ABOUT THE AUTHOR: Richard Grasby TEP is an
Associate in Maples and Calder’s Hong Kong office
An initial public offering (IPO) transaction was traditionally
reserved for the corporate finance department of a law firm. Armies
of lawyers would conduct due diligence in a data room, draft huge
prospectuses for the market and carry out all-night negotiations
with other parties to the transaction. The remainder of the law
firm would leave them to get on with it. Not any more. The trust
lawyer is now an integral part of any IPO transaction, with a vital
role to play, whether acting for the founder of a business to be
listed, for pre-IPO investors looking for a profitable exit via a
listing, or for the business itself.
Hong Kong has been the leading IPO market for the past three
years and, while 2012 has begun
slowly, there are IPOs with an anticipated value of more than USD15
billion planned for the Asian markets. However, as the
first wave of IPOs by People’s Republic of China (PRC) state-owned
companies has come to an end, attention has turned to potentially
more risky Chinese private enterprises. This has not been
lost on the Hong Kong regulator, which has indicated that changes
may be implemented to make sponsors and others more
accountable. The Hong Kong Securities
and Futures Commission (SFC) has recently levied a record fine on a
sponsor that failed to carry out proper due diligence.
As will be shown below, the current climate relating to
regulation and good practice only serves to emphasise the
advantages of a trust structure.
Why use a trust?
A typical IPO, certainly in Asia, will, in basic terms, involve
an individual (founder) holding, directly or indirectly, the
majority of the shares in an offshore company (Listco).
The other main shareholder will generally be a ‘seed investor’ –
probably a private equity fund – that has provided a certain amount
of capital to grow Listco and make it attractive to be listed. The
sale of a portion of Listco to the public will result in a large
gain both for the founder and for the seed investor. So how does
the addition of a trust add to the structure?
The first observation to make is that individuals, being human
beings, are not well-suited to owning assets because of what may
happen to them. For example, they may die, lose capacity, be
affected by human relationships and emotions or be the victim of
blackmail or kidnapping. Where an individual holds most of the
shares in Listco, the consequences of any of these events can be
severe, ranging from chaos and uncertainty to complete paralysis of
Listco.
Such possibilities are often overlooked, and, as the timeline
for an IPO can be many years from conception to final listing,
there is a significant period during which the IPO is at risk. For
example, despite popular misconception, on the death of the
founder, the founder’s shares in Listco (assuming for these
purposes its share register is kept in the Cayman Islands) will not
pass automatically to the deceased’s surviving spouse or to the
founder’s eldest son or to whomever’s name is inserted into the
blank signed stock transfer form left in a drawer to be dated the
day before death. Only those with the authority of the Cayman
Islands court can instruct the directors of Listco in respect of
the shares – such as where to transfer them or how to exercise
votes attaching to them. Until such a time, the
shares (i.e. the controlling interest in Listco) are paralysed.
Administration in the Cayman Islands can easily take six
or nine months (longer if contentious) – a critical time in the
lead-up to an IPO.
In addition, following such a court process, it is likely that,
as part of the administration of the founder’s assets, the
shareholding will be broken up and placed in the hands of more than
one person – none of whom will have control. If these persons are
family members, there may be family infighting, which can only
damage Listco further.
Incapacity of the founder may result in even greater
uncertainty, as there may be heated debate about whether the
founder lost capacity and when. Or, in certain cases, the loss of
capacity may only be temporary and the founder will recover. What
happens during this time? Again, until the court has stepped in,
there will be uncertainty and paralysis relating to the shares in
Listco.
Risk management
These problems can be reduced considerably if, as part of the
pre-IPO structuring, the controlling block of shares is transferred
into the ownership of a corporate trustee
(preferably located in the Cayman Islands, being the same
jurisdiction as the place of incorporation of Listco, and regulated
as a trust company for the reasons set out below). This trustee
will be the shareholder of record of Listco and cannot die, lose
capacity, get divorced or fall out with its family members. With
proper management of the trust assets in place, this will remove
the possibility of the controlling shareholding in Listco becoming
paralysed or being broken up. This is the top priority for the seed
investor and is, in all probability, likely to result in greater
wealth being generated for the founder’s family. A derailed
transaction is also most likely to be bad news for the professional
advisors (auditors, sponsors, lawyers, etc) looking to recover
their fees.
Having the controlling shareholding in Listco owned by a
regulated, corporate trustee also provides an additional layer of
security to the transaction. As a trustee is personally liable, the
corporate trustee will ensure the IPO is done properly without any
corners being cut. The trustee will typically be a subsidiary of a
large financial institution and will instruct its own lawyers to
carry out its own due diligence. It will only give
representations and warranties about matters that it knows are true
or which it knows it can perform. This can only provide additional
comfort to the seed investor, the relevant regulator, the investing
public and other advisors.
Ownership and control
But how does this deal with the control of Listco? Day-to-day
control will be in the hands of its board of directors but a
controlling shareholder may have a significant role to play. The
trustee will not wish to have ultimate control (and therefore
responsibility). Likewise neither the founder nor the seed investor
will want the trustee to have control and a large
corporate trustee being in control is unlikely to be attractive to
the investing public. Those who have got the business suitable to
be listed need to remain front and centre. The solution lies in the
ability of a trust structure to separate legal ownership of the
trust property (Listco shares) from control of the trust property
and from economic enjoyment by the beneficiaries of the
trust.
‘A corporate trustee can remove the possibility of the
controlling shareholding becoming paralysed’
The premier trust structure for a trust of this type is one
where investment and management of the trust assets (i.e. the
controlling block of Listco shares) is reserved to a management
committee. The trustee will have no choice but to follow the
direction of the committee relating to the Listco shares – in
particular how and when to exercise any votes attaching to them.
The committee will invariably include the founder,
but the provisions relating to the committee must be structured to
ensure that there are always members of the committee able to act,
even in the event of the death, incapacity or retirement of the
founder. Such committee members
should be familiar with the business of Listco and could include
adult children of the founder, trusted advisors or senior
management of Listco. Ownership by the trustee ensures that the
shareholder of record does not change; the committee
ensures that the business is run by those most suited to run
it.
This reservation of investment management would be founded
primarily on the ‘reserved powers’ legislation of the Cayman
Islands, whereby powers can be granted to persons other than the
trustee without calling into question the validity of the trust. To
further tighten this mechanism (particularly because the trustee
will only have one asset), management of the trust assets by the
committee should be made a non-charitable purpose of the trust,
under the Special Trusts (Alternative Regime) provisions of the
Cayman Islands.
Incentivising employees
Finally, there is another beneficial use of trusts in the
context of an IPO. This relates not to the holding of the founder’s
shares, but to the use of a trust as a means of
retaining and incentivising employees. The last thing that the
founder and the seed investor want in the period up to and
following an IPO is for senior management to leave. A small portion
of Listco can be placed into a trust for employees and,
at the relevant time, the shares, share options or sale
proceeds distributed to those
employees who have remained loyal and worked hard. This should be
regarded as an investment by the founder or the seed investor,
which should easily pay for itself in due course.
Therefore, in addition to the typical advantages of a trust
dealing with an individual’s personal affairs, the use of a trust
has benefits to persons who are not beneficiaries – primarily the
seed investor.