Risk allocation in Hong Kong trust arrangements
An adverse ruling from Hong Kong’s High Court against a corporate trustee and nominee director means that, depending on the settings of trust services offered by a financial institution, it may need to consider reviewing risk management of trust arrangements: Zhang Hong Li & anr v DBS (Hong Kong) Ltd & ors, HCCL 2/2011, Hong Kong High Court.
A private trust was set up for a wealthy family’s benefit, with the husband and wife as settlors. The trust was incorporated by a BVI corporate services entity. Trust property consisted of shares in a BVI investment company (Wise Lords Ltd) with a BVI nominee director. This director was a BVI management company held by a Jersey corporate trustee with Jersey-based directors responsible for making management decisions for the trustee. The BVI corporate services entity and the BVI management company were both subsidiaries of the bank.
A management agreement between the Jersey corporate trustee, two other Jersey entities and the bank was governed by Jersey law. A services agreement, governed by Hong Kong law, between the Hong Kong-based corporate services entity, the trust’s investment company and the Jersey corporate trustee, provided for company administration and nominee services to the trust’s underlying BVI investment company, Wise Lords Ltd. Following the trust’s set-up, Wise Lords Ltd opened a private banking account with the bank in Hong Kong. The trust deed was governed by Jersey law.
Family trust suffers losses
Between 2005 and 2008, the settlor’s wife, Ji, an “astute and experienced investor”, having been appointed as the trust’s investment adviser, executed over 500 investment transactions through the trust’s account. Ji invested heavily in foreign currencies, particularly AUD and EUR, currency-linked notes and currency decumulators, with increasing leverage. Despite repeated warnings from the bank’s relationship manager, Ji remained bullish and resisted unloading long positions at anything less than break-even point. The trust’s overdraft facility was gradually increased from USD10m to USD100m and the portfolio grew substantially in a short time against leverage. Then the 2008 global financial crisis hit. The trust sued for recovery of investment losses.
Claims for breach of trust and fiduciary duty
The claims were not based on “mis-selling” of investment products but primarily on alleged breach of trust by the Jersey corporate trustee and breach of fiduciary duties by the BVI corporate services entity and the BVI corporate management company. The settlors also claimed that those breaches were committed with the bank’s and its employees’ dishonest assistance.
Trustee’s and nominee director’s duties under the trust deed
The trust deed stated that the trust was allowed to engage in speculative investments and that the corporate trustee was under no duty to diversify investments or ensure that the value of the trust was preserved or enhanced in any way. However, the court, construing the trust terms and Jersey law (which the court felt able to interpret because there was no evidence adduced that the law in Jersey governing agents was different from Hong Kong law), ruled that the trustee owed duties to the trust to take a high level and overarching supervisory role in respect of the trust assets, to conduct regular monitoring, and to ensure that the trust’s value was subject to appropriate controls, reviews, investment, expertise and management. Significantly, the settlor wife’s power to make investments was subject to the trustee’s and the nominee director’s powers to override or reverse her decisions or transactions she conducted for the trust’s investment vehicle. However, neither the trustee nor nominee director ever queried, or exercised its power to counter, any investment made by the settlor wife. In practice, approvals to transactions and credit facilities were sought from and given by the trustee and nominee director after transactions were conducted.
Breaches of duty by corporate trustee and nominee director
The court ruled that the Jersey corporate trustee had failed to discharge its supervisory duty owed to the trust, and the corporate nominee director failed to discharge its fiduciary duty owed to the investment company, in approving, after the event, (i) many of the AUD currency purchases made by the settlor wife in July and August 2008; (ii) the increased credit facility obtained; and (iii) the investment in three decumulators, which exacerbated the currency risks in the trust’s portfolio, by the investment company. The trustee was held liable for breach of trust and the nominee director held liable for breach of directors’ duties. Equitable compensation for the trust’s losses was ordered (the amount is to be determined at a future hearing).
Bank’s duties not breached
All claims against the bank and those of its employees involved were dismissed. The court ruled that the bank did not assume either contractual or common law duties of care to advise or ensure suitability of investments to the settlors or the trust. The relationship between the investment vehicle and the bank was not advisory in nature, but was transaction-execution only. There was no banker-customer contract between the bank and the settlors. Instead, the only banker to-customer relationship was one between the investment company and the bank.
Practical consequences: heightened risk management
In view of the adverse findings of Hong Kong’s High Court against the corporate trustee and nominee director in this decision, and depending on the settings of trust services offered by financial institutions, financial institutions might consider reviewing their risk management of trust arrangements and revisiting the following:
the classification of their advisory and execution-only services for settlor investment advisers to head off doubt as far as possible;
procedures for approval and rejection of investments;
procedures for portfolio reviews;
suitability criteria for appointing investment advisers; and
importantly, contractual provisions for risk allocation between trustees (and other service entities) and settlors (in their capacity as investment advisers).
This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch – firstname.lastname@example.org, or tel +44 20 3088 3710.