortune. On the other hand, they also increase interest rates, because banks demand compensation for the lower expected recovery in the case of debtor bankruptcy. The model further shows that both effects are more pronounced for less wealthy potential entrepreneurs, because the wealthy bring in their wealth as collateral and thus neither benefit as much from the insurance, nor suffer as much from the increased interest rates. Parliamentary Debates Singapore: Official Report, vol 93 (13 July 2015) (Senior Minister of State for Law, Indranee Rajah SC). T. M. Safley, The History of Bankruptcy: Economic, Social and Cultural Implications in Early Modern Europe (Routledge, 2013), p. 231. Modernising bankruptcy and diligence in Scotland: Draft Bill and Consultation (Scottish Executive, 2004). J. J. Kilborn, ‘The Innovative German Approach to Consumer Debt Relief: Revolutionary Changes in German Law, and Surprising Lessons for the United States’, Northwestern Journal of International Law & Business, 24 (2004). T. K. Graziano, Juris B., and Veronika S., A Guide to Consumer Insolvency Proceedings in Europe (Edward Elgar Publishing, 2019), at para 3.145. P. C. Hautcoeur, N. Levratto, ‘Bankruptcy law and practice in 19th century France’, PSE Working Papers halshs-00587828 (2007), at p. 5. R. Efrat, ‘The Transformation of the Israeli Bankruptcy System as a Reflection of Societal Changes’, Journal of Transnational Law and Policy, 10(1) (2000). I. Benohr, EU Consumer Law and Human Rights (Oxford University Press, 2013), at pp. 142–143.

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a personal bankruptcy regime that is more concerned with providing debtors with the opportunity for a ‘fresh start’. There is currently no unified and organised personal bankruptcy regime in China. Under the new PRC Enterprise Bankruptcy Law, effective since 1 June 2007, individuals are not eligible for bankruptcy. Currently, there are several sanctions for debtors that default on loans in China: (1) the debtor shall be included in the List of Dishonest Persons subject to Enforcement and shall face a series of penalties;301 (2) the debtor may be subject to expenditure limits302 and restrictions on overseas travel;303 (3) depending on the severity of the situation, courts may fine or impose custodial sentences on the debtor;304 (4) if the elements of any criminal offences are met, the debtor may be prosecuted for his failure to comply with payment judgments. However, the absence of a personal bankruptcy regime in China for a long period can arguably be viewed as deliberate. There are two main reasons. First, there is a legitimate concern by the government that Chinese citizens are unable to accept the fact that, to a certain degree, the responsibility of debt repayment is avoided through personal bankruptcy laws. This is because the average Chinese citizen considers the concept of personal bankruptcy inappropriate. This view is influenced by a traditional belief that all debt must be repaid. To the average Chinese citizen, there is a duty to repay debts owed even if the debt was incurred by previous generations in the family. Even today, this traditional view continues to prevail in the Chinese culture. Second, there are alternative measures in place in China that are similar in function to personal bankruptcy laws. For ordinary debt collection, four such measures are available to creditors. First, similar to an administrator’s 301

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This is of particular relevance to a corporate debtor who may face more restrictions in its subsequent business operations. Several Provisions of the Supreme People’s Court on Announcement of the List of Dishonest Persons subject to Enforcement, Interpretation No. 17 (2013) of the Supreme People’s Court, Article 1. Several Provisions of the Supreme People’s Court on Restricting High Consumption of Judgment Debtors, Interpretation No. 8 (2010) of the Supreme People’s Court, Article 1. Interpretation of the Supreme People’s Court of Several Issues concerning the Enforcement Procedures in the Application of the Civil Procedure Law of the People’s Republic of China, No. 13 [2008] of the Supreme People’s Court, Article 37. Civil Procedure Law of the People’s Republic of China (Adopted at the Fourth Session of the Seventh National People’s Congress on 9 April 1991 and promulgated by Order No. 44 of the President of the People’s Republic of China on 9 April 1991), Article 241.

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subrogation right and right of revocation provided for under the PRC Enterprise Bankruptcy Law, the PRC Contract Law also provides for creditor subrogation305 and rescission.306 Second, when a debtor’s property is insufficient to offset all incurred debts, execution creditors can participate in the distribution of the debtor’s assets.307 The order of priority of such execution creditors is similar to that of the distribution order of a debtor’s liquidation proceeds under the PRC Enterprise Bankruptcy Law.308 Third, in the course of the execution, if the court

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Article 73 of Contract Law: If a debtor is indolent in exercising its matured creditor’s rights and thus causes losses to the creditor, the creditor may apply to a people’s court to subrogate the debtor’s creditor rights, except for the creditor rights exclusively belonging to the debtor, and exercise them under its own name. The scope for exercising the subrogation right is limited to the creditor rights enjoyed by the enforcing creditor. The expenses required for the subrogation shall be borne by the debtor. Article 74 of Contract Law: If a debtor disclaims its matured creditor’s rights or transfers gratis its property and thus causes losses to the creditor, the creditor may apply to a people’s court to rescind the debtor’s action. The creditor may also apply to a people’s court to rescind the debtor’s action if the debtor causes losses to the creditor by transferring its property at a low price that is patently unreasonable and the transferee has notice of such prejudicial behaviour. The scope for excising the right of rescission is limited to the creditor rights enjoyed by the creditor. The expenses required by the creditor to exercise its right of rescission shall be borne by the debtor. Article 508 of the Supreme People’s Court’s Explanation on the Application of the People’s Republic of China Civil Procedure Law states that in the implementation of the execution procedure, if the execution creditors find that the debtor’s property cannot satisfy all claims, they can apply to a people’s court to participate in the distribution of the debtor’s residual assets. Secured creditors or creditors with otherwise derived legal priority to the debtor’s seized and frozen assets can apply directly to the court to gain priority of compensation. Article 511 of the Explanation states that after execution cost is deducted from the execution proceeds, priority claims shall be first settled. Ordinary creditors will then be compensated according to the proportion of its claim in relation to the total amount of claims made by participating creditors. The debtor shall remain liable for any unpaid debt obligation. If a creditor discovers that the debtor has any other property, the creditor may apply to a people’s court to obtain a second debt enforcement judgment at any given time. This subsequent execution proceeding is not subject to the limitation period. The right to participate in distribution of debtor’s asset is only available to execution creditors and creditors that have successfully obtained legally effective judicial orders, court judgments, arbitration rulings by recognised arbitration institutions, and enforceable notarised debt instruments. Creditors that have yet to initiate legal proceedings or obtain execution judgments are unable to participate in the distribution. Payment is thus de facto made on a first-come-first-serve basis, and this is conceptually different from the pari passu treatment of unsecured creditors under Enterprise Bankruptcy Law.

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finds that a debtor does not have any available assets that can be executed, the execution procedure shall be terminated.309 Finally, creditors seeking payment may apply to the court for the enforcement of such payment.310 To deal with debtors with the repayment ability but who refuse to pay, creditors have three courses of action. First, under the Supreme People’s Court’s rules,311 ‘where any person subject to enforcement has the ability but fails to perform obligations determined in an effective legal instrument, and falls under any of the [listed] circumstances, a People’s Court shall include him or it in the List of Dishonest Persons Subject to Enforcement and impose credit-related punishment thereon according to law’.312 Second, a ‘Dishonest Person’ programme was launched in 2016, with eight specific 309

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Nevertheless, the termination of execution procedure does not mean that the debtor is therefore exempted and legally discharged from the debt. If the creditor finds that the debtor has assets available for execution, the creditor may again apply for execution. According to China’s Civil Procedure Law, creditors seeking payment in terms of money or priced securities may apply to a basic people’s court with jurisdiction for a payment order assuming that there are no other debt disputes between the creditor and debtor, and the payment order can be delivered to the debtor. If the debtor does not settle the debt fifteen days after the issuance of the payment order, or does not submit a written objection to the people’s court, the creditor can apply for compulsory execution. The greatest advantage in applying for a payment order is its speed. Of course, if the debtor submits a written objection to the people’s court within the statutory imposed time limit, the debt claim must be handled via litigation proceedings. The Several Provisions of the Supreme People’s Court on Announcement of the List of Dishonest Persons subject to Enforcement has been implemented since 1 October 2013. Article 1 of Several Provisions of the Supreme People’s Court on Announcement of the List of Dishonest Persons subject to Enforcement. These circumstances include: (a) Obstructing or resisting enforcement by forged evidence, violence, threat or any other method; (b) Evading enforcement by fraudulent litigation or false arbitration, concealment or transfer of property or any other method; (c) Violating the property reporting system; (d) Violating the Order on Restriction of High-Level Consumption; (e) A person subject to enforcement refuses to perform the enforcement reconciliation agreement without any justifiable reasons. Any other circumstance under which any person subject to enforcement has ability but fails to perform the obligations determined in an effective legal instrument’. Article 2 of Several Provisions of the Supreme People’s Court on Announcement of the List of Dishonest Persons subject to Enforcement also stipulates that ‘If the enforcement applicant believes that the enforcee has engaged in one of the dishonest acts listed in Article 1, he can apply to a people’s court to include him on a list of dishonest persons subject to enforcement, and the people’s court shall decide after reviewing the application. If a people’s court believes that the enforcee has engaged in one of the dishonest acts listed in Article 1, it can also exercise its authority to include him or it on a list of dishonest persons subject to enforcement. Such a list shall be published via media platforms such as newspaper, radio, TV, internet, and court bulletin boards. Individuals or entities on the list will be subject to credit-related sanctions.’

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sanctions available for implementation under this programme.313 Finally, when a debtor fails to perform its obligations, creditors may apply to court to request (1) the imposition of a fine on or to detain the debtor, its legal representative, or its principal responsible person(s);314 or (2) to limit overseas travel by the debtor’s legal representative or principal responsible person(s);315 or (3) to impose limits on ‘high consumption’ on the debtor, its legal representative, and principal responsible person(s).316 High consumption in this 313

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On 20 January 2016, Memorandum of Cooperation on the Joint Implementation of Sanctions imposed on Dishonest Persons Subject to Enforcement was made. These include: (1) Restrictions on establishment of financial institutions; (2) Restrictions on civil and commercial behaviours; (3) Restrictions on industry permits; (4) Restrictions on holding important positions; (5) Restrictions on enjoyment of preferential policies and honour titles; (6) Restrictions on high-level consumption and other consumer behaviour; (7) Limiting international travel, convicting individuals of offences, and imposing relevant punishment; and (8) Assistance in search and publicity of information on dishonest persons subject to enforcement. Article 241 of the PRC Civil Procedure Law stipulates that ‘when the debtor fails to perform its obligations specified in a legal document, it shall report its current financial position and its financial position one year prior to the date of receipt of the notice of execution. If the enforcee refuses to report or fraudulently reports, the people’s court may, according to the seriousness of the situation, fine or detain the enforcee, or its legal representative, or its principal responsible persons.’ Article 37 of Supreme People’s Court’s Explanation on the Application of the People’s Republic of China Civil Procedure Law states that ‘when the enforcee is an organization, the court may impose exit restrictions on the organization’s legal representative, principal responsible person, or person directly responsible for performance of debt obligation’. According to Article 1 of Regulations of Supreme People’s Court on Restricting High-Level Consumption by Person Subject to Enforcement, when the debtor fails to perform the payment obligation specified in an effective judgment within the time limit designated in the enforcement notification, the People’s Court can restrict the enforcee’s high-level consumption and other non-necessary consumptions not relating to living or business operations. Article 3 states that ‘when the enforcee is a natural person and is subject to high-level consumption restrictions, he may not (1) commute by plane, first class seat if by train, or second class or better if by ferry; (2) engage in high-level consumption in places such as starrated hotels, restaurants, nightclubs and golf clubs, etc; (3) purchase real estate or construct, expand or extravagantly decorate buildings; (4) rent high-end office building, hotel, department or other places for work; (5) purchase vehicles not necessary for business operation; (6) travel or take vacation; (7) pay for expensive tuition for the dependents to attend private schools; (8) purchase insurance or financial products with high premiums; (9) engage in other non-necessary consumption activities. When the enforcee is an organization, the enforcee and its legal representative, principal responsible person, person directly responsible for performance of debt obligation are not allowed to conduct consumption activities stated hereinabove.’

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context may include the purchase of real estate, luxury items, and other non-essential consumption. On top of these possible sanctions, the court can also impose criminal sanctions,317 social sanctions,318 or administrative sanctions depending on the circumstances of the case.319 However, despite the availability of these alternative measures, they suffer from various shortcomings. First, there is a lack of a framework for these measures because the legal rules from which such measures are sourced remain unorganised and scattered within sectoral laws and civil procedure law. The lack of a coherent structure renders these measures incomprehensible and there is hence a need for a unified framework, complete with relevant supporting systems in order to establish a personal bankruptcy regime. Second, these alternative measures are subject to the precondition that a debtor shall retain sufficient residual assets for his day-to-day activities. While this is in line with the social harmony principle within Chinese regulations, given China’s flawed social security system, the practice of transferring the state’s responsibility to provide for a debtor’s basic needs to the creditor deeply weakens creditor protection. Finally and most importantly, all of these measures are punitive, hence only serving the ‘punishment’ 317

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Criminal Law Amendment (Nine), which was officially implemented on 1 November 2015, amends Article 313 of Criminal Law to ‘individuals who are held by the people’s court to have the ability to repay but refuses to perform the debt obligations, if circumstances are deemed to be serious, shall be fined, imprisoned or detained for less than 3 years; if circumstances are particularly serious, a fine shall be imposed together with a fixed-term imprisonment of more than 3 years and less than 7 years.’ The State Administration for Industry and Commerce declared on 1 December 2015 that the countrywide information exchange system on dishonest persons subject to enforcement shall be in full operation. Dishonest enforcees will not be permitted to serve as legal representatives, directors, auditors, or senior management personnel. In December 2015, the Supreme People’s Court and the China Banking Regulatory Commission jointly issued the Manual for People’s Court, Banks and other Financial Institutions’ Implementation of Investigation and Control through the Internet. The Manual notice demands the banks and financial institutions to complete the network connections with the courts so that the internet investigation and control system may be in operation by February 2016. After February 2016, the People’s Court shall be electronically connected with China’s 4,000 banking institutions and can directly take freezing, confiscation, and other disposal measures against the enforcee’s bank accounts, bank cards, deposits, and other financial assets through the internet. The people’s courts will send electronic legal documents to the financial institutions, and electronically receive data regarding the result of inquiry, freezing, confiscation, and other measures taken by the financial institutions. Enforcement judges in any region and at any level can easily inquire about and take measures against the enforcee’s properties located at more than 4,000 Chinese banking institutions. Credit defaulters now are unable to conceal their assets and this greatly promotes debt enforcement efficiency.

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aspect of bankruptcy law. A debtor is not discharged from repaying debts and his future income will still be used to service these past debts. Ultimately, there is a need for a unified framework of personal bankruptcy laws in China because the current lack of a coherent regime detracts from providing debtors’ with opportunities for a ‘fresh start’. Not only will bankruptcy laws allow debtors to start afresh, it will also ensure that creditors can obtain a fair share of the bankrupt debtor’s assets.

4.4.2 Ways Forward for PRC Bankruptcy Law The central government has been successful in promoting entrepreneurship in recent years. In order to keep up with this development, China has been working to strengthen its personal bankruptcy regime by developing its personal credit system and its debt enforcement system. Significantly, the Shenzhen government announced on 1 May 2020 that it will establish a personal bankruptcy regime to allow innovations and start-up businesses to continue playing a fundamental role in propping up the city’s economy.320 This part will, first, analyse the importance of a personal credit system to a bankruptcy regime and the improvements in China’s personal credit system. It will then deal with sceptics who continue to reject the need for a personal bankruptcy regime in China. Finally, it will conclude that such a regime is necessary to promote innovation and entrepreneurship, and reform should be conducted together with any necessary supporting policies and institutions. In May 2013, the central government launched the ‘Mass Entrepreneurship and Innovation’ reform.321 This was followed by several specific measures that aimed to improve institutional mechanisms to facilitate entrepreneurship and innovation. Examples of such specific measures include measures to: (1) deepen business system reforms; (2) strengthen intellectual property protection; and (3) establish a mechanism for the training and hiring of talented professionals.322 320

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Shenzhen Daily, Personal bankruptcy system to be established in Shenzhen (1 May 2020), www.szdaily.com/content/2020-05/01/content_23114318.htm. See also Shenzhen People’s Congress, ‘Shenzhen Jingjitequ Geren Pochan Tiaoli Gongkai Zhengqiu Yijian’ (深圳经济特区个人破产条例公开征求意见) [The Public Solicitation of Opinions on Personal Bankruptcy Provisions in Shenzhen Special Economic Zone] (3 June 2020), www.szrd.gov.cn/szrd_dtxx/szrd_dtxx_rddt/yw/202006/t20200603_19246984.htm. ‘Opinions of the State Council on Several Policies and Measures for Vigorously Advancing the Mass Entrepreneurship and Innovation’, State Council Gazette, 32 (2015) [国务院关于大力推进大众创业万众创新若干政策措施的意见]. Ibid.

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These policies resulted in the emergence of young entrepreneurs in China’s VC market.323 From 2011 to 2017, the proportion of university students starting businesses immediately after graduation rose from 1.6 per cent to 3.0 per cent, stabilising around 3.0 per cent in recent years. Amongst the 7.95 million new graduates in 2017, the number of entrepreneurial graduates exceeded 200,000. In September 2019, the director of the Higher Education Department of the Ministry of Education proudly announced the success of China’s educational reforms during a press conference, stating that it has ignited graduate students’ desires to innovate and create start-ups. He similarly noted that up to 3 per cent of all university graduates are becoming entrepreneurs.324 There is also an increasing number of students returning to China after their studies abroad (haigui) that have started businesses with their technological knowhow and overseas resources. Since 2012, the number of overseas Chinese returnees has been increasing. In 2017, a total of 608,400 students went abroad to receive education, with a record number of 489,900 students returning to China. By the end of 2017, there were 351 Overseas Students Pioneer Parks, 4 more than in 2016 (an increase of 1.1 per cent). A total of 86,000 overseas Chinese returnees started businesses in these parks (accounting for 3.7 per cent of the total number of returnees after 2012).325 However, it is not possible for this army of entrepreneurs to be completely free of steep bankruptcy risks. Hence, China has been working on improving its personal bankruptcy regime. For a long time now, there have existed concerns about loopholes in China’s personal bankruptcy laws due to the weak personal credit system. The fear was that savvy individuals could exploit these loopholes, resulting in fraudulent bankruptcy claims. In the US, a strong personal credit system played an important role in making personal bankruptcy a reality. However, compared to the US, China’s personal 323

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The State Council has encouraged young entrepreneurs by promulgating the Guidelines on Mass Entrepreneurship and Innovation, State Council (11 Mar 2015) and the ‘Opinions of the State Council on Several Policies and Measures for Vigorously Advancing the Mass Entrepreneurship and Innovation’, supra note 321. ‘Daxue Biyesheng Zizhuxing Chuangye Geng Zhide Guli’ (大学毕业生自主型创业更 值得鼓励) [Graduates Starting their Own Business ought to deserve more Encouragement], Xin Hua Net, www.xinhuanet.com/2018-02/03/c_1122362155.htm, accessed 9 February 2020. ‘48 Wan Haigui Renshu Chuang Xingao, Zhuyao shi Yinwei Liuxue Guodu Yimin Zhengce Suojin’ (48万海归人数创新高，主要是因为留学国度移民政策缩紧) [480,000 Returnees Hit Record High, Mainly due to Tightening Immigration Policies], https://kknews.cc/other/x29bbjg.html.

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credit system is in nascent stages of development. China’s pilot run of its social credit system only began at the end of October 2003. As of now, China has yet to establish a national credit information network that can adequately cover its population of 1.3 billion. Only in the big cities, such as Beijing and Shanghai, are there institutions resembling credit agencies.326 However, the necessity of a credit system as a pre-requisite for a personal bankruptcy regime is doubtful. With the development of big data capabilities among Chinese tech companies and the increased reliance on Fintech solutions, individual debtors are no longer capable of effectively evading payment, be it through fraudulent transfers of property or simply by refusing to fulfil their repayment obligations. Hence, the premise that the lack of a credit system would result in a more debtor- friendly personal bankruptcy regime no longer stands. Although a credit system may not be a pre-requisite, it remains an important part of a personal bankruptcy regime. China has been working on its credit system in recent years. In particular, the Supreme People’s Court has engaged in an official partnership with Sesame Credit, a consumer credit agency backed by Alibaba, to implement a Social Credit System and to impose credit-related sanctions. Sesame Credit is connected to the Supreme People’s Court’s database and maintains a real- time blacklist based on the List of Dishonest Persons Subject to Enforcement.327 Additionally, in conjunction with Taobao, Tmall, China Auto Rental, Qufenqi,328 and other application platforms, credit defaulters are subjected to comprehensive restrictions. They are prevented from engaging in various internet transactions such as applications for loans or financing, purchases of luxury goods and non-essential items, and investments in insurance and financial products. This pressures defaulters to comply with court judgments and encourages offending debtors to make payment arrangements. 326

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‘China’s Top 10 Credit Agencies in 2017’, China Industry Information Website, (16 May 2017), www.chyxx.com/top/201705/522893.html. As of 17 December 2015, Sesame Credit has prevented more than 13,000 credit defaulters from purchasing plane tickets, booking rental car services, applying for loans, etc. As such, 5,300 enforcees have voluntarily paid their debts, 1,500 of which were long-term defaulters who had flouted court payment verdicts for three or four years. ‘Ant Financial 2016 Corporate Sustainability Report: Moving Towards a Better Society for the Future’, Ant Finance, at p. 33.

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Improvements in China’s credit system have resulted in a stronger deterrence effect against all types of debtors. However, the main targets of the current system are dishonest persons subject to enforcement, namely those with the ability to pay but who do not perform their debt obligations. As for insolvent debtors with no ability to pay, apart from limitations on ‘high consumption’, they face limited sanctions and are not subject to other penalties such as disqualification from public office and from corporate executive positions. Alongside improvements in the credit system, the practice of debt enforcement has also since evolved. In the past, the legal process relied heavily on investigative work done by creditor and judicial officers who had to visit the registered residence of the debtor so as to carry out enforcement. Hence, the ability of the court to enforce judgments relied heavily on the creditor’s ability to obtain such information and, even then, tended to be ineffective due to difficulties in finding the debtor. Having since moved on from this approach, courts now leverage technology to ensure debt enforcement through a central database. This database allows the court to view a debtor’s assets, namely, inter alia, bank deposits, vehicles, real estate, securities, and even funds in popular digital platforms such as WeChat and Alipay. While this new enforcement system is still a work in progress and is being gradually implemented, there is increasingly less space for a debtor to evade his payment obligations. This will minimise public concerns about fraud should a personal bankruptcy regime be introduced.329 While some commentators might continue to believe that the Chinese cultural aversion to the forgiveness of debts will remain an obstacle to the successful implementation of a personal bankruptcy regime, there is no reason to consider this insurmountable. There are many Asian jurisdictions that share similar Confucian value systems, such as Japan,330 South Korea,331 Hong Kong,332 and Singapore.333 Yet, these jurisdictions have 329

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Telephone interview with Mr Chi, Partner, Dentons Law Firm (Guangzhou office), 12 December 2019. ‘Is it a debtor or creditor friendly jurisdiction?’, The In-House Lawyer, 11 September 2017, www.inhouselawyer.co.uk/wgd_question/is-it-a-debtor-or-creditor-friendlyjurisdiction/. T. Pinansky, J. H. Jang, Korea: Corporate Recovery & Insolvency 2019 (Global Legal Group, 2019). N. Gall, A. Sood, Hong Kong: Corporate Recovery & Insolvency 2019 (Global Legal Group, 2019). TKQP, ‘Singapore: Restructuring & Insolvency’ 2019, 3rd Ed, The Legal 500 & The InHouse Lawyer Comparative Legal Guide.

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managed to design detailed personal bankruptcy regimes that are more debtor-friendly. The key, therefore, lies with a nuanced implementation of the proposed regime in a maturing market environment. Others may instead argue that personal bankruptcy law will not have much impact on VC as entrepreneurs usually do not take loans from creditors, but obtain equity investments from venture capitalists. They argue that entrepreneurs can then protect themselves from bankruptcy since there will be no outstanding loans or any personal guarantees. However, this is a misconception. As John Armour observed, Entrepreneurs are likely to seek to incorporate their business as a limited liability company. Indeed, the cost of incorporating a business – in particular, minimum capital requirements – have been shown to be negatively correlated to the incidence of entrepreneurship. Yet even with easy access to limited liability, personal bankruptcy law may be expected to make a difference. This is because creditors frequently demand personal guarantees from owner-managers, which constitute a ‘contracting out’ of the liability shield incorporation otherwise gives to the entrepreneur.334

In the context of China’s VC market, as explained in Chapter 3 of this book, it is common for entrepreneurs to take on personal guarantees when entering into VAMs with investors (e.g. PE/VC funds). In such situations, the entrepreneur will be personally liable for the debts of the company and hence personal bankruptcy law will be of relevance. However, this does not mean that personal bankruptcy law is completely irrelevant for countries that were not mentioned by John Armour. This is because VC is not the only way to promote entrepreneurship. Some entrepreneurs may (for some reason or another) decide to adopt a partnership model, or provide personal guarantees to get more financing from the bank for their limited liability company. In such situations, there is still scope for the use of personal bankruptcy law in order to provide failed entrepreneurs with opportunities for a ‘fresh start’. Furthermore, when it is hard to separate the company assets from the personal assets of the entrepreneur or in situations of corporate veil piercing, the entrepreneur will also be personally liable for the debts of the company. Personal bankruptcy law will also come into play in such situations. Fortunately, the Chinese government has since clearly stated its intention to undertake legal reform in this area of law. On 22 June 2019, the 334

J. Armour, supra note 289.

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NDRC announced the proposed establishment of a personal bankruptcy system. In doing so, the focus of the new law would be the resolution of personal debts arising from joint liability guarantees or security provided in favour of companies. This appears to be directly aimed at the problem of personal bankruptcy arising from failed entrepreneurship ventures as discussed earlier. To promote innovation and entrepreneurship, the new personal bankruptcy system needs to strike a balance between meeting the interests of creditors and providing opportunities for a ‘fresh start’ to debtors. However, a key issue remains to be addressed by future research. That is, what is the socially optimal level of entrepreneurship that governments should aim for? Despite increasing evidence of the positive externalities of entrepreneurship, mainly due to its functions in stimulating competition, innovation, and job creation,335 there is no general consensus on whether the social benefits of additional entrepreneurship can really exceed its social costs. Such social costs are most evidently reflected as high failure rates of entrepreneurship.336 These costs are magnified in China, especially since there are national policies promoting entrepreneurship in place. In June 2019, the Supreme People’s Court announced its plans for a pilot project that will lay the foundation for a nationwide personal bankruptcy system. Some local authorities, such as that of Taizhou and Wenzhou cities of the Zhejiang province, have also begun tests for a local personal bankruptcy system. Since 2011, the courts of both levels in Taizhou have begun to explore a regulatory framework for personal bankruptcy that merges the shareholder’s personal assets and the company’s assets. The courts in executing this regulatory framework included borrowed concepts of voluntary bankruptcy petitions and mechanisms for bankruptcy administrators; the execution also included the enforcement of a combination of the appointment of a receiver with the assessment of the debt situation, and so on. Additionally, starting from May 2018, Taizhou Intermediate People’s Court officially began its trial of the ‘Introduction of a Liquidation Mechanism in the Execution Procedure for Individual Bankruptcy’. This exploration of personal bankruptcy frameworks is hoped to result in an 335

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C. M. van Praag and P. H. Versloot, ‘What is the value of entrepreneurship? A review of recent research’, Small Business Economics, 29 (2007), 351 S. C. Parker, ‘The Economics of Entrepreneurship: What We Know and What We Don’t’, Foundations and Trends in Entrepreneurship, 1–54, http://dx.doi.org/10.1561 /0300000001.

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instituted system which may ultimately encourage individual innovation and entrepreneurship. However, the establishment of a personal bankruptcy system is a significant legal reform which is associated with many political, social, and economic problems. In order to implement this system on a nationwide level, the necessary supporting policies and institutions must also be established and improved upon. In particular, relevant legal frameworks relating to credit investigation and punishments for breach of trust have to be improved. The ability to enforce judicial decisions must also be strengthened.

4.5 Conclusion By analysing how various aspects of Chinese legal infrastructure and financial regulations directly or indirectly influence the market for VC exits, this chapter has illustrated that law plays an instrumental role in facilitating exit, which in turn is a key determinant of the success of a VC market. Most notably, recognition must be given to laudable legal reforms such as the decades-long efforts in developing a multi-tiered capital market, with the recent tailor-made focus on facilitating listing for innovative start-ups (the STAR Market), and the relaxation of the rules on leveraged transactions. These developments provide great comfort for VC market participants when they approach the question of exit – specifically, for both entrepreneurs and venture capitalists, under the incentive-compatible implicit contract (in the case of IPO exits), and generally, as both parties are more assured as to the prospects of their ‘investments’ (in terms of time/energy and money) in the venture coming into fruition. It is thus not surprising that the monumental growth of the Chinese VC market closely tracked these milestone reforms.337 In other words, when there is no market to begin with, or when the market is still in its infancy, positive legal intervention may provide the key impetus to development. A key limitation in this approach is, however, that whenever intervention turns out to be disruptive, however unintended this disruption may be, the market takes a disproportionate hit. This was the experience when the Chinese VC market was detrimentally affected by IPO suspensions. Times are changing. With China’s VC market now being the world’s largest in terms of the amount of VC funds raised by start-ups,338 the 337 338

L. Lin, supra note 28, at p. 12. See, J. D. Rowley, ‘Chinese Startups Lead US Rivals In 2018 Venture Race’, Crunchbase News (2018), https://news.crunchbase.com/news/chinese-startups-lead-us-rivals-in2018-venture-race/.

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appropriate question to ask is no longer ‘how can we further grow the market?’ but rather ‘how can we sustain its growth and improve its ecosystem?’ With this end-goal in mind, it must then be acknowledged that many aspects of the current model leave much to be desired. The dissatisfaction seems to stem from the same root cause as China’s sustained practice of financial suppression – that the government still holds too tight a grip over financial regulation and refuses to completely surrender to market forces. In other words, over-regulation leaves little wiggle room for market forces to gain their full expression, thus distorting the fundraising, investment, and exit activities. Examples already covered in this chapter include the hesitation to transit from an approval-based IPO system to a registration-based one in the two Main Boards, the various regulatory burdens relating to the funding, contracting, and approval of private M&As, and the lack of a debtor- friendly personal bankruptcy regime. Through all of these areas run the common thread of regulatory conservatism and an underlying fear of the proverbial Pandora’s Box. This is so especially considering that the consequences of financial regulations in these areas are far-reaching and not only limited to the VC market alone. Is there any solution that strikes the perfect balance between letting market forces run their course and guarding against exploitative market behaviour? It is suggested that the answer lies in a change of mentality – specifically, a change of regulatory philosophy, from interventionist to reactive, all-encompassing to supplementary, from the coupling of market and intervention to the decoupling of the two. This means that Chinese regulators should, as a general starting point, give a free pass to marketbased activities. For example, the IPO system should be further reformed and listing applications should be vetted and selected not by regulators but by competent financial intermediaries familiar with market trends; DCS structures should be permitted for the other boards because they answer a real, dire need of entrepreneurs who are caught between the need for funding and the desire for control in the predominantly equity-based VC market. When market forces are given greater freedom of expression, organic and sustainable growth is more likely to ensue. However, regulators must be prepared to meet the risks of a more liberalised market, which may include the daunting task of establishing a supportive legal infrastructure that can adequately deal with the risks of foul play; such risks have not been adequately addressed under the current framework. Specifically, this could entail providing a stronger and more accessible investor protection framework, raising the bar for

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the administration and regulation of financial intermediaries, and establishing a more comprehensive national credit system. These are ‘reactive’ or ‘supplementary’ reforms that do not seek to directly influence market behaviour but instead guard against or discipline bad conduct. In order for the Chinese VC market to take a step forward, regulators should be prepared to, first, take a step back.

5 Lessons from China and Ways Forward

This book has sought to provide an understanding of the unique features of the Chinese venture capital (VC) market, especially from the perspective of legal and corporate practices. Drawing on the materials covered earlier in this book with regard to the life cycle of VC in China – fundraising, investment, and exit – this chapter seeks to answer the questions raised in the first chapter on a more principled basis. 1. How did China create the world’s second-largest VC market within such a short period of time? 2. Are there any lessons of general applicability which may be extracted from China’s VC story? 3. What are the ways forward for China’s VC market? These questions will each be discussed in turn.

5.1 The Chinese VC Story When the question is posed – ‘how did China create the world’s secondlargest VC market within such a short period of time?’ – the focus is squarely on how China’s VC market managed to achieve high-speed growth against a backdrop of backward legal and financial systems. It is apposite at this juncture to revisit two important features undergirding China’s financial system. On the one hand, China’s legal system has been consistently criticised for being weak on investor protection, especially with respect to the lack of judicial independence.1 For example, although the People’s Republic of China (PRC) Company Law provides a legal basis for shareholders to bring a derivative action against directors, it remains underused and, in some cases, even impracticable.2 As it stands, there are several problems with the derivative action regime, such as the stringent preconditions, the free-rider problem, and the high cost of 1

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L. Lin, ‘Regulating Executive Compensation in China: Problems and Solutions’, Journal of Law and Commerce, 32 (2014), 207–254. See discussion in Part 2.6.1.5 of Chapter 2 of this book.

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litigation.3 Furthermore, the fact that contingency fee arrangements are not recognised in China also limits the funding available for derivative actions and exacerbates the free-rider problem, making the derivative action less popular in China as compared to the US. Remedies protecting minority shareholders (such as the oppression remedy, which allows investors who have been personally prejudiced in the running of a company to bring a personal claim against corporate controllers) that are typically available in other common law jurisdictions are also unavailable. On the other hand, China’s financial infrastructure, for the most part, carries on the legacy of the 1990s, when banks, especially state-owned commercial banks, commanded absolute dominance in the financial system.4 Consequently, in the grand scheme of China’s financial systems, China’s capital market has been sidelined as a result of the extensive role played by banks as the main source of funds.5 Participation in the capital markets has also been limited by high levels of financial repression,6 as demonstrated by heavy-handed governmental interference in the country’s financial system and capital allocation, which was made possible by China’s special political and economic structure.7 In fact, the Chinese stock market was not developed until the 1990s. Since then, it has been operated under an approval-based IPO system, that is, the listings should 3

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Article 151 of the PRC Company Law. See also Robin Huang, ‘Shareholder Derivative Litigation in China: Empirical Findings and Comparative Analysis’ 27(4) (2012), Banking and Finance Law Review 619; D. C. Clarke, ‘Pathway to Minority Shareholder Protection: Derivative Actions in the People’s Republic of China’, in The Derivative Action in Asia: A Comparative and Functional Approach, edited by D. Puchniak, H. Baum, and M. Ewing-Chow eds., (Cambridge University Press, 2012) pp. 43–95. For example, the notice requirement is stricter than the counterpart action in the US in the sense that it can be waived only in cases of emergency. Y. Huang, ‘Zhongguo Jinrong Gaige Luxiantu’ (中国金融改革路线图) [Roadmap to China’s Financial Reform], (Zhongxin Publishing House, 2019). Y. Huang, ‘Zhongguo Jinrong Gaige de De yu Shi’ (中国金融改革的得与失) [Financial Reform in China: Progress and Challenges], (17 September 2018), Sina Column, http:// finance.sina.com.cn/zl/china/2018-09-17/zl-ihkahyhy0386058.shtml Financial repression was introduced in 1973 by Edward S. Shaw and Ronald I. McKinnon. It refers to the policies and measures by which governments channel funds from the private sector to the governments as a form of debt reduction. See E. S. Shaw, Financial Deepening in Economic Development, (Oxford University Press, 1973); R. I. McKinnon, Money and Capital in Economic Development (Brookings Institution Press, 2010). Y. Huang, supra note 5; Y. Huang, X. Wang, B. Wang, and N. Lin, ‘Financial Reform in China: Progresses and Challenges’, in Y. C. Park and H. Patrick (eds.), How Finance Is Shaping the Economies of China, Japan and Korea (Columbia University Press, 2013), at pp. 44–142; According to the Financial Repression Index of the World Bank, China ranked the 14th in 2015 among all 130 countries for which statistics were available, ahead of other medium-income countries and even the average of low-income countries.

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be vetted and selected not by regulators but by competent financial intermediaries familiar with market trends. Such an approval system prevents potential issuers from going to the market and has led to regulatory rentseeking.8 From the perspective of potential investors, there is a limited range of workable financial instruments, seen in the absence of convertible preferred stock and the practical difficulties in utilising convertible bonds. As can be seen, governmental interference has severely limited the efficiency of the financial system in which financial resources are utilised and impeded the development of the capital market.9 Despite these limitations on the legal and financial systems, China’s VC market has developed into the world’s second-largest market in terms of annual VC investment.10 There are three key aspects to this development. First, although its rule of law remains subject to much criticism, China has been progressing towards international standards over the past few decades in the area of corporate law and regulation. Constant judicial reforms have brought about a higher degree of judicial independence,11 while legal reforms have afforded investors and entrepreneurs with stronger legal rights and protections. For example, directors’ fiduciary duties, shareholders’ derivative action, circumstances in which the corporate veil will be pierced, and the shareholders’ appraisal right were introduced to the PRC Company Law in 2005 to enhance shareholder protection.12 To facilitate starting businesses in China, the minimum requirement for capital was abolished in 2013.13 China has also undertaken substantial efforts to improve the domestic business regulatory environment for small and medium-sized enterprises (SMEs). These include: (1) fully integrating issuance of company seals into a business registration one-stop shop; (2) strengthening the 8

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L. Lin, ‘Venture Capital Exits and the Structure of Stock Markets: Lessons from China’ Asian Journal of Comparative Law, 12(1) (2012), 1–40. It must be noted that IPO registration-based reforms have been launched on the ChiNext and the STAR Market. McKinnon, for example, basically argues that governmental interference in financial systems will harm the efficiency at which financial resources are utilised and thus impede financial development, thereby hurting economic growth. R. I. McKinnon, Money and Capital in Economic Development (Brookings Institution Press, 1973). See discussion in Part 1.1 of Chapter 1 of this book. See Judicial Reform in China, available at: http://www.court.gov.cn/shenpan-gengduo-67. html. See Zhu Ciyun, ‘PRC Company Law Evolves amid The Convergence of Internationalisation and Domestication – The Past, The Present and The Future since 40 Years of Opening Up’ [中国公司法在本土化与国际化的融合中演进 – 改革开放四 十年的历史沿革、最新发展与未来走向], online: https://events.law.umich.edu/clc/ wp-content/uploads/sites/36/2019/09/ZHU-Ciyun.pdf . Ibid.

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protection of minority investors by imposing liability on controlling shareholders for unfair related-party transactions and clarifying ownership and control structures; (3) making contract enforcement easier by regulating the maximum number of adjournments that can be granted and limiting adjournments to unforeseen and exceptional circumstances; and (4) making resolving insolvency easier by providing rules for post-commencement credit priority and increasing the participation of creditors in insolvency proceedings.14 These efforts have contributed to the consistent and rapid rise in China’s ranking on the World Bank Doing Business Report Rankings.15 This, in turn, has encouraged further entrepreneurship in China. Second, China has been going through an era of economic and financial reform, and the degree to which the government intervenes in the market has been gradually reduced, due to a combination of constant marketisation and mixed-ownership reforms in state-owned enterprises (SOEs).16 Unlike in the past, China has also been developing the capital market by building a multi-layer stock market. This has been done in a progressive manner through the establishment of the Main Boards in 1990, the SME Board in 2003, the ChiNext in 2009, the NEEQ in 2013, and, most recently, the STAR Market17 in 2019. The adoption of a registration-based system for the STAR Market, as well as the registration-based reforms of the ChiNext Board18 and other boards19 14

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17 18

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The World Bank, ‘Doing Business 2020: China’s Strong Reform Agenda Places it in the Top 10 Improver List for the Second Consecutive Year’ Press Release, (2019), https://www .worldbank.org/en/news/press-release/2019/10/24/doing-business-2020-chinas-strongreform-agenda-places-it-in-the-top-10-improver-list-for-the-second-consecutive-year Ibid., China has improved its ranking incredibly fast from 2017 to 2020; S. J. Grand, ‘Doing Business in China got easier according to World Bank’, Economy & Trade, www .sjgrand.cn/doing-business-china-easier-according-to-world-bank/. (Between 2017 and 2018, China jumped from 78th to 46th position on the World Bank’s Ease of Doing Business Indicator. In 2019, China ranked 31st.) See further Wang JiangYu, and Tan Cheng Han, ‘Mixed Ownership Reform and Corporate Governance in China’s State-Owned Enterprises’ Vanderbilt Journal of Transnational Law, 53(3), (2020), 1055–1107. See Part 4.2.4 in Chapter 4 of this book. Liu Caiping and Guo Yingzhe, ‘Task Forces Prepare for ChiNext’s Registration-Based IPO Reform’ www.caixinglobal.com/2019-10-21/task-forces-prepare-for-chinextsregistration-based-ipo-reform-101473808.html (China’s securities regulator and the Shenzhen Stock Exchange have prepared to abolish the approval-based IPO system and to prepare for the widely expected trial of a registration-based IPO system on the NASDAQ-styled ChiNext Board in China). The revised PRC Securities Law 2019 highlights the rules on the newly devised STAR Board, which will pilot a registration-based initial public offering (IPO) system. As discussed in Chapter 4, under the current IPO system, new shares are subject to approval from the China Securities Regulatory Commission before being listed. The revised

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are positive attempts at improving the regulatory environment to facilitate exits by VC-backed companies via IPOs. Additionally, a significant step was recently announced after the revised PRC Securities Law in December 2019 – the approval system will be gradually phased out and replaced with a registration system in the ChiNext Board, the SME Board, and Main Boards.20 Such reforms reduce barriers to listing, and therefore increase the possibility of investments coming to fruition. The effect is to facilitate the VC exit – the key last stage of each VC cycle. Third, this book has shown the important role of the government, both on central and local levels, in creating a VC market through continuous law and policy reforms. The growth of the Chinese VC market was achieved by laying down the necessary legal and institutional infrastructure for a VC market, including: (1) increasing the availability of capital through various initiatives, such as through injecting public capital through various government programmes and government guidance funds, increasing the inflow of private capital by easing regulatory barriers against market participation by institutional investors, providing tax incentives, and facilitating the VC-backed exits by building a multi-layer capital market; (2) increasing the number of market participants by establishing a clear and easy-to-use licensing regime for intermediaries and facilitating fundraising by introducing the limited partnership form, which has proven to be popular; and (3) encouraging entrepreneurship by revising the country’s corporate and securities laws and streamlining the process of establishing and doing businesses.21 Through these government measures, China has facilitated the simultaneous availability of the three elements that are needed for a VC market: (1) capital with appetites for high-risk, high-return investments; (2) specialised financial intermediaries – VC firms – that properly incentivise all participants in

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Securities Law has changed the requirement of issuing new shares from ‘capable of continuous profitability’ to ‘capable of continuous operation’, authorised stock exchanges to review public offering applications, and made information disclosure requirements stricter. See China Focus: China approves landmark revision to securities law, Xin Hua, ‘China Approves Landmark Revision to Securities Law’, Xin Hua Net (2019), www .china.org.cn/business/2019-12/29/content_75559634.htm. Xinhua, ‘Full Implementation and Step-by-step Implementation of the Registration System will Stimulate the Vitality and Efficiency of the Capital Market’ [全面推行, 分 步实施注册制将激发资本市场活力和效率], 30 December 2019, online: XinhuaNet, www.xinhuanet.com/fortune/2019-12/30/c_1125403395.htm. L. Lin, ‘Engineering a Venture Capital Market: Lessons from China’, Columbia Journal of Asian Law, 30(1) (2017), 160–220.

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the VC market; and (3) the emergence of a class of entrepreneurs with the skills and incentives to put that capital to work. Although the success of China’s market can be largely attributed to interventions by the government, a key reason for its rise is the government’s recent efforts at shifting away from heavy-handed interventionism and its increased reliance on market forces in allocating capital. Meanwhile, it must also be noted that the Chinese government’s role in encouraging entrepreneurship and VC differs across various regions of China. For example, in Beijing’s Zhongguancun Park, the so-called Chinese Silicon Valley, renowned universities and research institutions abound, and the availability of talents in technical areas provides a natural advantage in developing high-tech sectors. Here, the government’s primary role is encouraging and facilitating the prototypical development of theoretical research. This might not be the case in other areas, such as the city of Hangzhou where the bulk of entrepreneurial activity was driven by Alibaba’s success, contributing to a virtuous cycle of start-up development. In this context, the government of Hangzhou has actively held back from excessive intervention, but instead, facilitated the VC investments by providing incentives to attract overseas talents.22 Shenzhen, another prominent centre of start-up activity and home to a great number of global tech leaders, such as Tencent and Huawei, developed from a small fishing village into a technological hub primarily due to effective market mechanisms. There is minimal path dependence on governmental intervention and there is a lack of large-scale SOEs in this young city.23 It appears that the Shenzhen government has learnt to recognise where governmental intervention was not needed or would have been counter-productive in the various regions; in such cases, the government refrains from intervention when it is not required.24 22

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See, for example, Opinions of the Hangzhou Municipal People’s Government on Encouraging and Attracting Overseas High-level Talents to Settle in Zhejiang Overseas High-level Talent Innovation Park for Innovation and Entrepreneurship [杭州市人民政 府关于鼓励和吸引海外高层次人才入驻浙江海外高层次人才创新园创新创业的若 干意见], online: www.hangzhou.gov.cn/art/2010/8/20/art_807977_1177.html. Interview with Dr Zheng Yongnian, former director of East Asia Institute of National University of Singapore, 18 December 2018, Singapore. J. Lerner has also pointed out that ‘When we look at the regions of the world that are, or are emerging as, the great hubs of entrepreneurial activity – places such as Silicon Valley, Singapore, Tel Aviv, Bangalore, and Guangdong and Zhejiang provinces – the stamp of the public sector is unmistakable. Enlightened government intervention played a key role in creating each of these regions.’ See J. Lerner, Boulevard of Broken Dreams: Why Public

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Different economists have posited different hypotheses regarding the right balance to be struck between governmental interference and freemarket mechanisms. Stiglitz argues that adopting a completely freemarket approach in a country where financial infrastructure and regulatory frameworks are underdeveloped would be adverse to economic growth and financial stability, since market institutions are not sufficiently developed for the free market to effectively and efficiently allocate resources. For countries that have yet to develop sufficient financial and regulatory infrastructure, moderate financial repression may instead be more appropriate.25 Stiglitz’s hypothesis26 may have been borne out by China’s VC story. In the early stages of China’s economic reforms and capital market development, the weak state of market institutions in China meant that interventionist governmental policy and market mechanisms effectively combined to impel the rapid growth of China’s economy. This, however, leads us to the second question: Are there any lessons of general applicability which may be extracted from China’s VC story?

5.2 Lessons from China First, as the economy progresses through different stages of development, the optimal financial structure of an economy and the appropriate role of governmental intervention may also evolve. This has already occurred in China’s past. China has tried to move away from a planned economy and pursue market-based economic reforms since 1978. During this transitional period, the extent of governmental intervention in the financial market has changed over the years with differences in its emphasis and extent. Some efforts were more successful in promoting marketisation than others. For instance, in the initial stages of development of the Chinese VC market, which roughly took place between 1990 and 2010, governmental intervention was beneficial in the sense that it helped to

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Efforts to Boost Entrepreneurship and Venture Capital Have Failed – And What to Do about It (New Jersey: Princeton University Press, 2009), at p. 5. See R. J. Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’, Stanford Law Review, 55(4) (April 2003), 1067–1103. J. E. Stiglitz, ‘The Role of the State in Financial Markets’, in M. Bruno and B. Pleskovic (eds.), Proceeding of the World Bank Annual Conference on Development Economics, 1993: Supplement to the World Bank Economic Review and the World Bank Research Observer, (The World Bank, 1994), 19–61. Ibid.

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build the legal and regulatory infrastructure for market forces to function effectively. However, after a VC market has already been established, continued governmental intervention may unduly increase transaction costs and limit the organic development of the market. For instance, there was a tangible increase in the extent of governmental supervision in the financial space after 2015 due to the increasing occurrence of fraud in the fundraising exercise, resulting in increases in the regulatory oversight of Asset Management Association of China (AMAC) in the funds industry.27 The side effect of such tightened regulatory control has been to make VC fundraising and operations more costly, which predictably inhibits industry development. Another example is the frequent involvement of administrative agencies in structuring and allocating capital. In 2015, the State Council initiated, and various provincial and municipal governments implemented, the Mass Entrepreneurship and Innovation Movement, where industrial policies were put in place at all administrative levels across the country, establishing a large number of entrepreneurship incubators, high-tech industrial development zones, and industry-focussed funds with the stated objective of facilitating innovation. Such campaign-like initiatives might waste administrative and financial resources,28 overshadowing the role of the market in their allocation. In addition, different geographical regions in China are naturally gifted with different resources and comparative advantages, so that an attempt to apply the same formula of Mass Entrepreneurship and Innovation throughout all regions in China is unlikely to produce uniform success. The third example of such sub-optimal governmental intervention is the various restrictions placed by the central bank over cross-border capital movements.29 These restrictions are placed in a blanket manner without any considered exceptions for certain VC-related applications, and have limited the free flow of foreign capital and institutional investors into the Chinese VC market. Relatedly, the state is also a significant shareholder in almost all large-scale financial institutions.30 This means 27 28

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See Part 1.5 in Chapter 1 of this book. Y. Huang, ‘Lishishang Chenggong de Chanye Zhengce Henshao’ (历史上成功的产业政 策很少) [Few Successful Industrial Policies in History], Chinese Economists 50 Forum, (2016), http://finance.sina.com.cn/zl/china/2016-09-09/zl-ifxvukhv7925465.shtml. See He Weiping, ‘Paternalistic Regulation in China's Banking Sector’, The Chinese Journal of Comparative Law, 1(2) (2013), 289–302. See He Weiping, ‘The Regulation of the Financial Sector in China: A Tale of Two Governments’, Journal of Corporate Law Studies, 18(2) (2018), 3398.

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that state intervention and influence is inevitable in the context of China’s political economy, unless the state continues to reduce its ownership in state-owned financial institutions.31 Second, the VC market’s recent rapid growth stemmed largely from the central government having established a firm foundation of institutional and legislative infrastructure to increase the role of market forces in the capital allocation process. According to Lerner, ‘getting the laws right’ – ensuring that the legal system supports entrepreneurial activity – is the first cluster of policies that encourage entrepreneurship and VC.32 Empirical data in this book also proved that the law does make a difference in the development of China’s VC market. However, some institutional obstacles remain, including the flawed cadre appointment system and flawed incentives for government officials in this party-state, preventing local governments from achieving the delicate balance of allowing local government funding to operate based on market forces while concurrently pursuing the governments’ policy goals.33 This might be a fundamental reason explaining why the level of innovation among China’s entrepreneurs remains low despite the high volume of activity in the Chinese VC market – market forces are being hampered by governmental intervention. A residual degree of bureaucratic involvement in capital allocation prevents the Chinese regime from being fully efficient. As a whole, China serves as an imperfect model for other governments in a world where unfettered market forces have not brought about successful VC markets. Third, although capital market reforms have been a constant focus of the Chinese government, and were even enshrined in the Decision on Major Issues Concerning Comprehensively Deepening Reforms of the Third Plenary Session of the 18th Communist Party of China (CPC) Central Committee in 2013, the actual development of the capital market is still considerably restricted by entrenched systemic limitations.34 The fundamental challenge in ensuring sustained VC growth is building an ecosystem that is supportive of innovation. In China, this goal is hampered by the conflict inherent in VC investments. On the one hand, VC investments involve long investment cycles, great uncertainty, and high agency costs. This directly conflicts with the unwillingness of Chinese 31 32 33 34

For the recent SOE reforms, see Wang JiangYu, and Tan Cheng Han, supra note 16. J. Lerner, supra note 24. L. Lin, supra note 21, at 165. Ibid.

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investors to accept risks, as evidenced by their attempts to mitigate all risk through the use of VAMs, as discussed in Chapter 3. Meanwhile, as discussed in Chapter 2, the investors in the Chinese VC market remain relatively unsophisticated, as compared to their counterparts in the US. Wealthy individuals and families form a majority of investors in VC funds by number and, unlike institutional investors, they do not have the appetite for long-term and high-risk investments.35 Fourth, the Chinese experience in building a VC market offers several lessons to other countries seeking to solve the three-factor simultaneity problem that was introduced in Chapter 1. The Chinese success story is based on the government doing the following: (1) encouraging the establishment of private funds, especially by providing public funds through the well-designed government programmes; (2) introducing business-friendly legal vehicles for fundraising and starting business; and (3) creating a conducive regulatory environment which, in turn, encourages capital supply, boosts entrepreneur participation, and attracts knowledgeable financial intermediaries to the market. Governments can also facilitate the creation of a market premised on market forces and private contracting by restricting their own participation in capital allocation and leaving capital allocation decisions to private-sector parties with the right incentives.36 This should be done only after the relevant infrastructure has been set up. Failure to do so would prevent the industry from attaining sustainable growth. Fifth, and following on from the previous point, the Chinese experience is further evidence that governmental intervention is not fundamentally inconsistent with harnessing the power of market forces. In fact, financial economic theory provides two justifications explaining that appropriate government intervention can be a boon to the VC market by providing support during a company’s infancy stage, allowing it to enter the VC cycle.37 The first justification for governmental intervention is the possibility of net societal gain. From the perspective of a company, societal gains that cannot be internalised do not add value to its cost-benefit analysis and, as a result, it is unlikely to invest in developing innovations that may 35

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Part 2.3.2 in Chapter 2 of this book. See also, L. Lin, ‘Private Equity Investor Protection: Conceptualizing Duties of General Partners In China’, Berkeley Business Law Journal, 15 (1) (2018), 43–91 at p. 56. See generally R. J. Gilson, supra note 24. P. Gompers and J. Lerner, The Venture Capital Cycle, 2nd ed. (The MIT Press, 2006) at pp. 313–315.

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otherwise be beneficial to society as a whole. Governmental intervention, such as through a grant, would be able to incentivise the company to develop these potential innovations, resulting in a net societal benefit, including potential benefits to the market as a whole.38 The second justification is that intervention also allows the government to facilitate the VC market by acting as an information intermediary.39 Its involvement with a company signals to other investors that they should consider an investment while also indirectly encouraging other market participants to do business with the company. From a cost-benefit point of view, the government is also subsidising dealing with the company as it indirectly covers some of the costs of doing research and due diligence. Within the Chinese market, this effect can be seen through the market’s warm response towards companies that have been backed by state-owned funds and enterprises.40 Nevertheless, the success of such a government programme is premised on it being well designed and properly implemented as failures in decision-making and policy design may also limit the effectiveness of such programmes.41 The Chinese experience also showcases some of these potential pitfalls. For example, corruption may result in the diversion of funds, while an attempt to implement a one-size-fits-all approach that spreads investment evenly across geographic areas has resulted in lacklustre results with deserving firms being passed on simply because they are in an area with a high concentration of innovative firms.42 Any government looking to use intervention as a tool should remain aware of these limitations and cater their designs appropriately.43 Governmental intervention is also an element of the VC market in the US, and the difference in approach, when compared to China, is merely a matter of degree. Mazzucato suggests that ‘[d]espite the perception of the US as the epitome of private sector–led wealth creation, in reality it is the State that has been engaged on a massive scale in entrepreneurial risk taking to spur innovation’.44 The government, therefore, plays a crucial role in identifying and investing in ventures even before VC firms see 38 39 40 41 42 43 44

Ibid., at pp. 313–314. Ibid., at pp. 314–315. See generally, Part 2.4 of Chapter 2 of this book. P. Gompers and J. Lerner, supra note 37, at pp. 315, 318–322. Supra note 40. See generally, P. Gompers and J. Lerner, supra note 37, at pp. 324–339. Mazzucato, Mariana, The Entrepreneurial State: Debunking Public vs. Private Sector Myths. Public Affairs, 2015.

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a profitable opportunity, thereby facilitating the development of the market. In summary, engineering a VC market is a highly specific exercise that must be tailored to the unique circumstances of each country. On top of capital, specialised financial intermediaries, and entrepreneurs, an effective VC market also requires a wide range of complex social, legal, and economic institutions, such as robust stock markets, sophisticated auditing and legal professions, strong investor protection, effective judicial enforcement of contracts, liberal bankruptcy laws, and an effective reputation and credit system. This, brings us to the last question: what are the ways forward for China’s VC market?

5.3 Ways Forward 5.3.1 Reform of Government’s Role in the VC Market On a general level, with market forces playing an increasingly important role, there should be a corresponding decrease in governmental intervention in China’s financial market, so as to allow market players to participate in direct capital allocation. The theory of new structural economics45 advocates for the subordination of industrial directives to market movements except for certain strategic industries.46 An industrial policy of a country,47 that is, its official strategic effort to encourage the development and growth of the economy, should be used to guide the market, rather than to substitute market forces.48 45

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J. Y. Lin, ‘New Structural Economics: A Framework for Rethinking Development and Policy’, World Bank Policy Research Working Paper No 5197, (2016), https://papers .ssrn.com/sol3/papers.cfm?abstract_id=1547636. Ibid. Such intervention can come in the form of various types of subsidies or through administrative and regulatory measures (for example, aimed at lowering barriers to entry). Regardless of form, such intervention ultimately aims to remove bottlenecks in emerging industries. See Y. Huang, ‘What is considered good industrial policy?’ (怎样才 算好的产业政策？), Chinese Economists 50 Forum, 30 August 2016, online: www .50forum.org.cn/home/article/detail/id/6627.html. The effect of industrial policies on economic growth remains debatable. For example, there is a divergence in opinions over the contribution of industrial policies to the rapid development of jurisdictions such as Japan, Taiwan, and South Korea in what has become known as the ‘East Asian Miracle’. Chalmers Johnson opines that Japan’s increase in labour productivity and economic growth was largely a result of its industrial policies. However, Heather Smith came to another conclusion. Her study of Korea and Taiwan

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The problem with using industrial policies in China stems from China’s economic and governance system. Once the central government issues a policy, regulatory authorities of all levels will follow suit in order to conform. These measures implemented in response to the directive tend to be cookie-cutter measures transplanted from other areas without regard for differences in needs. Banks are usually also responsive to such policies and tend to follow suit. The intricate and complex nature of China’s system and the way in which it uniformly responds to conform with directives means that any industrial policy that is unclear in scope will unwittingly become a national industrywide policy even if it is only intended to apply locally. More importantly, the officials in charge of policy are often more concerned with collecting personal career achievements and rarely do post-evaluations that would allow them to glean learning points for the future. They may not be around long enough to have to deal with any fallout that may arise from gaps in implementation. In the final analysis, reputation and connections tend to trump any objective evaluation of effectiveness, perpetuating the cycle of dysfunctional administration and piecemeal rectification. Furthermore, even if the implemented policies are ineffective, policymakers are not required to bear responsibility, resulting in a lack of incentive and a general attitude of apathy. The current state of a high degree of governmental intervention and the dominance of banks, especially state-owned commercial banks in China’s current financial system, are clearly out of sync with the official policy of developing an innovation-fuelled economy. To fulfil its aim of building an economy fuelled by innovation, the government should leverage the VC market as it is better placed than the administrative bureaucracy to encourage innovation in the marketplace. Accordingly, the proper role of the Chinese government in the VC space should not be that of a strong-armed regulator and intervener. While there might be concerns about investor protection, it should be remembered that VC investors are ultimately accredited investors.49 These investors should be better placed than regulators to manage their own risks and should also internalise the costs of doing so. The attitude of

49

suggested that instead of industrial policies, the main driver of labour productivity and economic growth was the opening of markets. Academics come to different conclusions even within different periods in the same jurisdiction. The question of whether the current definition of accredited investors is suitable is another matter altogether. For definition of accredited investors, see text accompanying note 99 in Chapter 2 in this book.

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high returns for little to zero risk should be abandoned. The fact that retail investors are not able to participate in the VC market also means that it poses less of a systematic risk and should arguably be more lightly regulated as compared to traditional stock markets. Instead of intervening heavily, the government should limit itself to the following roles: first, to act as the guardian of a market order based upon fair competition and productive innovation; second, to correct market failures and buttress investor confidence; and last, to ensure that good financial infrastructure is in place, including the presence of experienced professional financial intermediaries. These proposed roles stand in sharp contrast to the government’s prevailing regulatory stance in the VC space. The government’s current approach is unduly intrusive and manifests itself through measures such as industrial policymaking and financial supervision. In the past, industrial policymaking, coupled with China’s regionally decentralised authoritarianism (RDA) model of governance,50 has led to intense competition between regions and their respective governments. During the early stage of development of the VC market in China, the RDA governance model facilitated VC development as building the foundational infrastructure for the VC market was the main target of regional competition within China. However, now that a sizeable VC market has already been established in China, the focus of regional competition should be changed towards sustaining quality market growth. In the future, both the central government and the regional administrations should reduce their intervention in the market and facilitate the replacement of governmental incentives with market-based incentives. If these changes are made, companies will be forced to compete. A fundamental shift in regulatory mentality is also required – Chinese regulators who are accustomed to dealing with banks need to think differently when it comes to VC as these are two different types of financing methods involving parties with very different profiles and risks. The starting point should be minimal regulation of VC. ‘Campaign-style Law Enforcement’ (yundongshi zhifa)51 – such as 50

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This means that regional governments are highly decentralised in resource allocation and business activities and are relatively self-contained. See C. Xu, ‘Difang Jingzheng de Kunjing’ (地方竞争的困境) [Dilemma of Local Competition], in ‘ Zhongguo Gaige’ (中国改革) [China Reforms], 9 (2011), http://magazine.caixin.com/2011–08-30/ 100296343.html. There are three approaches typically used in campaign-style law enforcement in China: investigating and punishing multiple similar illegal activities at the same time, investigating and severely punishing any major infringement, and conducting deep and thorough investigations into special cases. See Natasha XIE, ‘“Chinese-Style” Regulatory Enforcement Essence and Trajectory’, www2.deloitte.com/content/dam/Deloitte/lu/

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clamping down in an excessive manner when there is a market failure (such as the banning of initial coin offerings in 2017), while leaving emergent financial activities unregulated (such as the lack of clear regulatory framework governing PE/VC before 2014) – should be avoided. Such attempts at regulation in the past have resulted in the creation of extreme regulatory stances: in the former case, over-regulation has a market-killing effect while in the latter case, under-regulation results in chaos as the market descends into a free-for-all. In this vein, past incidents (such as stopping the registration by PE funds in 2018 due to severe frauds in fundraising52) have been shown to lead to the decline of fundraising.53 A balance should, therefore, be struck between maintaining financial stability and market efficiency. Further research must be done in particular areas for there to be a comprehensive examination of how the relationship between the government and the free market should be balanced and how the effectiveness of private ordering can be maximised in China.

5.3.2 Cultivating Patience in VC Investments As discussed in this book, one major weakness of China’s VC market relative to its American counterpart is the relatively low level of participation by institutional investors. In the US, the majority of investors (i.e. the limited partners) in VC funds are pension funds, funds of funds, sovereign wealth funds, and university endowments, which have the requisite appetites for high-risk, high-return VC investments.54 In contrast, Chinese investors are mostly high-net-worth individuals and families.55 These investors often exhibit impatient behaviour, low risk tolerance, and short-termism as discussed in Chapter 2. Such impatience is incompatible with the type of long-term investment required for highrisk, high-return investments in cutting-edge innovations. In this context, there is tension between the short-term demands of the parties

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Documents/financial-services/IM/lu-chinese-style-regulatory-enforcement-essencetrajectory-092018.pdf. Q. Liu and Q. Ren, ‘Guangzhou Quanmian Zanting Simu Zhuce’ (广州全面暂停私募注 册) [Guangzhou suspends private placement registration], PE Daily, (2018), https://m .pedaily.cn/news/434976. Guo Libo, ‘Difficulties in Raising VC/PE Funds’ (VC/PE基金“募资难”真相) China Securities Journal, 6 August 2018, online: http://finance.sina.com.cn/money/fund/jjyj/ 2018-08-06/doc-ihhhczfc1083503.shtml. See Table 2.4 and Table 2.5 in Chapter 2 of this book. Ibid.

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providing the VC funds and the long-term requirements for innovation – if entrepreneurs are overly concerned about satisfying the short-term demands of investors, how can they adequately focus on delivering innovation? Thus, regulations should be further relaxed to permit greater participation by institutional investors, such as pension funds and insurance funds, in the VC market. These market participants have the patience and risk profile required for long-term VC investments. Correspondingly, this would also reduce the divergence between investors and venture capitalists in the management of VC funds and encourage sustainable capital supply to the VC market.

5.3.3 Moving towards a Legal Framework that Enhances Investor Protection and Incentivises all Parties Empirical studies have proved that adopting legal structures that are friendlier to the entrepreneurs and the investors does matter in the development of a VC market.56 In China, various laws under the existing legal regime such as the Trust Law and the revised Partnership Enterprise Law promulgated in 2001 and 2006, respectively, are already out of sync with the fast-changing needs of the sizeable Chinese VC market. For example, provisions regarding the use of derivative actions in the Partnership Enterprise Law lack clarification,57 do not meet their aims of investor protection, and stand in dire need of reform and simplification. In addition, China still lags behind the US in terms of innovation in deep-tech areas. To fill this gap, China requires many more entrepreneurs to follow in the footsteps of leading industry figures such as Microsoft and Qualcomm. Intellectual property protection needs to be strengthened to create an environment in which intellectual property can be fairly valuated and innovative failures tolerated (provided that responsibilities are clearly defined).58 Failure to do so would limit any incentive to innovate.

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See J. Lerner, supra note 24, at pp. 92–96. See further in L. Lin, ‘Limited Partners’ Derivative Action: Problem and Prospects in the Private Equity Market of China’, Hong Kong Law Journal, 41(2) (2011), 517–546. See further Li Yahong, ‘Intellectual Property and Innovation: Case Studies of China’s High-Tech Industries’, Oregon Review of International Law, 13(2) (2012), 101–144.

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In terms of insolvency, a personal bankruptcy regime should be developed so that aspiring entrepreneurs who wish to enter this high-risk market may limit their personal exposure, especially by alleviating the harshness of some VAMs which may be imposed on these entrepreneurs. Furthermore, the existing legal framework governing corporate insolvency and restructuring should be revamped with a view to facilitate market clearing.59 Tax reforms in the fund industry may need to be carried out as well to ease the tax burdens imposed on VC funds and encourage VC investments. In sum, the regulatory framework governing China’s VC market should be clarified in greater detail (because clearer laws are more easily enforced) and enshrined in legislation. This calls for the substitution of bureaucratic-minded regulatory institutions with institutions operating with a firm basis in law, constitutional protection of the private property rights of natural persons, and judicial independence at all levels of court. Only then can the law be said to be providing real and meaningful protection for investors, entrepreneurs, and venture capitalists.

5.3.4 Establishing a Workable Reputation System A functioning reputation or credit system that is closely tied to entrepreneurial activities would also be beneficial in supporting VC growth. These should emulate the reputation mechanism which plays a crucial role in reducing agency costs in the American VC sector.60 Indeed, China has already been developing a national credit system. At the end of 2019, China’s current enterprise credit system already had on its record 33 million entries of credit-related information for enterprises and other organisations.61 Meanwhile, the AMAC is also seeking to develop its own credit system: a credit management protocol established from the very first stage of fund registration, which would operate on an ongoing 59

60 61

For the discussion of the lack of personal bankruptcy regime in China, see Section 4.4 in Chapter 4 of this book. See R. J. Gilson, supra note 24. General Office of the National Development and Reform Commission, 1 September 2019 ‘国家发展改革委办公厅关于推送并应用市场主体公共信用综合评价结果的通知’ (Notice of the General Office of the National Development and Reform Commission on the Delivery and Application of the Results of Comprehensive Public Credit Appraisals of Market Entities) (No. 885 [2019] of NDRC), online: Gov.cn, www.gov.cn/xinwen/201909/16/content_5430181.htm.

322

ven t ur e c ap i t al l aw in c hina

basis.62 This development by the AMAC would be a positive step towards increasing the role of the reputation mechanism in the VC market. However, the credit system in China, especially as administered in the rural and less economically developed areas of China, still leaves much to be desired. Some of the prevailing problems include the lack of comprehensive coverage, a deficient guarantee system, and incomplete and incoherent data, all of which continue to impede the establishment of a specialised credit profile database for SMEs. In these circumstances, the government should continue to take the lead in integrating all the available credit-related information, whether stored online or offline, especially information held by the government, so as to establish a new credit database to facilitate the decision-making of financial institutions and further development of the credit system.

5.3.5 Creating an Ecosystem for Innovation Aside from the measures proposed earlier, more needs to be done to nurture the next generation of creative thinkers, problem solvers, and entrepreneurs, especially from the first stages of education. Starting from a younger age, students should be encouraged to evaluate risks instead of avoiding them, and rote learning should be eschewed in favour of problem-solving and critical-thinking skills. Yet this may not amount to much if the socialist market economy model is not developed in a way that can harness these talents. As has already been intimated, the socialist market economy model needs to develop more market characteristics, instead of being held back by the demands of socialism. It is hoped that individual success stories may also encourage shifts in cultural mindsets in favour of innovation and appropriate risk-taking. More can be done to encourage the free exchange of ideas so valuable to the development of a flourishing VC market. Ultimately, it remains to be seen whether the Chinese VC market can replicate the success of the US market in the long run. 62

AMAC, ‘From Credit Accumulation to Credit Utilisation, Differentiation Guides the Standard Development of the Industry – Asset Management Association of China will launch a pilot project for the reform of the “separation system plus random inspection system” for private equity fund products’. [从信用积累走向信用运用 差异化引导行业 规范发展——中国证券投资基金业协会将推出私募基金产品备案“分道制+抽查制” 改革试点], 17 January 2020, online: AMAC, www.amac.org.cn/aboutassociation/ gyxh_xhdt/xhdt_xhyw/202001/t20200117_6442.html

APPENDIX

List of Chinese Legislation

Table 1 法律 (Legislation)

中华人民共和国证券投 资基金法 中华人民共和国证券法 中华人民共和国合同法 中华人民共和国信托法 中华人民共和国合伙企 业法 中华人民共和国公司法 中华人民共和国外商投 资法

Translation

Date of enactment

Securities Investment Fund Law of the People’s Republic of China Securities Law of the People’s Republic of China Contract Law of the People’s Republic of China Trust Law of the People’s Republic of China Partnership Enterprise Law of the People’s Republic of China Company Law of the People’s Republic of China Foreign Investment Law of the People’s Republic of China

1 June 2013

1 July 1999 1 October 1999 1 October 2001 1 August 1997

1 July 1994 1 January 2020

Table 2 国务院文件 (State council opinions)

国务院关于进一步促进 资本市场健康发展的 若干意见

Translation

Date of enactment

Opinions of the State Council on further promoting the sound development of capital markets

9 May 2014

323

324

ap pe n dix – lis t of ch in es e l eg islat ion

Table 2 (cont.)

国务院关于促进创业投 资持续健康发展的若 干意见 国务院关于推动创新创 业高质量发展打造 “双创”升级版的意见

国务院关于加强地方政 府性债务管理的意见

Translation

Date of enactment

Several opinions of the State Council on promoting the sustainable and sound development of venture capital Opinions of the State Council on promoting the highquality development of innovation and entrepreneurship and creating an upgraded version of ‘Entrepreneurship and Innovation among All the People’ Several opinions of the State Council on strengthening the administration of local government debts

20 September 2016

26 September 2018

2 October 2014

Table 3 部门规章 (Departmental rules)

私募投资基金监督管理 暂行办法 创业投资企业管理暂行 办法 外商投资创业投资企业 管理规定

Translation

Date of enactment

Interim measures for the supervision and administration of privately offered investment funds Interim measures for the administration of start-up investment enterprises Provisions concerning the administration of foreignfunded business-starting investment enterprises

30 June 2014

1 March 2006

1 March 2003

a p p en d i x – l i s t o f c h i n e s e l e g i s l a t i o n

325

Table 4 部门规范性文件及其他 (Departmental regulatory documents and others)

(1) 创投基金类 (Venture capital funds related)

发行监管问答——关于 首发企业中创业投资 基金股东的锁定期 安排 私募基金监管问答—— 关于首发企业中创业 投资基金股东的认定 标准 上市公司创业投资基金 股东减持股份的特别 规定 财政部关于取消豁免国 有创业投资机构和国 有创业投资引导基金 国有股转持义务审批 事项后有关管理工作 的通知

Translation

Date of enactment

Q&A on issuance supervision – requirements for the lock-up period of venture capital fund shareholders in IPO enterprises Q&A on the supervision of private equity fund – on the criteria for identifying the shareholders of venture capital fund in IPO enterprises Special provisions on shareholding reduction by venture capital fund shareholders of listed companies Notice of the Ministry of Finance on the relevant administrative work after the abolishment of the exemption from the obligation to seek approval for the transfer of state-owned shares in state-owned venture capital institutions and stateowned venture capital guidance funds

2 June 2017

2 June 2017

2 June 2018

11 August 2015

(2) 税收类 (Tax related)

财政部 国家税务总局关 于合伙企业合伙人所 得税问题的通知

Translation

Date of enactment

Notice of the Ministry of Finance and the State Administration of Taxation on the income tax of partners in a partnership

24 January 2009

326

ap pe n dix – list of ch in es e l eg islat ion

(2) (cont.)

国家税务总局关于有限 合伙制创业投资企业 法人合伙人企业所得 税有关问题的公告

私募基金监管问答—— 中国证监会关于享受 税收试点政策的创业 投资基金标准及申请 流程 国家税务总局关于创业 投资企业和天使投资 个人税收政策有关问 题的公告

财政部 税务总局关于创 业投资企业和天使投 资个人有关税收政策 的通知

财政部 税务总局 发展 改革委 证监会关于创 业投资企业个人合伙 人所得税政策问题的 通知

Translation

Date of enactment

Announcement of the State Administration of Taxation on issues concerning the enterprise income tax on incorporated partners of limited partnership venture capital investment enterprises Q&A on the supervision of private equity fund – China Securities Regulatory Commission’s criteria and application process for venture capital fund to enjoy tax policies Announcement of the State Administration of Taxation on relevant issues concerning the tax policies regarding venture capital enterprises and individual angel investors Notice of the Ministry of Finance and the State Administration of Taxation on the tax policies on venture capital enterprises and individual angel investors Notice of the Ministry of Finance, the State Administration of Taxation, the National Development and Reform Commission and the China Securities Regulatory

16 November 2015

7 July 2017

1 July 2018

1 January 2017 (enterprises), 1 July 2017 (individuals)

10 January 2019

a p p e nd i x – list of chinese l egislation

327

(2) (cont.) Translation

财政部 国家税务总局关 于明确金融 房地产开 发 教育辅助服务等增 值税政策的通知

财政部 国家税务总局关 于资管产品增值税政 策有关问题的补充 通知

财政部 国家税务总局关 于资管产品增值税有 关问题的通知

国家税务总局关于个人 终止投资经营收回款 项征收个人所得税问 题的公告

Commission on issues concerning income tax policies for individual partners of venture capital enterprises Notice of the Ministry of Finance and the State Administration of Taxation on specifying the value-added tax policies for finance, real estate development, educational support services, etc. Notice of the Ministry of Finance and the State Administration of Taxation on issues concerning value-added tax policies for asset management products Notice of the Ministry of Finance and the State Administration of Taxation on issues concerning the valueadded tax on asset management products Announcement of the State Administration of Taxation on issues concerning the imposition of individual income tax on funds recovered by individuals from the termination of investment operations

Date of enactment

21 December 2016

10 January 2017

30 June 2017

25 July 2011

328

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(2) (cont.)

财政部 国家税务总局关 于个人非货币性资产 投资有关个人所得税 政策的通知

关于企业重组业务企业 所得税征收管理若干 问题的公告

Translation

Date of enactment

Notice of the Ministry of Finance and the State Administration of Taxation on individual income tax policies for individual investment with non-monetary assets Announcement on several issues concerning the collection of enterprise income tax on enterprise restructuring

30 March 2015

24 June 2015

(3) 政府投资基金类 (Government investment funds related)

政府投资基金暂行管理 办法 财政部关于财政资金注 资政府投资基金支持 产业发展的指导意见

国家发展改革委政府出 资产业投资基金管理 暂行办法

Translation

Date of enactment

Interim measures for the administration of government investment funds Guiding opinions of the Ministry of Finance on injecting financial funds into government investment funds to support industry development Notice of the National Development and Reform Commission on issuing the interim measures for the administration of government-sponsored industry investment funds

12 November 2015

25 December 2015

1 April 2017

a pp e n d i x – list of chinese l egislation

329

(3) (cont.)

国家发展改革委办公厅 政府出资产业投资基 金信用信息登记指引 （试行）

国家发展改革委办公厅 关于发挥政府出资产 业投资基金引导作用 推进市场化银行债权 转股权相关工作的 通知

国家发展改革委办公厅 关于进一步做好政府 出资产业投资基金信 用信息登记工作的 通知

Translation

Date of enactment

Notice of the General Office of the National Development and Reform Commission on issuing the interim measures for the registration of credit information of government-sponsored industry investment funds (for trial implementation) Notice of the General Office of the National Development and Reform Commission on establishing the leading role of governmentsponsored industry investment funds in promoting the relevant market-oriented debt-forequity swaps of banks Notice of the General Office of the National Development and Reform Commission on further improving the credit information registration of government-sponsored industry investment funds

1 April 2017

15 July 2017

8 November 2017

330

ap p en dix – lis t of ch in es e l eg islat ion

Table 5 基金业协会自律规则及其他 (Self-regulatory rules and other documents of the Asset Management Association of China)

(1) 私募基金登记备案 (Private fund registration and recordation)

私募投资基金管理人登 记和基金备案办法 （试行）

关于进一步规范私募基 金管理人登记若干事 项的公告 中国基金业协会负责人 就落实《关于进一步 规范私募基金管理人 登记若干事项的公 告》相关问题答记 者问

中国证券投资基金业协 会私募投资基金备案 须知 中国证券投资基金业协 会就“私募股权投资 基金参与上市公司并 购重组”相关问题答 记者问 中国证券投资基金业协 会发布《私募基金管 理人登记须知》更 新版

Translation

Date of enactment

Measures for the registration of management institutions of privately offered investment funds and the recordation of funds (for trial implementation) Announcement on several issues of further regulating the registration of privately offered fund management institutions Director of Asset Management Association of China answers questions about the ‘announcement on the several issues of further regulating the registration of privately offered fund management institutions’ Asset Management Association of China notes on filing of privately offered investment funds Asset Management Association of China answers questions about ‘privately offered investment funds participating in the M&A of listed companies’ Asset Management Association of China issues the updated edition of the notice for registration of private fund managers

17 January 2014

5 February 2016

2 March 2016

23 December 2019

22 October 2018

7 December 2018

appendix – l i s t o f c h i ne s e l e g i s l a t i o n

331

(1) (cont.)

私募投资基金募集行为 管理办法 基金募集机构投资者适 当性管理实施指引 （试行）

私募投资基金命名指引

Translation

Date of enactment

Measures for the administration of the fundraising of privately offered investment funds Implementation Guidelines for the suitability management of investors in fundraising institutions of privately offered investment funds (for trial implementation) Guidelines for naming privately offered investment funds

15 July 2016

1 July 2017

1 January 2019

(2) 内控及信息披露 (Internal control and information disclosure)

私募投资基金管理人内 部控制指引 私募投资基金信息披露 管理办法

私募投资基金信息披露 内容与格式指引1 号 （适用于私募证券投 资基金）

Translation

Date of enactment

Guidelines for the internal control of managers of privately offered investment fund Measures for the administration of the disclosure of information on privately offered investment funds Guidance No. 1 for the content and format of disclosure of information on privately offered investment funds (applicable to private securities investment funds)

1 February 2016

4 February 2016

15 July 2016

332

ap p e ndi x – list of chinese l egislation

(2) (cont.)

私募投资基金信息披露 内容与格式指引2 号 适用于私募股权（含 创业）投资基金

关于私募基金信息披露 备份系统正式运行的 公告

Translation

Date of enactment

Guidelines No. 2 for the content and format of disclosure of information on privately offered investment funds applicable to private equity (including venture capital) investment funds Announcement on the formal operation of the backup system for information disclosure for privately offered funds

1 January 2017

10 October 2016

(3) 从业人员管理 (Fund practitioner management)

基金从业人员执业行为 自律准则 关于基金从业人员资格 管理实施有关事项的 通知 关于私募证券投资基金 管理机构投资管理人 员投资业绩填报有关 事项的通知 关于开展基金销售机构 基金从业人员资格注 册管理的通知

Translation

Date of enactment

Rules for practice selfdiscipline of fund practitioners Notice on the relevant matters concerning the management of the qualification of fund practitioners Circular on the filling and reporting of the investment performance of the managers of privately offered fund management institutions Notice on the management of the qualification of fund practitioners in fund sales agencies

15 December 2014

26 June 2017

19 January 2018

21 March 2019

a p p en d i x – lis t of ch in es e l eg islat ion

333

(4) 外包服务 (Outsourced services)

私募投资基金服务业务 管理办法（试行）

关于私募基金服务机构 登记系统正式运行的 公告 关于私募证券投资基金 管理人提供投资建议 服务线上提交材料功 能上线的通知

中国证券投资基金业协 会会员管理办法 关于“资产管理业务综 合报送平台”会员模 块全面上线运行与会 员信息登记相关事项 的通知 私募证券投资基金管理 人会员信用信息报告 工作规则（试行） 中国证券投资基金业协 会会费收缴办法 关于私募证券投资基金 管理人会员信用信息 报告功能上线的通知

Translation

Date of enactment

Measures for the administration of privately offered investment fund services (for trial implementation) Announcement on the formal operation of the registration system of private fund service institutions Notice on the official launch of the function for the online submission of materials by private investment fund managers concerning the provision of investment advice services Administrative measures for members of Asset Management Association of China Notice on the official launch of the ‘Asset Management Business Electronic Registration’ system and relevant matters concerning members’ information registration Rules for the reporting of credit information on private securities fund managers (for trial implementation) Measures for the collection of membership fees Notice on the official launch of the credit information reporting function of private equity investment fund managers

1 March 2017

2 May 2017

23 March 2018

6 June 2012

1 September 2017

12 January 2018

6 June 2012 7 May 2018

334

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(5) 自律管理 (Self-Regulation)

中国证券投资基金业协 会纪律处分实施办法 （试行）

中国证券投资基金业协 会自律检查规则 （试行） 中国证券投资基金业协 会投诉处理办法 （试行） 中国证券投资基金业协 会投资基金纠纷调解 规则（试行）

关于实行私募基金管理 人分类公示制度的 公告 关于建立“失联（异 常）”私募机构公示 制度的通知 关于进一步加强私募基 金行业自律管理的 决定

Translation

Date of enactment

Measures for the implementation of disciplinary measures of the Asset Management Association of China (for trial implementation) Self-discipline inspection rules of the Asset Management Association of China (for trial implementation) Measures of the Asset Management Association of China for handling complaints (for trial implementation) Rules of the Asset Management Association of China for the mediation of investment fund disputes (for trial implementation) Announcement on the implementation of the classified publication system for private fund managers Notice of the establishment of the publication system for ‘lost connection (abnormal)’ privately offered fund institutions Decision on further strengthening the selfdiscipline management of the private fund industry

4 September 2014

4 September 2014

5 September 2014

5 September 2014

19 March 2015

29 September 2015

27 March 2018

a p p en d i x – lis t of ch in es e l eg islat ion

335

(5) (cont.)

关于加强私募基金信息 披露自律管理相关事 项的通知

Translation

Date of enactment

Notice on the relevant matters concerning the strengthening of information disclosure and self-discipline of privately offered funds

30 September 2018

Table 6 其他相关业务规则 (Other relevant rules)

(1) 上海证券交易所 (Shanghai Stock Exchange)

上海证券交易所上市公 司与私募基金合作投 资事项信息披露业务 指引

上海证券交易所上市公 司创业投资基金股东 减持股份实施细则

Translation

Date of enactment

Guidelines of the Shanghai Stock Exchange for the information disclosure of cooperative investments between listed companies and privately offered funds Detailed implementation rules of the Shanghai Stock Exchange for shareholding reduction by venture capital fund shareholders of listed companies

11 September 2015

2 June 2018

(2) 深圳交易所 (Shenzhen Stock Exchange)

深圳证券交易所上市公 司创业投资基金股东 减持股份实施细则

Translation

Date of enactment

Detailed implementation rules of the Shenzhen Stock Exchange for shareholding reduction by venture capital fund shareholders of listed companies

2 March 2018

336

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(3) 中国证券登记结算有限责任公司 (China Securities Depository and Clearing Corporation Limited) Translation 中国证券登记结算有限 责任公司关于私募投 资基金开户和结算有 关问题的通知

中国证券登记结算有限 责任公司证券账户管 理规则 关于私募基金管理人开 立证券账户有关事项 的通知 关于加强私募投资基金 等产品账户管理有关 事项的通知

Circular of China Securities Depository and Clearing Co., Ltd. on issues related to the account opening and settlement of privately offered investment funds Rules of China Securities Depository and Clearing Co., Ltd on securities accounts management Notice on relevant matters concerning the opening of securities accounts by private fund managers Notice on strengthening the account management of privately offered investment funds and other products

25 March 2014

1 October 2014

21 April 2016

19 January 2018

(4) 全国中小企业股份转让系统有限责任公司 (National Equities Exchange and Quotations Corporation Limited)

全国中小企业股份转让 系统关于加强参与全 国股转系统业务的私 募投资基金备案管理 的监管问答函

Translation

Date of enactment

Regulatory letter of questions and answers of the National Equities Exchange and Quotations on strengthening the recordation management of privately offered investment funds participating in the

20 March 2015

a p p en d i x – l i s t o f c h i n e s e l e g i s l a t i o n

337

(4) (cont.) Translation

关于金融类企业挂牌融 资有关事项的通知

business of the National Equities Exchange and Quotations Notice of matters concerning the quoted financing of financial enterprises

Date of enactment

25 May 2016

INDEX

Administration for Industry and Commerce, 155, 168, 176 Alibaba, 14, 250, 256, 298, 310 Apple, 5 Approval system, 12, 236, 306, 309 Asset Management Association of China, 8, 11, 26, 29, 30, 31, 33, 34, 36, 80, 81, 83, 94, 109, 139, 312, 321, 322, 330, 332, 333, 334 Baidu, 250, 251 Business judgment rule, 125–127 Cheng Siwei, 17 China Banking and Insurance Regulatory Commission, 36 China Banking Regulatory Commission, 25, 67, 282 China Insurance Regulatory Commission, 27, 67, 75 China Securities Regulatory Commission, 18, 19, 21, 25, 26, 28, 66, 67, 80, 84, 121, 123, 124, 127, 138, 152, 157, 158, 173, 192, 195, 224, 225, 230, 231, 232, 233, 234, 236, 263, 274, 275, 276, 277, 285, 287, 326, 327 ChiNext, 20, 21, 220, 222, 224, 225, 226, 228, 239, 240, 241, 243, 244, 246, 274, 275, 276, 308, 309 Chiron, 5 Civil Code, 51 Clawback mechanism, 88 Code of Corporate Governance, 195, 280 Company Law of the People’s Republic of China, 13, 28, 59, 60, 63, 64, 146, 147, 148, 149, 151, 152, 154, 155, 156, 157, 160, 161, 163, 164, 165, 166, 167,

170, 172, 173, 174, 175, 178, 191, 193, 194, 195, 196, 202, 204, 205, 206, 207, 212, 270, 305, 307, 323 Compaq, 5 Contract Law of the People’s Republic of China, 35, 202, 205, 292, 323 Convertible preferred stock, 146, 178, 179, 187, 188, 189, 190, 207, 208, 209, 210, 211, 212, 216, 307 Co-sale rights, 166 Delaware, 54, 55, 56, 57, 58, 78, 118, 122, 125, 126, 129, 131, 211 Dual-class share, 247, 248, 249, 250, 251, 252, 253, 255, 256, 257, 258, 259, 260, 261, 262, 263, 264, 266, 268, 269, 270, 271, 272, 273, 277, 278, 279, 303 Duty of care, 115, 116, 120, 122, 123, 124, 125, 127, 194 Duty of due diligence, 193 Duty of loyalty, 115, 117, 120, 122–123, 193, 267, 280, 281 Earnout, 183, 184–185 Facebook, 248, 256 Fiduciary duties, 44, 57, 64, 100, 115, 116, 118, 121, 128, 193, 194, 207, 211, 212, 307 Foreign-invested Venture Capital Company, 106, 108 Fund of Funds, 69, 72, 76, 77, 141 General partnership, 48, 57, 58, 81, 86, 102, 110, 118, 125, 128 General partnership enterprise, 48 Germany, 1, 5, 51, 56, 222, 256, 290

338

in dex Government Guidance Funds, 42, 45, 92–104, 138, 139–142, 309 Gross negligence, 125, 127 Guiding Opinions of the State Council on Preferential Share, 149 Han Kun Data, 153, 154, 158, 162, 165, 166, 168, 170, 174 Han Kun Law Offices, 153 Hong Kong, 109, 253, 256, 257, 258, 261, 266, 268, 269, 271, 275, 280, 299 Hong Kong Exchanges and Clearing Market, 220, 250, 253, 254, 257, 260, 261, 262, 263, 265, 266, 267, 270, 272 Huawei, 310 IDG Capital Partners, 18, 105 Institutional Limited Partners Association, 88 Intel, 5 Internal Return Rate, 87 Israel, 1, 5, 6, 290 Jack Ma, 256 Japan, 1, 4, 46, 56, 222, 299 JD.com, 250 Limited liability company, 48, 58, 60, 149, 152, 156, 157, 160, 163–165, 167, 168, 172–173, 174, 175, 178, 192, 204, 209, 300 Limited partners, 44, 45, 50, 52, 53, 54, 55, 56–57, 58, 60, 64, 65–77, 78, 79, 80, 83, 85, 86, 87, 88, 89, 100, 109, 111–113, 114, 115, 118, 119, 125, 127–137, 143, 144, 214, 319 Limited partnership, 3, 17, 18, 20, 36, 39, 41, 44, 45, 46, 47–57, 59, 60, 61, 62, 63–92, 100, 108, 109, 110, 111–113, 118, 127, 128–137, 143, 309 Listing Manual of the Stock Exchanges, 59 London Stock Exchange, 256 Microsoft, 320 Ministry of Commerce, 34, 36, 96, 138, 281, 284

339

Ministry of Finance, 17, 50, 96, 97, 142 Morgan Stanley, 18, 183 Multi-layered capital market, 10, 222, 224 National Aeronautics and Space Administration, 4 National Association of Securities Dealers Automated Quotation, 20, 211, 250, 251, 252 National Development and Reform Commission, 9, 25, 34, 36, 94, 96, 97, 138, 139, 142, 288, 301 National Equities Exchange and Quotations, 21, 161, 175, 192, 224, 225, 226, 228, 308, 336 National Social Security Fund, 21, 67, 73 National Venture Capital Association, 148, 150, 153, 158, 163, 176, 177, 187, 188, 192 New Third Board, 21, 175, 224 New York Stock Exchange, 250, 251, 252 New Zealand Venture Investment Fund, 5 Partnership enterprise, 48, 52, 119 Partnership Enterprise Law, 28, 36, 47, 48, 51, 54, 55, 56, 58, 59, 64, 78, 81, 83, 108, 116, 118, 119, 121, 123, 124, 126, 127–128, 129–137, 320, 323 Pre-emptive right, 159–163, 166 Preferred return, 87, 88 Preferred stock, 149, 150, 151, 152, 156, 158, 187, 189, 190, 209, 210 Price-to-earnings Ratio, 220, 238, 274 Qualcomm, 320 Qualified Foreign Limited Partners, 21, 109, 110 Registration-based system, 273, 308 Right of first refusal, 163–166, 167, 171, 172 RMB Qualified Foreign Limited Partners, 110

340

in de x

Science and Technology Innovation Board, 42, 211, 215, 224, 225, 226, 228, 234–247, 261, 262, 263, 265, 266–268, 269, 270, 271, 278, 279, 280, 302, 308 Securities Investment Fund Law, 29, 36, 81, 120, 323 Securities Law of People’s Republic of China, 35, 36, 38, 59, 191, 232, 309, 323 Shanghai Angel Investment Guidance Fund, 99, 100, 102 Shanghai Stock Exchange, 11, 18, 42, 220, 222, 224, 225, 230, 235, 236, 238–239, 271, 335 Shenzhen Capital Group Co. Ltd, 91 Shenzhen Stock Exchange, 11, 18, 220, 222, 224, 230, 276, 335 Silicon Valley, 4, 153 Sina, 14, 106 Singapore Exchange, 254, 257, 258, 260, 261, 263, 267, 268, 272 Small and Medium-sized Enterprise Board, 19, 220, 222, 224, 225, 226, 228, 236, 243, 274, 308, 309 Small Business Innovation Research, 4 Sohu, 14, 106 State Administration of Taxation, 50 State-owned Assets Supervision and Administration Commission, 91 State-owned enterprises, 12, 53, 54, 57, 98, 140, 275, 281, 284, 288, 308, 310 Stewardship Code, 260 Supreme People’s Court, 127, 132, 160, 164, 201, 203, 205, 293, 298, 301

Tag-along rights, 166–169, 170 Taiwan, 1, 45, 46, 109 Tencent, 251, 310 Tesla, 248, 256 Trust-type fund, 47, 60, 61, 62 Uber, 255 Uniform Limited Partnership Act, 122, 129, 132, 134 Uniform Partnership Act, 122, 125, 126 United Kingdom, 46, 54, 100, 114, 121, 122, 123, 124, 126, 156, 178 United States, 2, 3, 4, 10, 16, 38, 40, 41, 44, 45, 47, 51, 63, 65, 73, 74, 75, 77, 79, 84, 89, 100, 112, 114, 116, 117, 118, 121, 123, 125, 134, 136, 137, 143, 144, 145, 147, 148, 152, 153, 156, 158, 163, 166, 169, 172, 174, 176, 178, 182, 183, 184, 187, 189, 194, 195, 219, 222, 248, 249, 250, 252, 254, 256, 279, 297, 306, 314, 315, 319, 320 University endowment funds, 70, 72, 73 Valuation Adjustment Mechanism, 42, 145, 146–147, 177, 178, 179, 180, 181, 182, 183, 184, 185, 186, 187, 188, 190, 192, 193, 196, 197, 198, 199, 200, 201, 202, 203, 204, 205, 206, 207, 208, 209, 300, 314, 321 Yozma programme, 5–6 Zero2IPO, 89