Fiduciary Ownership

Fiduciary Ownership: Does China's Trust Law Bring It Home?

Richard GUO

The long-awaited Law of the People's Republic of China on Trusts (hereinafter "Trust Law") finally came into force on October 1, 2001, having been passed by the National People's Congress Standing Committee five months earlier. The Trust Law applies to the conduct of civil, business or public interest trust activities in China by settlors, trustees and beneficiaries.

Who Shall Be the Owner of a Chinese Trust?

Article 2 of the Trust law provides that a trust is "an act whereby a settlor, based on his trust in a trustee, entrusts the property rights in his property to the trustee who shall, in turn, manage or dispose of the trust property in the trustee's own name, in accordance with the wishes of the settlor, and for the benefit of a designated beneficiary or for a specified purpose."

In comparison, the Taiwan Trust Law defines a trust as a (fiduciary) relationship in which a settlor transfers his property rights to a trustee, and the trustee manages or disposes of the trust property, in accordance with the purpose of the trust, for the benefit of a beneficiary or for a specified purpose. (Article 1, Taiwan Trust Law)

In a trust, be it a legal act or legal relationship, a piece of "new" property named "trust property" (or "trust res") is created as a matter of law. (Article 14, Trust Law) Shall the trustee, the settlor, or both be the owner of this trust property?

The Anglo-American system of law answers this question by the notion of "fiduciary ownership," a peculiar judicial institution in which the trustee becomes legal owner, and the settlor/ beneficiary remains as an owner on equity. To the contrary, the Chinese legal system, rooted in civil law tradition, inherits Roman law rule dictating "one thing one owner." Does China's Trust Law change the landscape and bring in the same kind of fiduciary ownership commonly found in the common law system? The answer is not clear.

On the one hand, the Trust Law doesn't categorize a trustee as "owner" of the trust property. The trustee only has the right to "manage or dispose of" the trust property and only in accordance with the wishes of the settlor, while in orthodox Chinese law, "ownership" ("suo you quan") is widely assumed to be a bundle of legal rights of an owner to take possession of, use, benefit from, and dispose of his property at will.

On the other hand, it seems clear from provisions that, although property rights are "entrusted" rather than "transferred" to a trustee, the trustee essentially emerges as a legal owner or someone who is authorized to exercise fractional ownership rights, especially the disposal right, the most ostensible and tangible right of an owner.

First, under Article 14, trust property is the property "acquired" by a trustee because of his commitment to engage in such trust relationship. The term "acquire" seems to connote at least fractional ownership rights. Second, a trustee is to manage the trust res "in his own name," in contrast to an agent who can only act on behalf of his principal. Third, although a trustee's power to dispose of the trust property is subject to the wishes of the settlor, a disposal against the settlor's wishes still governs unless/ until the judiciary revokes it upon the petition of the settlor/beneficiary.

The rescission necessarily recognizes the effectiveness of the disposal in the first place notwithstanding the violation of the settlor's will and its judicial invalidation later on. Thus, the "wishes of the settlor" are purely contractual and rather ex ante; the settlor cannot prevent or interfere in every single disposal, as necessitated by orthodox trust structure. Finally, to ensure the validity of transactions, a bona fide third party transferee in an "unauthorized" transaction is legally protected so long as he had no knowledge at the time of the transaction with the trustee that it violated the purpose of the trust.

However, to say a trustee enjoys at least fractional ownership rights is not to deny the settlor or beneficiary's interest in the trust property. For instance, at least the right to benefit is expressly reserved for the beneficiary. The trustee cannot personally gain from the trust property except for normal remuneration (Article 26) because the personal interest should taint the trustee's "duty of undivided loyalty."

Moreover, by virtue of a trustee's duty to segregate trust property, it will not constitute part of the trustee's individual assets that could be used to satisfy his own civil liabilities (Article 37) including those related to his status as a trustee.

It is unclear whether a trust can give a trustee beneficial interest beyond normal income. As once proclaimed by Professor William Allen, the legal institution of the trust is the most innovative of legal devices that Anglo-American law has created and can be designed with great flexibility and utility. In terms of format, trusts have evolved from the classic ones limited in care-taking and capital preservation functions to modern ones characteristic of risk-taking, capital appreciation and income generation.

Considering the lukewarm performance of the American public trustees in the corporate bond market and numerous reform proposals regarding the trustee pay structures, it seems necessary to give Chinese trustees sufficient incentive to exercise their investment power. In light of this, Article 35, by allowing parties to adjust a trustee's remuneration by agreement, can be interpreted as having given parties discretion to design individually different trustee compensation plans.

Fiduciary Duties

Besides the property feature (fragmentation of ownerships between the trustee holding legal title and the settlor or beneficiary reserving equity title, or division of ownership rights among the parties with the trustee holding rights to take possession and to make disposal and the beneficiary keeping beneficial rights), a trust has a contract feature (the rights and obligations of the parties are negotiated at arm's length), combined with open-ended "catch-all" fiduciary duties to fill the gaps in the contract.

According to Article 25, a trustee shall manage the trust property for the beneficiary's best interest and shall fulfill the duties of honesty, trust, prudence and effectiveness. The trustee is strictly prohibited from commingling trust property with his own property (Articles 27 and 29), and is strictly prohibited from self-dealing (Article 26).

Only by the settlor or beneficiary's approval can the trustee enter into a transaction in which he is dealing with the trust in his individual capacity and the transaction must reflect the fair market price (Article 28). Therefore, a trust is functionally a fiduciary relationship in which a settler entrusts a piece of trust property to a trustee who shall then act as a fiduciary in the management of the trust res.

How to make sure the fiduciary fulfill his duties? Among others, the trustee is required to make periodic accountings (Article 33) and the settlor has a right to information (Article 20). More importantly, a settlor or beneficiary reserves the right to alter the provisions of the trust and the power to revoke the trust in limited circumstances, and thus the ultimate control over the trust estate (Articles 21 and 49).

It hence gives the creator of the trust the ability to control the trustee's activity in managing the trust while providing the trustee with the necessary autonomy. However, the most critical feature of the Trust Law is that it provides settlors and beneficiaries the long deserved right to bring fiduciary lawsuits in cases whereby trustees have breached their fiduciaries duties (Articles 22-23, and 49).

Both the settlor and beneficiary are given legal remedies in cases where the trustee has made a disposal in violation of trust intentions (Article 22), has violated trust duty or has failed to act prudently and thus caused injury to trust property (Article 22), or has engaged in gross negligence (Article 23). Where a prohibited transaction has taken place, the settlor or beneficiary has an option to either ratify the transaction, even though the trustee had acted improperly, or hold the trustee personally liable in a surcharge action.

It is noticeable that the Article 22 actions have a one-year statute of limitation, i.e., the substantive right to challenge an inappropriate disposal expires one year after the plaintiff knows or shall have known about the cause of action. This provides further support for the conclusion that the trustee is at least a de facto owner who can make necessary disposals of the trust property at his discretion.

To incentivize and not unnecessarily exclude potential trustees, fiduciary lawsuits shall not overreach. It is thus critical to have a legal buffer, such as the American "business judgment rule." The idea that settlors or beneficiaries have the right to discharge trustees only in events of "gross negligence" seems to endorse the trustees' discretion within the sphere of good faith and absent of conflict of interest. However, Article 22 still leaves open the possibilities of frivolous lawsuits, especially in cases where the trustee technically violates trust intentions, even if no injury or loss occurs.

Fiduciary duties have been a foreign concept in Chinese legal tradition. Chinese judges are not experts by training in dealing with such open-ended notions as "fiduciary duties." Their loyalty goes to statutory legislations and they lack the law-making capacities enjoyed by their Anglo-American counterparts. The politically dependent judiciaries and historically weak legal enforcement may compound the difficulties in implementation of the novel concept of fiduciary duty.

In summary, the PRC Trust Law arguably ushers in a fiduciary ownership notion of trust property, but its viability in the Chinese setting is still open for debate. Given further clarity, the trust model as a credible asset management vehicle in still fledgling Chinese capital market may help to cure the "ownerless syndrome" inherent in "state share ownership" and streamline the corporate governance in Chinese listed companies which are still by and large dominated by the state shareholding.

(The author is an associate with Pillsbury Winthrop LLP, an international law firm. The article is republished from the original version "A Look At China's New Trust Law" at http://www.chinaonline.com/commentary_analysis/thiswk_comm/010813/c01081658.asp. References are available from the author upon request.)