Legal due diligence on family trusts

From the perspective of the subject being investigated, legal due diligence in family trust business can be divided into due diligence by the settlor on the trustee and due diligence by the trustee on the settlor. This article proposes to discuss certain common issues encountered in the latter type of due diligence.

With respect to the question of whether legal due diligence is required in a family trust business, there currently is no consensus opinion among various trust companies when they engage in business. Certain trust companies with a more rigorous stance will engage lawyers to investigate the household relationships and credit status of the settlor and key beneficiaries, title to, and lawfulness of, the trust property, etc. Trust companies with a more flexible stance will, on the other hand, mainly rely on the various undertakings and warranties given by the settlor.

When investigating the qualifications of the settlor and key beneficiaries, the first step will generally be to check whether the settlor or the beneficiaries are state public servants, and whether they’ve been involved in any major social incident or investigation. The main family relationships of the settlor and beneficiaries, and the family relationship between the settlor and beneficiaries, will also be investigated. Although these steps are not required by the Trust Law, from the perspective of anti-money laundering, anti-corruption and guarding against the funnelling of benefits, the trustee genuinely needs to check the above-mentioned.

When verifying the identity of the settlor and beneficiaries, two other issues frequently trigger debate, the first of which is whether the settlor must be a “qualified investor”. The author would argue that the precondition to determining whether a settlor needs to be a qualified investor is whether a family trust constitutes an “asset management product”. If a family trust does not constitute an asset management product, the settlor only needs to satisfy article 19 of the Trust Law, namely, the settlor only need be a natural person, legal person or other lawfully established organization with full civil capacity to act.

In the Notice on Strengthening the Regulation of Trusts During the Transition Period for Making Asset Management Business Compliant it is expressly specified that the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (the asset management new rules) do not apply to family trusts. Accordingly, it is not necessary to examine whether the settlor of a family trust is a qualified investor.

Additionally, the notice sets out general provisions on the determination of family trusts, and emphasizes the principle of “substance over form”. With respect to trusts that include the words “family trust” in their name, but simply pursue the preservation and increase of the value of the trust assets as their objective and have dedicated wealth management and asset management attributes, they should still be deemed asset management products, and their settlors are required to satisfy the requirements on the qualified investor.

The second issue is whether the settlor and/or the beneficiaries can be foreign nationals (including residents from Hong Kong, Macau or Taiwan). By looking at trust-related laws, it can be seen that no restrictions are placed on the nationality of settlors or beneficiaries. When a settlor or beneficiary is a foreign national or foreign tax resident, the trustee should carry out due diligence on the tax-related information of the non-resident financial accounts and perform common reporting standards (CRS) tax information collection and submission obligations.

Pursuant to article 7 of the Trust Law, there must be determinate trust property to establish a trust, and this trust property must be lawfully owned by the settlor. Accordingly, when conducting legal due diligence on trust property, emphasis should be placed on the following issues:

1. Whether the trust property is clear and specific at the time of establishment of the trust, i.e., whether the trust property is clear in terms of quantity and its boundaries. Such investigations mainly address benefit-right-type assets, and the trustee should generally investigate title to the assets underlying the benefit rights and the relevant benefit distribution agreement.
2. Whether the settlor is the lawful owner of the trust property. When investigating ownership of the trust property, the investigation of registered rights in rem is relatively straightforward, but the investigation on the title of property that does not require registration is more difficult to conduct objectively. When investigating such property, the movable asset purchase and payment records, purchase contracts, invoices, settlor’s income and expenditure ledgers for recent years, etc., may be checked. If the same is income from grant, there should be an explicit grant contract and donor. The co-owned property rights relationship arising from a spousal relationship is an important matter that needs to be resolved before the establishment of a trust, as the settlor of most family trusts is an individual, not both spouses. In such a circumstance, if the spouse is aware of the matter and co-operates in issuing a letter of consent, the issue can be duly resolved, but if the spouse is not aware of the matter or does not agree, a careful investigation of whether the property to be used to establish the family trust is the personal property of the settlor needs to be carried out.

Pursuant to the Trust Law, where the establishment of a trust by a settlor harms the interests of the settlor’s creditors, the creditors have the right to apply to a People’s Court to revoke the trust. To ensure the stability of the trust and avoid a “debt avoidance trust”, the trustee must investigate the settlor’s basic credit status, access the credit records of the settlor and of the main enterprises under the settlor’s name, and check the settlor’s involvement in legal actions and debt position. In principle, the value of the trust property should not exceed the net value of the settlor’s assets. Like the issue of co-ownership of property rights between spouses mentioned above, when checking the settlor’s credit status, attention should also be paid to the issue of the joint debts of the spouses.

In practice, many difficulties are faced when doing due diligence on a settlor, due to the limited third-party inquiry channels that are available. However, despite this, from the perspective of the trust institution’s good faith, and prudential obligations and maintenance of the stability of the trust, a trustee should deem it necessary to conduct legal due diligence on the settlor and trust property of a family trust.