China: Risk Management for China's Real Estate Pooled Investment Funds (Part I of II)

Last Updated: 18 January 2012
Article by You Yang and Lin Kaiyi King

A real estate pooled investment fund ("RE Pooled Fund") is where trust companies raise funds from investors (who act as both "settlors" and "beneficiaries" in the trust) and work with real estate developers to provide beneficiaries with profits in return. RE Pooled Funds generate returns through specific assets, equity investments, loans, or a hybrid thereof.

With housing purchase restrictions being implemented in China's major cities, real estate developers working with trust companies are facing serious cash flow pressure and some of them have even experienced operating difficulties. When real estate developers are unable to provide trust companies with high investment returns on schedule, and investors continue to hold expectations of high returns regardless of investment risk, trust companies are inclined to pay investors at their own expense and solve investment return problems with real estate developers internally rather than disclose investment risk to the investors. This is partly because trust companies value their reputation and the reputation of their investment products and want to avoid upsetting trustees and commercial banks who engage in selling the trust company's products. Trust companies may also be concerned about the potential for class-action lawsuits by investors. However, such trust companies may one day be unable or unwilling to pay investors out of their own pockets, or investors may no longer be satisfied with being paid investment returns, leading to a very unsustainable situation.

I. Risk Control for Real Estate Trust Products

A. Common Risk for Real Estate Trust Products

a. Policy risk

Real estate trust products have to manage real estate and finance policy changes as such products are closely bound to the real estate industry. For real estate, the central government has tightened control of real estate financing, housing purchase and loan restrictions as well as increased the rate of low-income housing construction. All these policies will indirectly aggravate cash flow problems and increase compliance risks. In the financial industry, the China Banking and Regulatory Commission ("CBRC") has shown a willingness to exercise tight control and close supervision of balances of the top 20 trust companies. Until recently, CITIC Trust, Ping An Trust, ZRT Trust and 20 other trust companies have called off real estate trusts. A People's Bank of China news release reported that the Industrial and Commercial Bank of China and the China Construction Bank have issued circulars to suspend real estate trust business while the Agricultural Bank of China and the Bank of China have halted real estate trusts in practice.

Therefore, policy-oriented effects are a strong distinguishing factor for real estate trusts as any policy changes will affect creation, implementation and termination of real estate trusts.

b. Implementation risks

i. Risks for real estate project

In real estate development and construction, there are potential risks caused by policy changes or circumstance changes in the whole process of land use right acquisition, project examination and approval, construction, acceptance of a completed project, sales and so on. Possible loopholes are listed below: (1) Developers cannot get relevant licenses as planned; (2) Construction is delayed for geological reasons leading to high project cost; (3) Final acceptance delayed for construction contract disputes or construction quality problems; and (4) Sales unsatisfactory due to inaccurate project positioning.

Admittedly, real estate development is a comprehensive industry, and can be both a commercial activity and a practical science. It is difficult to anticipate when and where potential risks will appear, thus trustees and trust companies had better know in-depth understanding about the real estate industry and the specific project.

ii. Liquidity risk

Assets held by China's real estate developer are mainly land, real estate and other long-term investments. Such asset structures could easily result in cash flow issues and liquidity risks, which may lead to fundamental breaches due to delayed payment of investment returns.

There are two options left for trust companies, they could continue funding the project (at their own expenses or setting up new trust product), or quit the trust project (disposing property and withdrawing capital). Either option will lead to risks and challenges.

iii. Increasing cost or diverting funds

Increasing cost and diverting funds are common ways to breach the contract as project profits are the main source for investment returns. Trust companies are seeking control risk by ways of setting up supervision accounts, transferring funds according to project schedules, assigning superior executives and accountants, controlling official seals, and so on.

However, trust companies are not professional real estate institutions, and employees are unlikely to have sufficient real estate knowledge and sensitivity. Therefore, it is difficult for trust companies to identify fictional cash flows or false contracts for the sake of increasing costs and diverting funds. Even worse, capital supervision may get out of control due to the neglect of administrators' duties and inadequate supervision procedures.

c. Unusual trust plan termination

Trust plans terminate in an unusual way due to the early termination clause stipulated in a trust contract. Trust companies will announce the termination, withdraw capital and distribute to beneficiaries. Potential risks are hidden in this process:

i. Related provisions are not specifically stipulated in the contract

Trust contracts and trust product introductions may not specify or enforce over key provisions. Trust companies have to specify provisions with respect to actual situations and negotiate with real estate developers, ensuring that the trust contract is enforceable and dispute resolution is the ultimate legal remedy.

ii. Legitimacy review

Upon undergoing dispute resolution, legitimacy review for trust plan is the foremost procedure (though many parties, judges and arbitrators are unaware of this). If the trust plan is declared to be invalid, the trust companies not only cannot get profits from the trust plan, but also should bear contracting negligence responsibility.

iii. Evidence

Upon undergoing dispute resolution, trust companies and real estate developers will inevitably commit to a burden of proof in order to distinguish responsibilities. If the trust companies fail to present contracts, financial vouchers, correspondence and related documents, it will lead to a disadvantage position or cause allegations of negligence of duty against the trust companies.

iv. Loopholes in legal system

China's laws and regulations are in the process of continuous improvement and there are disputes in practice that trust companies are confused with in dealing with trust property. For example, enforcement notarization for payment agreement/guarantee agreement is stipulated in most trust plans to avoid litigation and arbitration. However, there is no specific provision for enforcement of notarizations in China's legal system, so courts may dismiss enforcement in judicial practice.

v. Long dispute resolution period

Many factors affect dispute resolution efficiency: hard or easy cases, the parties' influence, the dispute resolution institution's efficiency, attention by the authorities, market factors and so on. A relatively long dispute resolution period may result in deflated assets or impossible investment returns due to changing market or policy risks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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