Why equity family trusts require proper due diligence

By Ouyang Fangfei and Zhou Lu, Merits & Tree Law Offices
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Placing equity interests into a family trust is a business arrangement designed for passing on wealth, asset protection and tax efficiency. It typically exists for a long time and has a stable structure. To save costs, many trust companies and settlors of the trust dispense with due diligence on the equity interests held by the family trust and choose not to customise the equity trust deed.

Ouyang Fangfei, Merits & Tree Law Offices
Ouyang Fangfei
Partner
Merits & Tree Law Offices

In the short run, such a practice may save time and money. Nevertheless, it is not recommended. Given the current trust regulation regime in China, the authors believe conducting due diligence before setting up such a family trust is indispensable as it is conducive to the long-term stable existence of the family trust, as well as risk management from the trustee’s perspective.

A sound feasibility study and meticulous design structure based on due diligence can help forestall management deadlocks in the mid and late stages of the project. Dealing with information asymmetry in the early stages, identifying potential management risks and clarifying responses will help to facilitate a stable family trust.

PURPOSE OF DUE DILIGENCE

Due diligence is mainly aimed at solving information asymmetry. Through an objective and comprehensive review and assessment of the target company’s history, status and legal risks, the due diligence will pinpoint the equity risks for the settlor and underpin the trustee’s decision-making.

First, due diligence results serve as the bedrock of the feasibility study and structure design. Once any risk is identified through due diligence, the trustee can determine whether it may impede the establishment of the family trust or undermine its existence. This is in accordance with the settlor’s purpose of setting up the trust and its regulatory regime, so as to determine the feasibility of the project, the structuring of the trust and the boundaries of the trustee’s management responsibilities in the mid and late stages. The settlor can also take advantage of the due diligence to review and optimise the family’s equity assets.

Second, the risks uncovered in due diligence provide foundations for the management of the mid and late stages of the trust and allocation of responsibilities. The trustee can request that the target company reduce the risks or rectify the defects uncovered before setting up the trust, clarify the responsibilities and the precautions for any subsequent risks in the trust deed, reduce the management risks of the trustee after the establishment of the trust, and ensure the stability and safety of the family trust.

Given all these considerations, a due diligence report should provide both the settlor and the trustee with an effective basis for decision-making and considerations for trust management, which indicates legal risks, analyses the consequences and also presents practical legal advice and solutions that take into account the characteristics of family trusts. Such precautions reflect the value of legal due diligence.

ESSENTIALS OF DUE DILIGENCE

Zhou Lu, Merits & Tree Law Offices
Zhou Lu
Associate
Merits & Tree Law Offices

The due diligence on an equity family trust is conducted differently from that undertaken for investment and financing. Apart from the general matters to be examined, the following issues are of greater concern to the due diligence conducted on an equity family trust.

The authenticity and legitimacy of the ownership of the equity interests. The equity interests placed into the family trust must be owned by the settlor legally and validly. For example, if the equity interests were once the subject matter of an entrusted shareholding agreement, the trustee must verify the agreement’s reasons, validity and any controversies. Suppose the entrusted shareholding agreement was concluded to circumvent some legal restrictions or mandatory industry regulatory requirements, evade debts, transfer marital property, or other purposes. In that case, the reasonableness and legitimacy of putting such equity interests into the family trust will be called into question.

The legal compliance of the main business of the target company. The profitability and growth prospects are not of concern, rather, the legal compliance of its main business must be proven, otherwise the legitimacy of the capital put into the family trust via the target company’s dividends cannot be guaranteed.

The primary assets and debts of the target company. The due diligence on a trust should pay special attention to the debts and security of the target company. The equity interests of companies with debts in excess of their solvency or arising from unreasonable operations are generally unsuitable to be put into a family trust.

A connected transaction and horizontal competition. When the family trust is being established, the trustee usually conducts an anti-money laundering investigation into the sources of the capital to be placed into the trust, while ignoring the investigation into the sources of income of the target company. This unfair connected transaction involves major risks, including, but not limited to, money laundering, improper transfer of benefits, tax evasion and infringement on third-party interests.

The trustee, as the actual owner or manager of the rights and interests in the target company, should also verify whether the company violates any non-competition agreement. Suppose the trustee is ignorant of the settlor’s intention of engaging in an illegal connected transaction or horizontal competition under the camouflage of the trust. Then both the family trust and the trustee are at risk of accountability or liability by regulatory authorities.

SUMMARY

Although equity family trusts are generally responsible for internal affairs management, the trustee has a fundamental fiduciary duty under the law. If the trust structure is abused to infringe on the interests of any third party, violate regulatory rules, or for other illegal purposes, the reputation of the trustee and the trust industry, in general, will be severely jeopardised.

Ouyang Fangfei is a partner and Zhou Lu is an associate at Merits & Tree Law Offices

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