After a private equity investment fund completes its capital contribution in a project company and becomes a shareholder of such company, the post-investment management phase begins. The investment agreements usually stipulate that founders and the project company must fulfil a series of obligations and commitments after closing, such as observing non-compete obligations and fiduciary duties, maintaining operational and financial compliance, and obtaining the investor’s approval before making major decisions.
Wu Jialing
Partner
Starrise Law Firm
The investment agreement also includes corresponding breach of contract clauses, which may cover restoration of the original state, payment of liquidated damages, compensation for losses, and even triggering a share repurchase.
Should a founder or project company engage in misconduct, PE funds often face challenges when seeking remedies through conventional civil and commercial actions, such as difficulty in providing evidence, delays in court scheduling, enforcement hurdles, long timelines, and low efficiency. Some investment agreements have contractual flaws due to inadequate consideration during drafting, which also provides project companies and founders with grounds for defence in both substantive and procedural law.
Additionally, in projects adopting a red-chip structure, although the company’s shareholding platform is located overseas, the company’s core personnel, actual business operations and major assets are all in China. However, investment agreements usually stipulate that disputes shall be governed by foreign law and resolved by foreign arbitration institutions.
Mechanically adhering to the remedial methods specified in the agreement would result in high overseas legal fees and significant time costs. It also relies on cross-border judicial assistance procedures, leading to slow enforcement and fund recovery – during which the wrongdoers may have transferred or concealed core assets. In contrast, the legitimate and reasonable use of criminal law means offers advantages such as higher efficiency and direct outcome.
Evidence collection and preservation
As a precautionary measure, PE funds should establish awareness of evidence collection and preservation in advance. The process of obtaining and preserving evidence must “leave a trace at every step”.
Huang Xinran
Associate
Starrise Law Firm
Legality of evidence sources. During the investment agreement negotiation between a PE fund and a project company, the investor’s information rights and its specific exercise methods should be clearly stipulated. This ensures that relevant clauses can be effectively implemented during post-investment management. If an investor obtains the company’s materials through illegal or improper means, or if there are legitimacy flaws in the process of obtaining materials, it will instead be constrained by the founders and accused of suspected illegal theft of trade secrets.
Authenticity of evidence. When conducting due diligence on a project company, PE funds usually only have access to editable versions of financial statements. From the perspective of criminal evidence, editable documents are at risk of being tampered with, and their authenticity is easily questioned, affecting the effectiveness of subsequent rights protection efforts. The author suggests that, during the early “honeymoon period” between both parties, the sealed versions of key materials should be collected and solidified.
Relevance of evidence. Standard due diligence for private equity projects focuses on a company’s business and legal standing. However, considering the potential use of criminal means for post-investment disputes, during the due diligence and post-investment management phases the PE fund should proactively collect and review the company’s materials in accordance with the constituent elements of relevant criminal charges.
It should also continually monitor key indicators in the company’s financial statements, accounting books and operating systems to consolidate the evidential relevance between the obtained materials and specific criminal charges.
Offensive negotiations
Offensive negotiation is a strategy in which, after obtaining evidence that the company or its founder is suspected of committing a crime, the investor takes the initiative to initiate negotiations. The goal is to reach an agreement on a plan to address the misconduct of the company or its founder, thereby realising the remedy of rights.
Common criminal charges involving the invested company, its founder, and management include crimes related to executive positions and corporate operations. Compared to traditional civil and commercial remedies, offensive negotiation features penetrability, efficiency and challenge.
Penetration. Different from the risk isolation between different entities in the civil and commercial fields, criminal determination penetrates formalities to focus on substance. This makes it easier to directly trace the personal liability of founders and senior executives.
Efficiency. The main consequence of adopting civil and commercial remedies is being listed as a person subject to enforcement for failing to fulfil obligations. However, in reality, some people often bypass the impact of such a status through illegal means. In contrast, the consequences of criminal offences are more severe, and the deterrent effect on the parties involved is stronger. Therefore, offensive negotiation can often break the deadlock in rights protection and significantly shorten the cycle of rights protection.
Challenge. Due to the high sensitivity of criminal means and the complexity of PE fund investments, conducting offensive negotiation is highly challenging. PE funds need to respond cautiously to prevent themselves, as well as the directors and senior executives they appoint, from being accused of extortion and thus falling into a disadvantaged position.
After a PE fund negotiates with a company to reach a new agreement, the signing and execution of the agreement will also face issues related to the sensitivity of involving criminal matters. Therefore, it is suggested to choose lawyers with combined experience in corporate, litigation and criminal fields.
Case study
The author’s team successfully handled an offensive negotiation case targeting senior executives of a startup company that had completed its series D financing. A shareholder and senior executive of the invested enterprise had engaged in misconduct during the company’s operations.
After conducting a comprehensive due diligence investigation, the lawyers found evidence of the executive’s misconduct, including illegally withdrawing company funds, signing false business contracts and conducting related-party transactions, making unauthorised travel expense payments, and taking company assets without permission.
These actions were suspected of constituting the crimes of embezzlement and misappropriation of funds. Based on this, the lawyers represented the company in negotiations with the executive, and ultimately, the executive agreed to return the funds and resign from the company.
Takeaways
PE funds should establish awareness of penetrating criminal risks at an early stage, and engage lawyers with criminal practice experience in advance. When facing possible criminal liability, PE funds should use lawful measures, ensure risk isolation, and consult experienced lawyers to design and execute remedies.
Wu Jialing is a partner and Huang Xinran is an associate at Starrise Law Firm.
Starrise Law Firm
Room 1701, 17/F, China Resources Building
8 Jianguomen North Street, Dongcheng District
Beijing, China
Tel: +86 10 6401 1566
E-mail: wujialing@xinglailaw.com
huangxinran@xinglailaw.com
www.xinglailaw.com
