IPOs – not just for the Corporate Advisers
This article was first published in STEP Journal in July 2012
Richard Grasby of Maples and Calder's Hong Kong office1 illustrates the increasing role of the trust lawyer in IPO transactions, particularly in Asia, and discusses how, with the increased scrutiny of IPOs likely to be imposed by the Hong Kong regulator (and potentially others), a properly structured trust can give added comfort to all involved.
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 last three years2 and, whilst 2012 has begun slowly, there are IPOs with an anticipated value of more than US$15billion planned for the Asian markets3. However, as the first wave of IPOs by PRC state-owned companies has come to an end, attention has turned to potentially more risky Chinese private enterprises4. 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.5 The Hong Kong SFC has recently levied a record fine on a sponsor which failed to carry out proper due diligence.6
As will be seen 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 terms7, involve an individual ("Founder") holding8 the majority of the shares in an offshore company (usually incorporated in the Cayman Islands9) ("Listco"). The other main shareholder will generally be a "seed investor" – most likely a private equity fund ("Seed Investor")– which 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. Therefore, you may ask, how does the addition of a trust add to the structure?
The first fundamental 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 such individual holds the majority 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 Listco10 will not pass "automatically" to the deceased's widow/widower 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 the shares or how to exercise votes attaching to the shares.11 Until such time, the shares (i.e. the controlling interest in Listco) are paralysed. The administration process in the Cayman Islands12 can easily take 6 or 9 months (longer if contentious) – a critical time period in the lead up to an IPO.
In addition, following such court process, it is highly 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 such persons are family members, there may be family infighting which can only damage the 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.
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 trustee13 (preferably located in the Cayman Islands 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 advisers (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 diligence14. It will only give representations and warranties about matters which 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 advisers.
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 control15 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.16
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 ("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 Founder17 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 Founder18. Such Committee members should be familiar with the business of Listco and could include adult children of the Founder, trusted advisers or senior management of Listco. Ownership by the trustee ensures that the shareholder of record does not change19; 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. In addition, 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 STAR20 provisions of the Cayman Islands.21
Finally, there is another beneficial use of trusts in the context of an IPO and this relates not to the holding of the Founder's shares, but to the use of a trust22 as a means of retaining and incentivising employees. The last thing that the Founder and the Seed Investor wish to see 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 trust23 for employees and, at the relevant time, the shares, share options or sale proceeds24 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 it can be seen that 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.
1Maples and Calder advises on the laws of the Cayman Islands, British Virgin Islands and Ireland.
2The Financial Times 28/12/11: "China outshines US as top IPO venue".
3Thomson Reuters; as quoted in The Financial Times 16/4/12 "Key backers for $1.8bn Haitong IPO announced."
4The Financial Times 23/10/11: "Hong Kong looks to private IPOs from China".
5South China Morning Post 6/4/12: "IPO investors need better protection". Also South China Morning Post 20/4/12: "Bankers could be jailed over dodgy listings."
6South China Morning Post 25/4/12: "Crackdown on due diligence overdue".
7This is only an example for illustrative purposes only. There will frequently be multiple founders.
8Directly or indirectly (e.g. through one or more holding companies).
9Other companies are used and can equally be held in the trust structure described.
10Assuming Listco is a Cayman company and its share register is kept in the Cayman Islands.
11See IFLR 2/5/12: :"Lifetime trusts in the Cayman Islands" – R Grasby and J Appleyard.
12The issues are very similar in most common law territories, including, for example, the British Virgin Islands.
13An individual trustee is not suitable.
14Including site visits to underlying businesses of Listco e.g. in the PRC.
15In fact, this is likely to be essential for the Founder especially if not familiar with the concept of a trust.
16The dispositive provisions of any trust are not discussed in this article.
17Subject to local tax and regulatory advice.
18Or, indeed, any other members of the Committee.
19The trust should therefore be irrevocable where possible.
20Special Trusts (Alternative Regime). A detailed analysis is outside the scope of this article.
21The author acknowledges that other jurisdictions have similar "reserved powers" legislation but do not have STAR; thereby making a Cayman Islands trust under STAR the optimum structure.
22A different trust from the trust for the Founder.
23By Listco, the Founder or by the Seed Investor.
24Such trusts can take many forms, a detailed discussion of which is outside of the scope of this article.