Application of service trusts in distressed real estate

By Deng Weifang and Yu Jiahao, Merits & Tree Law Offices
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In relevant statements of regulatory authorities, a service trust refers to trust companies using their institutional advantages and service capabilities in account management, property independence and risk isolation to provide clients with various services besides asset management – which is quite different from a fund trust, which has the purpose of increasing investment value. However, legally speaking, a service trust is still a type of trust, and its effect is in the same strain as the legal system of trust.

Nowadays, with frequent bubble bursts of real estate giants, the introduction of service trusts brought new ideas for the easing and breakthrough of distressed real estate companies.

Before bankruptcy proceedings, a service trust may help preserve high-quality assets with the legal effect of risk isolation, facilitating the introduction of new investors and promoting revitalisation and reorganisation of a project. In bankruptcy proceedings, it can be used to bid for time, realise orderly distribution, and better serve the bankruptcy arrangement.

USE OF SERVICE TRUSTS

Application of service trusts in distressed real estate Deng Weifang Merits & Tree Law Offices
Deng Weifang
Partner
Merits & Tree Law Offices

Take, for example, a Shenzhen project company under a real estate group that recently experienced risks. If a funder provides financing to the project company in the form of shares and debt, the original shareholder of the project company assumes obligation to repurchase the shares, and the real estate group provides guarantee for the repurchase obligation. Now, due to the serious debt crisis of the real estate group as a whole, the project company, the original shareholder of the project company and the real estate group are all unable to fulfil their obligations as stipulated.

At this point, if the funder wants to exit smoothly, relying solely on dispute resolution will not only consume time and financial resources, but also face the risk of the real estate group being ordered to be substantively merged and bankrupt – resulting in a great reduction of the final compensation amount and efficiency. Therefore, from a multi-dimensional perspective, it is necessary to solve the dilemma of the funder by designing a transaction structure.

In the case of a service trust, the underlying assets of equity and creditors’ rights may be transferred to the trust by virtue of the independence of its trust property. Specifically, the newly introduced investor, the original funder (creditor) and original shareholder of the project company respectively invest by means of cash subscription, investment with equity plus creditors’ rights, and investment with equity income right in the property right trust established by the trust company for the target project.

On the one hand, this may avoid recourse by other creditors against the debtor, or loss of absolute control over assets, or preferential repayment due to the debtor’s entry into bankruptcy proceedings. On the other hand, it is also possible to introduce new investors to invest in the distressed project and carry out relevant design at the level of trust settler and beneficiary, according to the needs of all parties for the subsequent revitalisation.

LEGAL ISSUES

Application of service trusts in distressed real estate Yu Jiahao Merits & Tree Law Offices
Yu Jiahao
Associate
Merits & Tree Law Offices

Although the introduction of a service trust is conducive to the revitalisation of distressed real estate projects, there are still a series of legal issues worthy of attention when setting up a service trust.

Validity of establishment. On the one hand, in distressed real estate projects, the transaction structure is set up by transferring creditors’ rights, which may constitute a “debt collection trust”. However, since it is difficult to determine whether this is “for the purpose of litigation or debt collection only”, the possibility of invalidation of trust is low.

On the other hand, there is no clear legal provision on whether a trustee must be a trust company to enable the trust to have legal effect. However, in Yang Wen v Suweixiong Trust (2010) and other cases, it is considered that the trust may be invalid unless an institution with the qualification to operate trust business acts as the trustee.

Disguised debt. In real estate projects, the transaction structure of disguised debt is very common, and in specific transaction scenarios disguised debt is often identified as security by assignment. If the creditor delivers as trust property its creditors’ rights based on the repurchase transaction arrangement and its nominal equity, it remains to be further studied whether it will be deemed as invalid disposal of the collateral (equity) and lead to invalid delivery of the trust property.

Limited liability stipulation. Since a trust is not a legal entity in China and all its activities are carried out in the name of the trustee from the perspective of protecting the third party, there is the issue of assuming responsibility beyond the scope of the trust property. Therefore, in the transaction arrangement of service trust, if the trustee’s limited liability – such as the shareholder’s capital contribution obligation – cannot be stipulated through agreement, there are still some risks for the trust company objectively. However, in current judicial practice, there has been no guidance on the limited liability of service trusts. Therefore, judicial opinion on this remains to be further clarified.

Effectiveness against revocation right. One of the core reasons for the application of a service trust in distressed real estate projects is to use the independence of trust property to achieve risk isolation. However, the Trust Law, Bankruptcy Law and Civil Code all set up trust revocation rights, bankruptcy revocation rights and creditor revocation rights systems – all of which have the possibility of breaking through the trust risk-isolation function. Therefore, full attention should still be paid to the exercise of relevant revocation rights when designing the trust transaction structure of distressed projects.

Admittedly, giving full play to the risk isolation function of a service trust is helpful to easing difficulties of distressed real estate projects, there cannot be “blind faith” in the trust system itself – and the risk isolation advantage is not absolute. Moreover, from the perspective of regulatory opinions, the boundary between capital trust and service trust is still vague.

Therefore, whether the service trust model can be adopted to ease the difficulties of distressed real estate projects needs to be comprehensively judged based on specific situations.

Deng Weifang is a partner and Yu Jiahao is an associate at Merits & Tree Law Offices

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