Practical Guidance on Responding to Corporate Criminal Risks

After a private equity investment fund (hereinafter referred to as the “private equity fund”) completes its capital contribution and becomes a shareholder of the project company, it enters the post-investment management phase. The investment agreement typically stipulates that the founder and the project company must fulfill a series of obligations and commitments following the closing, including adhering to non-compete restrictions and fiduciary duties, maintaining financial and operational compliance, and obtaining investor approval before making significant decisions. The agreement also includes corresponding provisions on breach of contract liability, which may encompass restoring the original state, paying liquidated damages, compensating for losses, and even triggering a share repurchase.

When the founder or the project company engages in improper conduct, private equity funds that seek to protect their rights through conventional civil and commercial means often face challenges such as difficulty in gathering evidence, prolonged court scheduling, difficulties in enforcement, lengthy litigation cycles, and low efficiency. Moreover, some investment agreements contain defects in their terms due to insufficient consideration during drafting, providing both the project company and the founder with room for defense under substantive and procedural law. Furthermore, in projects structured using the red-chip model, although the company’s shareholding platform is located overseas, the company’s core personnel, actual business operations, and major assets remain within China. Yet, investment agreements typically stipulate that foreign law shall govern and that disputes shall be resolved by foreign arbitration institutions. If the remedies specified in the agreement are applied mechanically, this will result in exorbitant costs for overseas legal fees and extremely high time expenditures, while also relying on cross-border judicial assistance procedures, which can lead to slow recovery of funds. Meanwhile, the party responsible for the misconduct may have already transferred or concealed its core assets during this period. By contrast, the lawful and reasonable use of criminal dispute resolution mechanisms can achieve more efficient and direct results.

To prevent problems before they occur, private equity funds should proactively cultivate an awareness of evidence collection and preservation. The process of obtaining and securing evidence must leave a clear trail at every step.

Pay attention to the legality of evidence sources. During the negotiation stage of investment agreements between private equity funds and project companies, it is essential to clearly stipulate the investor’s right to information and the specific methods for exercising this right, ensuring that these provisions can be effectively implemented in post-investment management. If an investor obtains company materials for illegal or improper reasons, or if there are legal defects in the process of obtaining such materials, the founder side may instead impose restrictions on the investor and accuse them of allegedly illegally stealing trade secrets.

Emphasize the authenticity of evidence. During due diligence on a project company, private equity funds typically have access only to editable versions of financial statements. From the perspective of criminal evidence, editable documents carry the risk of tampering, making their authenticity easily questionable and potentially undermining the effectiveness of subsequent rights protection efforts. Therefore, the author recommends that, during the early “honeymoon period” when the relationship between the two parties is still strong, key materials should be promptly collected and their stamped versions securely preserved.

Emphasize the relevance of evidence. In general, the primary purpose of due diligence in private equity investments is to gain a thorough understanding of the company’s operational status and legal compliance. If there is a possibility that criminal measures may be employed to address post-investment risks in the future, it is advisable—during both the due diligence and post-investment management phases—to proactively refer to the elements constituting relevant criminal offenses, systematically collect and review company documents with a targeted approach, and continuously monitor key indicators from the company’s financial statements, accounting records, and operational systems. This will help strengthen the evidentiary links between the materials obtained and specific criminal charges.

An offensive negotiation refers to a situation in which an investor, after obtaining evidence that the company or its founder is suspected of committing a crime, proactively initiates negotiations to reach an agreement on how to address the company’s or founder’s misconduct, thereby achieving redress of their rights.

Invested companies, founders, and management teams are often implicated in crimes related to executive positions and corporate operations. Private equity funds and specialized lawyers can, based on the specific circumstances of each project, collect and organize evidence, assess criminal risks, and accordingly develop negotiation strategies and subsequent handling approaches.

Compared with traditional civil and commercial remedies, offensive negotiation is characterized by its penetrating nature, efficiency, and challenging approach.

Penetrating. Unlike risk isolation among different entities in the civil and commercial sphere, criminal determinations can look beyond formalities, focus more on substance, and more easily trace directly back to the personal liability of founders and senior executives.

Efficiency. The primary consequence of resorting to civil and commercial remedies is being listed as a discredited entity subject to enforcement. However, in practice, many people often circumvent the adverse effects of being listed as a discredited entity by employing illegal means. By contrast, the consequences of criminal offenses are far more severe and carry greater deterrent power over the parties involved. Therefore, proactive negotiation strategies can often break deadlocks in rights protection efforts and significantly shorten the duration of such efforts.

Challenging. Given the high sensitivity of criminal proceedings and the complexity of private equity fund investments, conducting aggressive negotiations poses significant challenges. Private equity funds must approach such negotiations with utmost caution to avoid implicating themselves or their appointed directors and senior executives, and to prevent being accused of extortion and thereby finding themselves in a disadvantageous position. After a private equity fund reaches a new agreement with a company through negotiation, both the signing and implementation of the agreement will also face issues involving criminal sensitivity. Therefore, the lawyers chosen by private equity funds should possess comprehensive experience spanning non-litigation, litigation, and criminal law areas.

Our team successfully handled an aggressive negotiation targeting a senior executive of a startup company that had just completed its Series D funding round. The shareholder and executive of the invested company had engaged in improper conduct during the company’s operations. After conducting a comprehensive due diligence, our lawyers uncovered substantial evidence of the executive’s misconduct, including unauthorized withdrawals of company funds, signing false business contracts and engaging in related-party transactions, improperly claiming travel expenses, and misappropriating company assets. These actions are suspected of constituting the crimes of embezzlement and misappropriation of funds. Based on this evidence, our lawyers negotiated with the executive on behalf of the company, and ultimately, the executive agreed to return the misappropriated funds and withdraw from the invested company.

In the early stages, improper conduct by project companies or founders tends to be relatively concealed. Therefore, private equity funds should cultivate an awareness of penetrating criminal risks from the very outset of a project and proactively engage lawyers with criminal law experience. When dealing with criminal-related activities, private equity funds should adopt reasonable and lawful criminal measures, carefully implement risk isolation, and hire professional, multi-disciplinary lawyers to comprehensively design and execute response strategies.

Editing and Layout: Wang Xin

Review: Management Committee