Developing trusts under harsh regulation in China

By Wu Yang, Merits & Tree Law Offices
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According to the figures on the main business of trust companies for the fourth quarter of 2017, released by the China Trustee Association, by the end of 2017 the balance of trust assets under the management of the 68 trust companies in China totalled RMB26.25 trillion (US$4.15 trillion), representing an increase of 29.81% over the same period last year and an increase of 7.54% over the previous quarter. The asset balance of account-managing-typed trusts accounted for as much as 59.62% of the total asset balance of trusts.

吴旸 WU YANG 植德律师事务所 合伙人 Partner Merits & Tree Law Offices
吴旸
WU YANG
植德律师事务所
合伙人
Partner
Merits & Tree Law Offices

While the total of trust assets has been growing rapidly, the regulators – with a view to preventing and controlling risk, building a sounder financial regulatory regime and intensifying financial reform – have in succession issued a series of regulatory documents including the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (Draft for Comments), the Notice of the China Banking Regulatory Commission on Regulating Bank-Trust Business (document No. 55), the Notice of the China Banking Regulatory Commission on Further Intensifying Rectification of the Disorder in the Banking Market (document No. 4), and the Administrative Measures for the Entrusted Loans of Commercial Banks, since 2017. In conjunction with the issuance of the regulatory documents, local banking regulators in various regions have, on the basis of on-the-spot inspections of trust companies, taken penalty measures against a number of companies. In January 2018 alone, local banking regulators ticketed administrative penalties against seven trust companies, whereas a total of only nine tickets were issued against the entire trust industry in 2016.

The above-mentioned facts show that the tide of stringent oversight over the financial asset management industry has taken shape. In the previous column article, the firm had pointed out that the elimination of multi-level nesting and passageway business, shattering of rigid payment, elimination of leverage, and prohibition of fund pools are the focus of regulation under the new regulatory regime of extensive asset management business, and that asset management products are required to return to their essence, i.e. “wealth management with entrustment on behalf of the trustor”. So then, how does the trust sector return to its essence, and what path must it take?

(1) Implementation of ‘net-worth-based management’ and shattering of rigid payment. Implementation of net-worth-based management on asset management products is a new requirement made by the regulators. Net-worth-based management might have a significant effect on promoting the return of the trust business to its essence.

In current trust business, provisions of fixed-return-rate and rigid payment for distribution to trust investors in trust documents are prevailing in practices. However, these practices seriously run counter to the basic theories of trust that investors must enjoy the gains and bear the losses from their own investments and assume the investment risks independently.

If the fluctuations in value of the products may not reflect the risks associated with underlying assets of such products, investors might fail to find out the significance of true risks that they bear.

In contrast, implementing of net-worth-based management on trust products on a fair value basis reflects the earnings on, and the risks associated with, the underlying assets, with no delay, and will serve as a precondition for promoting the transition from fixed-return-rate trust products to net-worth-based trust products, for the achievement of the practice that gains and losses come from investments per se, and investors assume risks independently.

(2) Starting from the principle of facilitating substantial economy, it is prohibited to offer passageway services to other financial institutions for the purpose of evading regulatory requirements. The figure presented at the beginning of this article shows that the scale of account-managing-typed trusts (passageway trusts) already account for as much as 59.62% of that of all trusts, especially prevailing in bank-trust co-operation businesses.

Document No. 55 expressly defines a bank-trust passageway business and sets out more stringent requirements for commercial banks and trust companies to follow. On the one hand, it prohibits banks from concealing substance risks by setting passageways trusts, evading regulatory requirements in respect of actual use of a fund by sector, asset categorization, allocation of risk reserves, as well as risk capital requirement, in accordance with the principle of “judge by substance over form”.

On the other hand, it prohibits trust companies from accepting security or guarantee provided directly or indirectly by a trustor bank, executing “agreements in drawers” with trustor banks, providing passageway services to trustor banks for evading regulatory requirements or to third-party institutions for concealing illegal practices, and investing trust funds against laws and regulations into sectors that are restricted or prohibited from accepting funding, such as real estate companies, “local government financing platforms”, stock markets, and industries with excessive production capacity.

(3) Enhancement of professional management capabilities and active engagement in genuine equity investment business. At present, trust companies establish trust plans/trusts and invest in the form of equity investment primarily to meet the fund-raising need of real estate enterprises, i.e., “de jure investment, de facto loans”.

Trust companies are required to enhance their professional management capabilities. They need to carry out effective designing of investment plans in terms of project development, management procedures, risk control standards, forms of investments, etc., and so genuinely serve the need of substantial economy in the process of business transformation and development of the trust industry.

Trust companies may also take advantage of their role as resource allocation platforms to provide financial services to production chain enterprises by satisfying the financial requirements of relevant upstream and downstream enterprises in the production chain. Trust companies may exploit their unique advantages in such sectors as asset management, wealth management and professional trust services, and travel a road of sustainable and innovative development against the tide of a stringent regulatory environment in order to promote the transformation and upgrading of future mainstay industries and better serve the substantial economy.

Additionally, by actively engaging in such business as asset-based securitization, consumer finance, family trusts, and charitable trusts, trust companies will achieve a diversified development of trust products.

Wu Yang is a partner at Merits & Tree Law Offices

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