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The previous article entitled *My Views on the Approaches for Lawyers to Represent Investor Suitability Dispute Cases (Part I)* has conducted a preliminary analysis of the institutional system of investor suitability obligations for private funds and other related issues. This article will further analyze the legal nature of investor suitability obligations and the review criteria for the performance of such obligations.

I. Legal Nature of Investor Suitability Obligation and Liabilities for Breach Thereof

The author has retrieved cases in recent years via keywords including "private equity fund" and "breach of investor suitability obligation". The search results indicate that judicial practice has not yet formed a unified opinion on the legal nature of the suitability obligation.

At present, there are three mainstream views on the legal nature of suitability obligation recognized in China's judicial practice. First, it is a statutory obligation, and a violation of such obligation shall incur tort liability. Second, it is a pre-contractual obligation, and a violation of such obligation shall incur liability for fault in contracting. Third, it is a contractual obligation, and a violation of such obligation shall incur liability for breach of contract. The author has carried out further analysis on relevant cases, and holds that the failure of people's courts to form a unified opinion on the legal nature of suitability obligation does not result from divergent legal understandings that lead to "different judgments for similar cases", but from the complexity of individual cases that renders unified adjudication rules inapplicable. For instance, in specific cases, some courts hold that a consignment distribution agency is not a party to the contract, and under the consignment distribution relationship, no direct contractual relationship is established between the agency and investors, hence it is improper to deem that the consignment distribution agency's violation of suitability obligation constitutes a breach of pre-contractual obligation. However, when trying individual cases, some courts hold that as investors purchase private fund products via the official website of the consignment distribution agency, the agency has essentially formed a contractual relationship with investors, and when the consignment distribution agency violates the suitability obligation, such act may be deemed as a breach of pre-contractual obligation or contractual obligation in light of the actual circumstances.

The author holds that in complex specific cases, there are certain legal defects in both recognizing the suitability obligation as a contractual obligation or a pre-contractual obligation. For the purpose of unifying adjudication rules, the legal nature of the suitability obligation may be determined as a statutory obligation, and this determination has the following advantages:

(I) Breaking through the Privity of Contract and Simplifying Litigation Procedures

Selling institutions of private funds include not only private fund managers, but also distributing institutions. In judicial practice, it is a common scenario that investors subscribe for private funds through distributing institutions. The counterparty to the fund contract executed by the investor does not include the distributing institution, but the distributing institution shall not be exempted from the suitability obligation for this reason. If an investor intends to hold the distributing institution liable after sustaining losses, choosing the cause of action for contract disputes will be subject to the restriction of privity of contract, making it impossible to list the distributing institution as a co-defendant. Pursuant to the provisions of the *Minutes of the National Symposium on Civil and Commercial Trial Work of the People's Courts of China* (hereinafter referred to as the "Nine-Minutes"), where an investor suffers losses in the process of purchasing financial products, he/she may either claim compensation liability from the issuer of the financial product, or claim compensation liability from the seller of the financial product. Therefore, with the suitability obligation recognized as a statutory obligation, if the investor chooses the cause of action for tort liability, all claims can be resolved in the same case, which simplifies the litigation procedure and increases the possibility of obtaining compensation after winning the lawsuit.

(II) Breaking through arbitration clauses to provide investors with more remedy channels

In judicial practice, most fund contracts concluded between private fund managers and investors are standard form contracts. For the purpose of commercial confidentiality, managers usually specify arbitration as the dispute resolution mechanism. When a dispute arises, investors may only initiate arbitration in accordance with the provisions of the arbitration clause. Where the suitability obligation is determined as a statutory obligation, investors who choose the cause of action for tort liability may bypass the arbitration clause and file a lawsuit with the people's court. At present, courts have accepted cases filed under such approach of cause of action selection. However, during the trial of specific cases, some courts will still define the underlying legal relationship of the case. If the dispute is identified as a dispute related to the fund contract, the arbitration clause set forth in the fund contract shall still apply, and the dispute shall only be resolved through arbitration.

(III) Differences in the Amounts of Compensation for Investors' Losses

If the appropriateness obligation is recognized as a pre-contractual obligation, the liability incurred shall be liability for negligence in contracting, and the scope of compensation covers loss of reliance interest. In principle, such compensation shall not exceed the losses arising from the non-formation, invalidity or rescission of the contract at the time of contract conclusion, nor shall it exceed the performance interest when the contract is valid or formed. However, if the appropriateness obligation is recognized as a statutory obligation, the liability incurred shall be tort liability, and the case shall be handled in accordance with the tort remedy approach.

II. Review Criteria for the Performance of Investor Suitability Obligations

How to examine whether the selling institutions of privately offered funds have fulfilled their suitability obligations also constitutes a key point of contention in judicial practice. At present, there are three views in judicial practice.

First, formal examination. Judicial authorities focus on whether seller institutions have fulfilled the procedures of suitability obligation in form, covering the performance and record retention of procedures including the establishment of internal investor suitability management systems, product risk rating classification, investor risk rating classification, product-investor risk matching, qualified investor confirmation, cooling-off period and return visit; the completeness of documents such as the *Qualified Investor Confirmation Letter*, *Investor Risk Assessment Questionnaire*, *Risk Disclosure Statement* and *Fund Contract*; and whether clauses related to risks, returns and other items are marked in bold as prompts, etc. In short, as long as an investor signs for confirmation on the relevant investment documents, it can be deemed that the seller institution has fulfilled its suitability obligation.

Second, substantive review. The core approach of judicial authorities is not to take the signature and confirmation on assessment materials such as the *Customer Risk Tolerance Questionnaire* and *Customer Risk Tolerance Assessment Report* as the basis for determining whether the suitability obligation has been performed, but to ascertain the actual risk tolerance of investors and the true declaration of intent underlying the transaction. In other words, even if there is prima facie evidence of the selling institution's performance of the suitability obligation such as signature confirmation, the suitability obligation shall be deemed not performed if the product does not match the customer's risk rating. As stipulated in Article 76 of the *Minutes of the Ninth National Working Conference on Civil and Commercial Trials*, where a selling institution merely claims that it has fulfilled its duty of disclosure and explanation on the ground that the financial consumer has written statements such as "I clearly understand that there may be a risk of principal loss" but fails to provide other relevant evidence, the people's courts shall not uphold its defense.

Third, comprehensive review. The core approach of judicial organs is to take investors' risk tolerance into consideration on the basis of formal judgment, and review the performance of suitability obligations by selling institutions against both the objective standard understandable to a reasonable person and the subjective standard understandable to the relevant investor. For example, the Shanghai Financial Court adopts the comprehensive review method in relevant cases: the objective aspect includes risk assessment, signature confirming acknowledgment of risk disclosure, return visit during the cooling-off period, etc., while the subjective aspect mainly involves past investment experience and other relevant circumstances.

The author prefers a comprehensive review approach, namely "formal review + substantive verification". During the formal review stage, judicial authorities shall, in accordance with the procedural rules of relevant laws and regulations, conduct a formal review on whether the selling institution has fulfilled its suitability obligation. If the selling institution explicitly violates regulatory provisions and has obvious procedural defects such as failure to conduct risk assessment on investors, sales personnel without required practicing qualifications, or mismatch between the investor and the product risk, it may be determined that the selling institution has breached the suitability obligation and shall bear corresponding tort liability. Under such circumstances, there is no need to enter the "substantive verification" stage. However, if the selling institution has no obvious formal or procedural defects, and has apparently fulfilled suitability obligations such as risk assessment and risk matching in terms of transaction form, but the investor still disputes the performance of obligations by the selling institution, the judicial authorities shall not resolve disputes solely on the basis of formal review, but shall carry out further substantive verification, conduct review from the perspective of fairness, examine whether the selling institution has genuinely known its customers through specific key matters (such as the customer's age, financial status, investment objectives, investment experience, risk tolerance, etc.) and fulfilled sufficient duty of care to prove that it has sold appropriate products to appropriate customers, so as to determine whether the selling institution has fully fulfilled its suitability obligation.