Plenty of Room to Grow: A Look at China's Business Trust Industry

The Way it Works: The Trust Business in China

In accordance with the Trust and Investment Companies Procedures, the business scope that TICs may be involved in is roughly divided into three categories: trust business; intermediary and consulting business; and the business of self-owned assets investment. The trust business is the core business.

Generally, a trust business includes using, managing and/or disposing of the property entrusted by the grantor for the benefit of the beneficiaries. The trust business includes capital trust and non-capital trust businesses.

In a capital trust business, the trust property is in the form of readily convertible currency. As such, in this form TICs have the most options in utilizing the funds: capital market investment (including setting up securities investment funds), commercial lending, inter-financial institution lending, purchasing real estate and project finance are all viable options. With the promulgation of the Holding Funds in Trust Tentative Procedures, and the fact that almost all trust projects launched in 2002 were capital trust projects, the capital trust business will likely become the majority business of TICs. Moreover, as China implements the legal separation of financial sectors, thus preventing each sector from getting involved in another's business area, the operation of a trust business has the most flexibility. However, in the area of capital investments, TICs will be confronted with the competition of the traditional leaders: commercial banks, securities companies and funds management companies. Therefore, setting up joint businesses or cooperating with other sectors appears to be an advisable selection. In 2002, for example, some TICs together with securities companies sponsored securities investment funds or fund management companies; and some TICs obtained the assistance of powerful commercial banks to promote their trust projects.

A recent trust project, the Shanghai Outer Ring Tunnel Project, is a typical capital trust project.² It was reported that its core structure consists of: use of trust funds in equity investment - cashing the equity upon the termination of trust - and vestment in the beneficiaries. The trustee (Shanghai AJ) uses the trust funds to purchase from the original shareholder the equity interests in the project company, the Shanghai Outer Ring Tunnel Construction Development Co., Ltd (Tunnel Co.) and to increase the registered capital, whereby Shanghai AJ becomes the majority shareholder thereof. Upon the declaration of dividends by Tunnel Co. after completion of the construction, Shanghai AJ will receive dividends commensurate with its equity proportion and within the valid term of the project Shanghai AJ can use such benefits to invest in national bonds or deposit them in commercial banks as stipulated in the trust contracts. When the proposed three-year term expires, Shanghai AJ will transfer the equity interests to other(s) so as to convert all the shares into money. Thereafter, all the money so arising plus the aforesaid trust benefits but less the trust management fee shall vest in the trust beneficiaries.

Notably, no matter how Shanghai AJ disposes of the trust funds, the assets from time to time converted from the trust funds will always belong to the trust property but will not be Shanghai AJ's own property; Shanghai AJ will merely hold the equity interest in the Tunnel Co. in the capacity of the trustee for the beneficiaries. However, in this structure the beneficiaries' risks might be significant although it is an infrastructure facility project supported by the Shanghai government. All trust funds are used in the form of equity for the project financing. In the event that the project fails, creditors (not trust beneficiaries) will have first crack at the assets of the Tunnel Co. Therefore, to control the risks accompanying the possibly ample yields, it would be better for the TICs to create trust products with diversified investments and thereby attract investors by virtue of stability, not an anticipated large return from a single project.

In contrast to the capital trust, the trust property of a non-capital trust is real property, chattel mortgages, negotiable instruments and, as stipulated in the PRC Trust Law (中华人民共和国信托法), legitimate property rights. At present non-capital trust businesses in China are not so popular as capital trusts. However, TICs will obviously encounter much less competition in non-capital trusts since the banking, securities and insurance firms have a much more limited chance to directly participate in such investments.

Current Market Situation

In 2002, we were happy to see quite a few TICs take advantage of the encouragement granted in the new regulations to launch new trust products. As discussed above, Shanghai AJ Trust and Investment Co. initiated the Shanghai Outer Ring Tunnel Project in July 2002 and Beijing International Trust and Investment Co. structured the CBD Trust & Investment Project in September 2002, both of which were open to the public and were said to be supported by the respective local governments. More recently in Dalian, Chongqing and other cities similar trust projects emerged.

Although these were the first trusts marketed in China, all were subscribed beyond what the TICs anticipated. In some cases hardly had the trust products started subscription when they were sold out. It is reported that the total funds raised in all such trust products reached Rmb3 billion in 2002. Why were these products so well received? We can highlight several reasons.

First, traditional investment channels have not been very attractive: low deposit interest rates, poorly performing stock markets, and unreasonably high real estate prices, have all led people to invest their surplus assets (especially cash) in other ways that at least appear to be more profitable. As the TICs claim, all these trust products have been seen to have fairly high return rates, even higher than government bonds that are generally deemed to be profitable.

Second, almost all of these instruments are supported by local governments to some extent, such as the infrastructure facilities mentioned above, suggesting that it seems safe to invest in them because of their government connection. A related point is that many individual investors take comfort in the thought that the government would not let these trust products fail as it is keen to promote the trust industry.

However, in accordance with the PRC Trust Law (中华人民共和国信托法), the two Procedures discussed above and the Circular, neither TICs nor local governments are permitted to guarantee the yields of trust products. Most individual investors are not aware of the hidden risks masked by the appearance of high return rates: in case the projects fail outright or do not achieve their anticipated success, investors would probably suffer large, unrecoverable losses, while if they deposit their money in banks or invest in the bond market they can obtain stable returns, and if they invest in the stock markets they can at least wait out tough times in hopes of a bull market.

As such, we think that the trust craze has resulted from external factors and the fickle psychology of investors, and not from the high quality of the trusts themselves. Many of the existing trust projects are in the form of equity participation, which generally have more risks than common investment means, such as providing loans or purchasing national bonds. Most investors, especially individuals, do not clearly know the ramifications of a failed project but they will learn quickly. Once they cannot obtain the anticipated yields nor even their principal investment, there will likely be widespread disillusionment with the trust industry. This could lead to a premature end for the industry as a whole.

The Competition

In addition to the above hazards, the trust industry faces competitive pressure from other traditional financial sectors. Due to a generally tough investment environment, the banking and finance sectors are trying to launch their own innovative products. The most significant event in 2002 that adversely impacted the trust industry was the launch of the Multi-Parties Entrustment Loan (MPEL) by the Shenzhen Development Bank. Commercial banks can carry out the intermediary business of entrustment loans, in which the principals of entrustment loans shall solely bear the risks as well as provide the loan amount. However, in a general sense there is only one principal for an entrustment transaction while there are at least two principals for one MPEL. Actually, an MPEL's operation method is very similar to that of capital trust projects: more than one individual or entity subscribes certain loan proportions and then the bank disburses such sums to the intended enterprise and charges certain fees, with all the risks borne by the principals. The basic shortcoming of an MPEL is that the funds gathered may only be utilized in the form of lending without any alternatives, while the utilization methods of the capital trust may be mutually agreed by the parties to the trust contracts. However, such a weakness seems trivial compared to its advantages, which we can summarize as follows.

First, in the MPEL there is no such restriction that no more than 200 contracts may be entered into with at least Rmb50,000 in each. Second, commercial banks have numerous branches, sub-branches and associated offices, which greatly facilitates promotion of their products. Third, the interest rate for an MPEL can be known beforehand (stipulated in the entrustment loan agreements), while the benefit rate of a trust can only be estimated but not guaranteed. Fourth, advertising is a legal method for the marketing of an MPEL. Last but not least, generally commercial banks have a better reputation than TICs; people continue to be wary of the trust industry, especially because of past scandals.

Obviously, all of these factors make it tough for TICs to fend off the competition from commercial banks. Now that Shenzhen Development Bank, a relatively small commercial bank, has undertaken an MPEL, it is foreseeable that other stronger and larger commercial banks will offer such projects soon.

Conclusion

We are only at the beginning of China's development of an international standard trust business. To promote the industry, TICs should take advantage of the fairly wide business scope they can work in, seek profitable domains untouched by other financial sectors, and endeavour to invent more new trust products with controllable risks.

Endnote

1 Unless otherwise specified, all references to "trust" below indicate a business trust.

2 For more details on this project, see page 87 of this issue.

By David Weizhong Wang, Jin Mao Law Firm