DOCVIT Interpretation | Analysis of Main Points of Derivative Actions for Private Equities of “Liquidation” Defense Line

Source: DOCVIT Law Firm  Time: 2019-08-14 15:49:24  Author: Private equity team

Abstract: 

The year 2018 witnesses large scopes of “liquidation” of P2P. According to the industry discussion, the year 2019 will witness a high incidence of private equities disputes. It is frequently occurred that the fund manager is under loss of communication and escapes. When the fund manager gets slack to exercise the rights, relates the transaction, transfers benefits with the party to be invested, and conducts other behaviors damaging interests of the investor, the investor, as a limited partner, may take advantage of the derivative action to initiate legal proceedings against the party causing the infringement on behalf of the limited partner enterprise beyond the authority of the private equity manager, so as to protect interests of the limited partner enterprise and the investor. The financial and capital market team of Beijing DOCVIT Law Firm proposes to make study and discussion about key problems on the law existing in the practice of the derivative action made by the limited partner. 

Article 151 of the Company Law specifies the “derivative action”, namely, the shareholders in a limited liability company or an incorporated company who meet certain conditions have the right to directly initiate legal proceedings to the court in his/her own name for the purpose of the company’s interests when the Board of Supervisors/supervisors refuse to initiate legal proceedings. If others infringe legitimate rights and interests of the Company, causing losses to the Company, the shareholders who meet certain conditions may also initiate legal proceedings to the people’s court under the premise that all internal reliefs of the Company have been taken. Meanwhile, Article 68 of the Partnership Enterprise Law also specifies that in the partner enterprise, if the executive partner privately transfers interests to the third party, damaging interests of the limited partner, or is inactive to exercise rights to cash rights and interests of the limited partner or slacks to exercise other rights, the limited partner, on one hand, may urge the executive partner to exercise rights in written or oral form; on the other hand, may also initiate legal proceedings in his/her own name for the interests of own enterprise. 

I. Analysis for main trial points of the court over the derivative action of the private funds 

Article 68 of the Partnership Enterprise Law specifies that the limited partner may urge the executive partner to exercise rights or initiate legal proceedings in his/her own name for the interests of own enterprise when the executive partner is slack to exercise rights. From the view of the segmented clause, the court supports the derivative action initiated by the limited partner based on the following four bases: The executive partner is slack to exercise rights; the limited partner urges the executive partner to exercise rights; the limited partner initiates legal proceedings in his/her own name; for the interests of own enterprise. 

(I) How to prove that the executive partner is slack to exercise rights 

The limited partner needs to present sufficient evidences to prove that the executive partner is slack to exercise rights. According to practical experience of the Firm, slacking at exercising rights includes the following circumstances: 

The first circumstance is that the limited partner puts forward written or oral requirements for the executive partner to ask him/her to actively exercise rights for the third party, sign a feasible repayment agreement and require the third party to provide full-amount guarantee or start the restructuring plan to guarantee interests of the limited enterprise, but the executive partner directly refuses or does not make reply within a reasonable period. The reasonable period hereof does not be clearly specified in the Partnership Enterprise Law, and it can be subject to thirty days specified in the shareholders derivative action based on the Company Law. Namely, if the executive partner fails to make reasonable reply within thirty days or directly refuses to claim rights against the third party conducting the infringement action, the executive partner shall be possibly affirmed to be slack to exercise rights. It is noted that the executive partner shall immediately initiate legal proceedings or arbitration if any delay in initiating legal proceedings or arbitration will possibly cause the limited partner suffer from serious damages under emergencies. 

The second circumstance is that when the limited partners require the executive partners to file a lawsuit or arbitration, the executive partners directly refuse it or respond to the requirement of the limited partners but do not timely claim rights against the partnership debtor through litigation or arbitration. Shaanxi High People’s Court adopted this standard in (2015) SMEC Zi No. 00012 Case. 

The third circumstance is that the executive partners lose contact, go bankrupt or run away, or are controlled by the public security organ because of being involved in crime, so they cannot implement the partnership affairs normally. The Supreme People’s Court adopted this affirmation standard in (2016) ZGFMZ No. 19 Case and Hebei Provincial High People’s Court also adopted it in (2015) JMEC Zi No. 19 Case. 

It shall be noted that under normal conditions, the limited partners will require the executive partners to exercise the rights by sending a letter, e-mail or shot message. From the perspective of the current judicial cases, it is not a prerequisite for a limited partner to initiate a derivative action that the limited partner shall send a letter to the executive partner to urge him / her to exercise the rights; however, if the executive partner makes no response or refuses to make any response after the letter is sent, combined with other acts of the executive partner, the executive partner will be usually affirmed by the court to be slack to exercise the rights. There is a certain difference between it and the shareholders’ derivative action stipulated by the Company Law. The shareholders’ derivative action stipulated by the Company Law clearly requires that the shareholders must submit a written application to the Board of Directors / executive director, the Board of Supervisors / supervisors first, that is, the shareholders must exhaust the remedies inside the company first. 

(II) Whether a derivative action must be filed for the benefits of the partnership enterprise 

Article 68 of the Partnership Enterprise Law clearly requires that the limited partners shall have the right to “initiate legal proceedings in his/her own name for the interests of own enterprise”, that is, the limited partners shall file a derivative action after a third party infringes the benefits of the partnership enterprise, and the limited partners shall file the lawsuit for the benefits of the partnership enterprise. 

The partnership enterprise is closely related to the limited partners in the personal benefits. The limited partners shall not file a derivative action only for the purpose of obtaining the corresponding benefits by themselves, and the benefits, such as compensations obtained after winning the derivative action shall not be paid to the limited partners directly. Xiuzhou People’s Court, Jiaxing City, Zhejiang Province clearly pointed out in the written judgement of (2016) Z 0411 MC No. 4419 Case that “in accordance with Paragraph 2(7) of Article 68 of The Partnership Enterprise Law of the People’s Republic of China, in case that Ronshine Jinshi as a general partner is slack to implement the partnership affairs, a lawsuit requiring the partnership debtor to perform the debts may be filed but the litigation benefits shall belong to the partnership enterprise; therefore, so there is no legal basis for the plaintiff in this Case to require the partnership debtor to perform the debts to his / her individual based on the legal provisions above, and this court does not support it.” (Jiaxing Intermediate People’s Court of Zhejiang Province quashed this civil judgment in the second instance of this case but not for the reason that “the benefits of the derivative action of the limited partner shall belong to the partnership enterprise”) 

(III) Whether the limited partners can file a derivative action in their own name 

The derivative action filed by the limited partners means the derivative action filed by the limited partners as the plaintiff. The following issues need to be noted: First, in the case of multiple limited partners, the Partnership Enterprise Law does not stipulate that the lawsuit can be filed only after all the limited partners reach a consensus, so it can be thought that each limited partner shall have the right to file the derivative action separately. Second, the limited partners as the plaintiff must have the limited partner identity of this partnership continuously in the whole process of the limited partner’s derivative action. In the practice, the derivative action of limited partners is usually accompanied by the investment failure of the partnership enterprise, the executive partners’ loss of management ability and other cases, so some of the limited partners will start on the matters, such as partnership withdrawal or the transfer of the partnership shares and such act will result in the limited partners’ loss of the limited partner identity and may also result in the limited partners’ loss of the subject qualification of filing and conducting the derivative action accordingly. 

II. Analysis on the special problems of the derivative action of the private equities 

Question 1: Exemption of the executive partners from being slack to exercise the rights 

The Partnership Enterprise Law specifies that the limited partner will file a derivative action in case “the limited partner urges the executive partner to exercise rights or initiate legal proceedings in his/her own name for the interests of own enterprise when the executive partner is slack to exercise rights.” 

We think that in the practice, the executive partners shall be affirmed to be slack to exercise the rights in the cases mainly including making no response when the limited partners urge them to exercise the rights, or failing to actively strive for the rights after making a response or not filing any lawsuit or arbitration when they shall file it. Therefore, it shall not be thought that executive partners shall be slack to exercise the rights as long as they do not file a lawsuit or arbitration. The exemption of the executive partners shall include but not be limited to the following two forms: First, the executive partners adopt the approach of negotiating with the third party making the infringement for treatment and signing the relevant resolution agreement, and such agreement shall conform to the maintenance of the benefits of the limited partnership enterprise, as well as the laws and regulations and the provisions of the Articles of Association; Second, the executive partners do not sign any relevant agreements or file any lawsuits or arbitration but have reasonably certified that they have actively exercised the rights by various means objectively. 

Question 2: Bearing of the derivative action costs 

The Partnership Enterprise Law does not clearly stipulate the bearing of the derivative action costs of the limited partners but the Company Law and its judicial interpretation stipulate the shareholders’ derivative action and bearing of its costs, which may be used for reference. Article 26 of Judicial Interpretation of the Company Law (IV) stipulates that “for the cases of which the shareholders file the lawsuits directly in accordance with Paragraphs 2 and 3 of Article 151 of the Company Law, if all or part of their claims are supported by the People’s Court, the Company shall bear the reasonable costs paid by the shareholders for participating in the litigation.” In the case of referring to the relevant provisions in the Company Law, if the limited partners win the derivative action filed, the reasonable costs, such as the legal cost, survey fee and assessment fee generated by them in the litigation process shall be borne by the partnership enterprise. 

However, the partnership enterprise’s bearing of the reasonable costs of the derivative action in case of the limited partners win it is only a reference and discussion, and it is uncertain that how a judge will make the judgment in an actual case. Therefore, on one hand, the lawyers suggest that the legislative body shall establish a compensation mechanism for limited partners because the limited partners directly strive for the benefits of the partnership enterprise; thus, the partnership enterprise shall assume the corresponding obligations and responsibilities certainly with the necessary expenditures actually incurred as the limit; On the other hand, the partnership agreement may clearly stipulate that in case of the limited partners’ derivative action, the partnership enterprise shall bear the reasonable expenses. Thus, the limited partners’ benefits can be better protected, and the benefits of the limited partnership can be protected. 

Question 3: Whether the silent limited partners can prosecute 

The “Silent” limited partners discussed in this Article mainly refer to the silent partners of two types; the first type refers to the limited partners who have reflected their identity of shareholder in the register of shareholders, but have not conducted the industrial and commercial registration; The second type refers to the limited partners who have signed the share-holding entrustment agreement with the significant shareholders but neither are shown in the industrial and commercial registration nor reflect their identity of shareholder in the register of shareholders. 

The laws and regulations do not clearly stipulate whether the silent limited partners of the first type can file any derivative action, but it may be discussed by referring to the relevant rules for confirming the identity of partner and the identity of shareholder in the Partnership Enterprise Law and the Company Law. The identity of partner is affirmed mainly based on the substantial elements of the performance of the partnership agreement and contribution obligation that is, whether there are the facts of joint capital contribution, joint operation, shared earnings and shared risks. In case of meeting the substantial conditions above, the identity of partner shall be affirmed instead of being subject to the industrial and commercial registration. Industrial and commercial registration is not an effective requirement for the identity of partner, but is an antagonistic requirement for the identity of partner. Specifically speaking, in the event of any disputes inside the partnership enterprise, such as the disputes arising from the implementation of partnership affairs, operation of the partnership enterprise and the content in the partnership agreement, the identity of partner shall be affirmed. In the event of any disputes outside the partnership enterprise, such as the disputes arising from the partnership enterprise’s external investment and signing of the relevant agreements, then the industrial and commercial registration shall still prevail. If no industrial and commercial registration is conducted for the publicity effectiveness, the external effectiveness of the silent partners shall not be recognized. The silent partners shall not file the relevant lawsuits, including the limited partners’ derivative actions, in terms of the external disputes as the partners. 

For the silent limited partners of the second type, the silent limited partners only have the corresponding relationship of rights and obligations with the significant limited partners on the content of the share-holding entrustment agreement, and the silent limited partners shall not file the derivative actions as the limited partners of the partnership enterprise unless they carry out the corresponding “significant” procedures. 

In addition, there still has been no clear stipulation on the question of whether the limited partners shall have the identity of partner at the time of filing a derivative action or whether the limited partners shall maintain the identity of partner from the time of filing the derivative action to the date when the effective judgment is made, and most lawyers support the second viewpoint. Most lawyers think that the limited partners will lose the basis for striving the benefits for the partnership enterprise once they lose the identity of partner, and the court may reject the plaintiff’s lawsuit or require the plaintiff to withdraw the lawsuit according to its choice. 

Question 4: Whether the limited partners can file a lawsuit based on the right of subrogation 

To file a derivative action, the limited partners need to consume greater personal time, energy and financial resources, but the benefits obtained can only belong to the partnership enterprise directly, and the benefits of winning the lawsuit shall be jointly shared by all the limited partners and executive partners, without belonging to the limited partners directly. It can be observed that the limited partners’ filing of derivative actions indirectly protects the limited partners’ personal rights, with low cost performance. Therefore, many limited partners attempt filing a lawsuit based on the right of subrogation, so that the benefits obtained by winning the lawsuit will belong to the limited partners directly. 

The legal basis for the right of subrogation is Article 73 of the Contract Law. Paragraph 1 of this article stipulates that “If the debtors cause any damages to the creditors because they are slack to exercise their matured creditors’ rights, the creditors may apply to the People’s Court for the subrogation of the debtors’ creditors’ rights in their own name, but except that those creditors’ rights are exclusive to the debtors”. Paragraph 2 stipulates that “the scope of exercising the right of subrogation shall be limited to the creditors’ rights. The necessary expenses incurred by the creditors to exercise the right of subrogation shall be borne by the debtors.” According to the provisions in this Article, one of the conditions for the creditors to exercise the right of subrogation is that there is the real and effective debtor-creditor relationship between the creditors and debtors. However, in limited partnership enterprises, there is the partnership and contribution relationship instead of the debtor-creditor relationship between the limited partners and the partnership enterprise. Therefore, the limited partners do not have the legal basis for exercising the right of subrogation to the third-party infringers, and in practice, it is difficult for the limited partners’ claim of right subrogation to be supported by the court. 

The private equity investment has a complete historical period of raising, investment, management and quit. Whether the private equity can achieve the greater return on investment in the quit stage after it experiences the large-scale investment period will really reflect the value of private equity. In the coming wave of private equity disputes, the derivative actions will be a powerful weapon for the investors to protect their own benefits. The financial and capital market team of DOCVIT Law Firm will continuously trace and conduct the in-depth research on how the derivative actions of private equities to guarantee the investors’ benefits, what the gist of the court’s judgment and trail will be and how to supervise and urge the fund managers to diligently fulfill their duties and exercise their rights. 

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