Rules for determining the ‘channel’ liability of entrusted parties

The Guiding Opinions on Regulating the Asset Management Business of Financial Institutions, officially implemented on 27 April 2018, expressly prohibit financial institutions from providing channel business for the asset-management (AM) products of other financial institutions to enable them to circumvent regulatory requirements in terms of scope of investment, gearing, etc.

“Channel business” means a trading arrangement wherein a commercial bank, as the client, uses wealth-management funds or its own funds to establish an AM plan, trust plan or other such investment product through an entrusted party, such as a securities, trust or insurance company, as a channel, and thereby provide financing for the client’s target customer or invest in other assets.

Channel business is so named because the client is responsible for raising funds at the funding end and investment designation at the asset end, while the entrusted party’s AM business merely serves as the “conduit” for the funds flowing towards the assets designated by the client. Although the channel business is coming to a close, the risks buried in it should be stressed. Once occurred, the liability of the entrusted party, owing to its unclear or ambiguous authorization and unfulfilled responsibilities, could be pursued by the client or a third party. In judicial practice, the rules for determining the civil liability of the entrusted party in channel business are as follows.

Internal liability: Respect of party autonomy, channel clause between the client and entrusted party is valid. In practice, the entrusted party will specify a channel clause in the contract executed with the client to minimize its management duties. These are typically manifested in the following ways: The entrusted party only bears a passive duty of managing affairs; the client, not the entrusted party, is responsible for due diligence; the entrusted party acts upon the instructions of the client, does not make the investment decisions and does not handle after-the-fact management; adding original distribution or delayed distribution clause, etc.

Furthermore, the fact that the entrusted party acts upon the instructions of the client and does not bear active management responsibilities make the investment risks that the client bears and the management fees relatively low. Although the regulators emphasize that the channel business in which management responsibilities are relinquished may not be engaged in, it is not prohibited by laws or regulations. In judicial practice, the adjudication authorities generally respect the autonomy of parties and do not deny the validity of a channel clause for channel business that violates regulations, e.g., where there is no violation of Article 52 of the Contract Law, they generally will not render a finding that the channel clause is invalid.

The contract is the key document between the entrusted party and the client, which explains the scope of the entrusted party’s duties and legal liability. In a case, tried before the Hubei Provincial Higher People’s Court, the trust contract specified the manner in which the entrusted party was to apply the trust property, and specified that, if the entrusted party executed the client’s instructions and extended loans in accordance with the specified investment orientation, it would be deemed to have performed its duties of acting with care, good faith, prudence and effective management. On this basis, the trial court found that the entrusted party, in executing the instructions as specified, had performed its fiduciary duty and duty of care in a manner compliant with the contract, and that the client’s claim that the entrusted party’s failure to conduct a pre-loan review and carry out post-loan management constituted breach of contract was untenable. In other words, if the entrusted party had failed to perform fully its specified duties and had not provided for the appropriate exemption clauses, it would have been required to bear liability towards the client.

Furthermore, in contrast to client-dominated channel business, in investment adviser or other such third party-dominated channel business, the entrusted party, as a third-party channel, cannot provide for a channel clause in the AM contract with the client. The entrusted party bears a statutory duty of diligence and care. If an investment recommendation violates regulations or the contents thereof do not comply with the provisions of the contract and the entrusted party executes the same, causing a loss, the entrusted party is required to bear liability for breach of contract towards the client in the first place.

External liability: Channel business is not exempt from liability, and the entrusted party may not counter a third party on the grounds of “channel business”. In a case retried by the Zhejiang Provincial Higher People’s Court, the AM institution became a shareholder after investing entrusted funds in the target company and, as instructed by the client, appointed a director cum general manager to the company. However, the appointee, on the day immediately after the capital injection, rerouted the paid-in capital contribution back to the client, whereupon a creditor of the target company claimed that the entrusted party was required to bear joint and several liability for the debt of the target company to the extent of the capital contribution that was withdrawn without authorization. The trial court held that the entrusted party failed to perform its attendant shareholder duties in accordance with the law, was liable for the capital withdrawn without authorization and that its claim of having an internal relationship with the client to counter the creditor was untenable.

Based on the privity of contracts, the rights and liabilities provisions in a channel clause apply only to the client and the entrusted party, and, if a channel party is in breach of contract toward, or commits a tort against, a party that is not a party to the AM contract, the entrusted party may not counter such third party on the grounds that the channel business gives it an exemption of liability. Furthermore, in investment adviser or other such third party-dominated channel business, if the AM product is used to manipulate the market or engage in insider trading and the entrusted party is at fault and is pursued for damages for tort by market investors, the channel business cannot serve as ground for a claim to counter the rights of third parties.

In short, in channel business, an entrusted party should not ignore the risks because it merely serves as the “conduit”. With respect to existing business, an entrusted party should, in addition to straightening out further its business contracts to ensure that rights and liabilities are clear, complete its duty of managing affairs in strict accordance with what was agreed and refuse to execute instructions and recommendations that run counter to laws, regulations and the contracts.

Yao Xiaomin is a partner and Ma Yupeng is an associate at Lantai Partners