By Hao Wang.
With the advent of the new century, China has further accelerated its pace of economic growth. In this tide, there have emerged a growing number of eminent persons and countless family enterprises. In the second decade of the new century, a staggering amount of family wealth has been accumulated in China, bringing about some new questions, such as how to pass on wealth effectively and how to ensure smooth transition of a family enterprise from one generation to the next generation.
During the process of exploring answers to these questions, the trust – an ancient system in Western countries – has begun to take root, sprout and grow in China. As time goes on, it has attracted more and more attention. However, as a new thing in China, trusts also face a variety of problems in practice. Due to their unreasonable designs, some trusts have been challenged by their beneficiaries through legal means. How then should trusts be used to escort family wealth and be used as a powerful tool for wealth inheritance and wealth management? This paper will briefly describe the impact of trusts on family wealth.
I. Main Challenges Facing Trusts in Judicial Practice:
(I) The Trustor’s Lack of Capacity
When many trusts are established, their trustors are already in their declining years, accompanied by physiological and psychological cognitive disorders. In accordance with the provisions of trust laws in most jurisdictions, if a trustor is unsound in mind at the time of signing a trust instrument, the beneficiary may bring an action based on this fact and request that the trust be declared invalid. In judicial practice, the capacities of a trustor are measured based on the standards of “contractual capacities”, which mainly include:
1) Whether the trustor can understand the rights and obligations involved in his or her decisions;
2) Whether the trustor can understand the consequences of his or her decisions to himself or herself and others;
3) Whether the trustor can understand the risks and profits inherent in his or her decisions, together with alternative solutions.
The standards of “contractual capacities” are in stark contrast to the standards of “testamentary capacities” employed to measure the capacities of a person making a testament. The standards of “testamentary capacities” are employed mainly to measure whether a person making a testament can understand the concept of testament, whether he or she is aware of the scope of the property he or she owns, and whether he or she can understand the relationship between himself or herself and his or her heir(s). Because the establishment of a trust is more complex than that of a testament, the standards employed to measure the capacities of the actor are different.
(II) Exertion of Undue Influence by Utilizing the Mental or Physical Defects of the Trustor
Undue influence refers to a circumstance in which a trustor is forced by a third party, including his or her family members or friends, to sign a trust instrument and dispose of his or her trust property against his or her own will. Common means of duress include threats, refusal to provide medication, as well as separation of a trustor from his or her family by force.
In judicial practice, when determining whether a party has exerted any undue influence on a trustor, the court will mainly consider the following factors:
1) the opportunity to exert influence;
2) whether the party exerting influence has an intimate relationship with the trustor;
3) whether the party exerting influence has participated actively in the establishment of the trust and transfer of property;
4) whether the property has been disposed of abnormally.
(III) Fraud
Fraud or misrepresentation can also be one reason based on which a beneficiary challenges a trust. Generally speaking, fraud means that a trustor is misled by the intentional misrepresentation of a third party to make changes to a trust.
In judicial practice, fraud falls mainly into inducement fraud and implementation fraud:
1) Inducement fraud means that a third party makes an intentional misrepresentation of specific terms, which do not involve a trust document, to a trustor, but the presentation exerts a material influence on the trustor when he or she selects to establish or change a trust.
2) Implementation fraud means that a third party tricks a trustor into signing other documents in the name of signing a trust document, so as to make the third party a beneficiary, etc.
(IV) Failure to Witness or Sign in Accordance with the Relevant Procedures
If a trustor is not witnessed by witnesses reaching a quorum at the time of signing a trust instrument, or if any witness signature is identified as a counterfeit, the beneficiary of the trust is entitled to bring an action against the trust based on this fact.
(V) Vague Language
Dispute between beneficiaries over the contents of a trust document may also lead to an action challenging a trust. Typically, the beneficiary will submit an application to the court for a judicial interpretation of the ambiguous contents of the trust document. If the court rules that the content of the trust document does not have any ambiguity, the trust document may be implemented as it is. By contrast, if the court rules that the content of the trust document indeed has some ambiguity, the original intention of the ambiguous content in the trust document shall be determined in combination with external evidence, such as related statements of the trustor before his or her death. Once the court presents a judicial interpretation, the trust assets will be distributed and executed thereby.
II. Impact of Challenges on Family Wealth:
(I) Affecting the Flexibility of Distribution and Transfer of Family Wealth
A reasonably designed trust can plan distribution and transfer of family wealth effectively. In the trust document, the trustor may plan in detail the way to distribute family wealth among one or more beneficiaries. Thus, through the trust document, the trustor may distribute family wealth to a beneficiary, who cannot manage his or her wealth effectively or make a reasonable plan for or decision on wealth, multiple times and in small amounts, rather than distributing the family wealth to the beneficiary in a lump sum, so as to effectively avoid the risk of overspending, to ensure the basic financial needs of the beneficiary and to achieve the purpose of the trust. If a trust is challenged, these arrangements will not be able to play their due role and the flexibility of distribution and transfer of family wealth will be affected.
(II) Paying Inheritance Tax and Reducing the Total Amount of Family Wealth
There are provisions on inheritance tax in many jurisdictions around the world. In essence, inheritance tax is established with regard to the right to transfer the property of a person after his or her death. For a huge amount of family wealth, once the owner of the wealth dies, the amount of inheritance tax arising thereafter cannot be underestimated. Trusts are one of the few legitimate tools to avoid inheritance tax. If a trust is challenged, the inheritance tax on the property transferred by the trustor to the trust structure cannot be relieved, resulting in unnecessary loss of family property and decrease in the total amount of family wealth.
(III) Losing Control over Some Property Which Is Difficult to Split and Increasing Property Distributing Costs
Whether family wealth is to be inherited through a testament or through the establishment of a trust, money, stocks etc. are property which are relatively easy to split, while real estate and boats are property which are difficult to split. A reasonably designed trust can set forth the way to transfer real estate property, who is entitled to use and own real estate property, the conditions for selling real estate property and the way to distribute the earnings. Once a trust is challenged, the beneficial interests of the beneficiaries in the property that is difficult to split will be challenged, which may lead to a dispute between the beneficiaries and increase the costs of wealth transfer.
(IV) Causing Conflicts within the Family
A reasonably designed trust can prevent struggles among the beneficiaries for property rights to the greatest extent, which is attributable to the feature of high “customization” of trusts, a tool for the transfer of property. Based on the detailed provisions in a trust document, the trustor may determine the type and amount of the property to be passed on to a beneficiary and define ownership of the property, which is helpful to the split and transfer of any property that may cause a dispute (for example, property with an emotional attribute). If a trust is challenged, its advantage over testament-based inheritance in terms of transfer of wealth cannot be brought into play. With regard to a large-scale family, the feature of “customization” cannot be taken advantage of, which gives rise to conflicts within the family.
(V) Increasing Wealth Transferring Costs and Exacerbating Loss of Wealth during the Transitional Period
As a legal tool for wealth transfer, trusts have attracted more and more attention from family enterprises in recent years and have begun to be applied at an increasing rate. Currently, many family enterprises in China are at an important moment of intergenerational transfer. For these young family enterprises, the transfer will be a big test. According to a study on several cases of transferring family enterprises in Asian countries and regions, including China, all the family enterprises concerned suffered significant losses of wealth in the process of intergenerational transfer.
Within eight years before and after transfer, the Cumulative Average Abnormal Return of corporate stocks is -60%. In other words, during the intergenerational transfer of family enterprises in Asia, significant wealth will dissipate. Taking society as a whole, the dissipation of wealth is not only a loss to enterprises, but also a loss to society. With more and more intergenerational transfers in the current society in China, challenges (if any) to trusts will intensify the risks of transfer of these family enterprises and may increase the losses. As a result, enterprises of value to society will not be able to operate and the new generation will have to start from the beginning, as the older generation did.
III. Trying to Solve the Problem Based on the Term “No Dispute”
In order to ensure the stability of a trust after it is established and to protect the intention of the trustor from being violated, the term “no dispute” is used as a tool in many jurisdictions. The original purpose of designing the term “no dispute” was to prevent a person who cannot enjoy trust interests from filing a lawsuit before the court simply due to dissatisfaction, from challenging the validity of the trust, from doing damage to the stability of the trust, from wasting judicial resources and from hindering the implementation of the trust.
If a trustor intends to use this tool, he or she should introduce the term “no dispute” into the trust document clearly. Generally, the term “no dispute” includes the following content: “if any of the beneficiaries of the trust files a lawsuit in court and requests that the whole or any part of the Trust Agreement be declared invalid, the beneficial interest of such beneficiary under the Trust Agreement shall be forfeited.”
However, if the term “no dispute” is applied inflexibly, there will be obvious disadvantages. Designing trusts for bulky or large-scale family enterprises will certainly be very complex because many complex issues will be involved. If the right of a beneficiary to file a dispute is completely forfeited, the beneficiary may have no authority to appeal to when his or her interests are genuinely damaged. The term “no dispute” is restricted to a certain degree in several jurisdictions where it is recognized precisely because the foregoing problem has been realized. Within the above-mentioned jurisdictions, a beneficiary may file a lawsuit to challenge a trust, but only when the lawsuit has a “reasonable basis”. With this kind of restriction, unnecessary “frivolous lawsuits” can be prevented and the right of a beneficiary to file a lawsuit to challenge a trust when his or her beneficial interests are indeed damaged can be protected.
How to give full play to trusts, an emerging field in China’s practice of law and wealth management, will be the subject of thought and studies of practitioners and scholars in the long run. While protecting the transfer of family property, it is also important to ensure the beneficial interests of the beneficiary. Whether this principle can be implemented successfully is crucial to whether trusts, an imported system, can survive the transfer of family wealth in China.
