Restricted by regulatory policies against “de jure investment, de facto loan”, trust companies in China’s rapidly growing real estate equity investment trust (REEIT) industry have, for the most part, abandoned investment via shareholder loans. In view of the numerous disadvantages in investing wholly in the registered capital, injecting sizeable chunks of their equity investment into the capital reserve of target companies has become common practice.
Note that REEIT is a type of privately sold trust product in China that differs from the better-known REIT on the open market.
Trust companies generally sign investment documents on behalf of trusts prior to their establishment. In other words, fundraising has not begun when the investment scale is determined. Out of risk concerns, a prerequisite to finalise the registered capital and the shareholding structure is often in place before any actual fund transfer. If equity investment is to be wholly credited to registered capital, trust companies would be required to complete their subscription of registered capital before the fundraising finishes. In case of oversubscription and insufficient trust capital to cover all subscriptions, trust companies may need to use their own capital for the portion subscribed for but not paid in.
While trust companies can always wait until the finalisation of the REEIT and gradually add to the registered capital based on the actual fundraising scale, this would considerably complicate the transaction terms and procedure and would be difficult to carry out. Excessive registered capital of the target company could also lead to a heavy tax burden for partners who co-invest in target companies. As a result, this option is rarely used.
By comparison, investing in the capital reserve of target companies falls under the scope of autonomy of will, which makes it relatively flexible. Trust companies, in practice, may arrange to invest in the capital reserve of target companies up to a certain limit, and to give themselves sole entitlement to the benefits, including but not limited to transfers from the reserve to capital and retrieval of residual property, represented by or derivative from their contributed portion of the capital reserve.
Trust companies, in practice, may arrange to invest in the capital reserve of target companies up to a certain limit
This helps trust companies avoid not only any commitment that may lead to supplemental payment down the line, but also burdensome procedures such as repeatedly filing for a change of business licence and modifying transaction documents. In projects with bet-on agreements, acquisition or exit arrangements, having sole entitlement to the capital reserve can also firmly support the fairness of the consideration to equity acquisition.
While the capital reserve is not registered capital, it remains, by nature, a company asset and does not belong to any shareholder. For third parties with a claim to interests in the target company, such as its creditors, they would be entitled to a claim for all assets under the name of the target company, including the capital reserve. In the case of a trust company investment, all arrangements set out in the transaction documents in respect of the capital reserve, including that for the sole entitlement of the trust company, would be dwarfed against the third-party claim.
If the operating or financial position of the target company or the partner should deteriorate to the point of insolvency, the only claim left for the trust company would be its rights over the target company’s residual property in its capacity as a shareholder. In such cases, the trust property may suffer losses.
Based on the principle of capital maintenance, shareholders directly requesting an allotment or refund from the capital reserve may also constitute withdrawal of capital. Consequently, if the counterparty in a bet-on agreement is unable to perform its equity acquisition obligation, shareholders could only withdraw their investment via equity transfer to third parties, capital reduction or liquidating target companies. There is no guarantee that the trust property will eventually be withdrawn intact.
First, request the partner to invest pro rata in the capital reserve and, if applicable, request any subsisting claims of the partner or its related parties on the target company to be invested as capital reserve. Failing that, where possible, investors should procure commitment of the partner or its related parties to not exercise their creditor’s rights until exit from the trust is completed.
Second, in terms of internal management of the target company, investors should establish a clarified internal decision-making process on transferring capital reserves to registered capital. Where the voting mechanism is concerned, investors are advised to augment the influence of the trust to the greatest possible extent and avoid the need for an absolute consensus in every scenario. This is to prevent any deliberate failure to co-operate by the partner in case a transfer to the registered capital or capital reduction is called for.
As the national policy of “a house is for living in, not for speculation” moves forward, trust companies are expected to face further challenges with REEITs. While focusing on the future investment value in the real estate sector, trust companies should also pay heed to the legal risks involved, take timely preventive measures and effectively perform their duties and responsibilities as trustees.
Ren Guobing is a partner and Yi Yi is an associate at Jingtian & Gongcheng
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