Does Excessive Reserved Power by the Settlor Invalidate a Hong Kong Trust?

The question of whether a settlor can retain excessive control over trust assets without destroying the trust’s validity has moved from academic debate to urgent practice in 2025, driven by two converging forces. First, the Hong Kong Court of Final Appeal’s 2024 ruling in Re Trust of LKM (FACV 12/2023) clarified the boundary between legitimate reserved powers and de facto ownership, creating a new benchmark for local practitioners. Second, the steady inflow of mainland Chinese families establishing Hong Kong trusts—estimated at over 1,200 new structures in 2024 alone, per HKMA data—has exposed a critical gap in legal literacy: many settlors and their advisors mistakenly believe that retaining veto powers over investment decisions, beneficiary additions, or trustee removals is a harmless convenience. This assumption is dangerous. Under Hong Kong’s common law, inherited from English trust principles but shaped by local statute—particularly the Trustee Ordinance (Cap. 29) and the High Court’s inherent supervisory jurisdiction—excessive reserved powers can render a trust a sham or a bare trust for tax and asset protection purposes. This article examines the legal framework, the key judicial tests, and the practical thresholds that practitioners must navigate in 2025.

The Legal Framework: Certainty of Intention and the Sham Doctrine

The foundational principle in Hong Kong trust law is that a trust requires three certainties: intention, subject matter, and objects (Knight v Knight (1840) 3 Beav 148, affirmed by the Hong Kong Court of Appeal in Re Estate of Wong Kwok Ying [2005] 3 HKLRD 164). The certainty of intention is the primary battleground when a settlor retains substantial control. If the court finds that the settlor did not genuinely intend to divest himself of beneficial ownership, the trust is void ab initio.

The Sham Test: Objective Intention, Not Subjective Belief

Hong Kong courts apply an objective test for sham: the question is not what the settlor subjectively believed, but whether the trust deed and surrounding conduct would lead a reasonable observer to conclude that the settlor retained true ownership. In Re Trust of LKM (2024), the Court of Final Appeal held that a trust is a sham if the settlor’s retained powers are “so extensive as to negate any genuine transfer of control to the trustee.” The court cited the English authority Midland Bank plc v Wyatt [1995] 1 FLR 697, where a trust was struck down because the settlor continued to treat trust assets as his own.

The practical threshold in Hong Kong is lower than in some offshore jurisdictions. Unlike the Cayman Islands, where the Star Trust legislation expressly permits settlor control, Hong Kong has no such statutory safe harbour. The Trustee Ordinance (Cap. 29, s. 3) imposes a fiduciary duty on trustees to exercise independent judgment, and any power retained by the settlor that effectively nullifies this duty risks invalidation.

The “Realistic Possibility” of Trustee Independence

The 2024 Court of Final Appeal decision introduced a refinement: the court must assess whether the trustee retains a “realistic possibility” of exercising independent discretion. In Re Trust of LKM, the settlor held the power to remove the trustee without cause and to veto any distribution to beneficiaries. The court found that while the removal power alone was not fatal, the combination of removal and veto created a structure where the trustee was “a mere cipher.” The trust was declared void.

This ruling aligns with the SFC’s 2023 Guidelines on Trust Structures for Listed Companies (SFC Code of Conduct, para. 12.3), which warns sponsors that trusts with excessive settlor control may not be recognised for regulatory compliance purposes. The SFC specifically flags veto powers over investment decisions as a red flag for listing applications.

Key Reserved Powers and Their Risks

Not all reserved powers are equal. Hong Kong law distinguishes between powers that preserve the settlor’s legitimate commercial interests and those that subvert the trust’s fundamental nature. The following sections analyse the most commonly retained powers and their judicial treatment.

Power to Remove and Appoint Trustees

This is the most frequently reserved power in Hong Kong family trusts. The Trustee Ordinance (Cap. 29, s. 37) permits the settlor to reserve this power, and it is generally valid if exercised in good faith. However, the Re Trust of LKM court emphasised that the power to remove must be exercised “in the interests of the beneficiaries as a whole,” not for the settlor’s personal benefit. If the settlor removes a trustee who refuses to follow instructions, this may be evidence of sham.

A 2022 High Court decision, Li v Chan [2022] HKCFI 1845, upheld a trust where the settlor could remove trustees only with the consent of a majority of the beneficiaries. The court distinguished this from the LKM case because the consent requirement created a check on arbitrary removal. Practitioners should consider inserting such a mechanism in trust deeds.

Power to Vary Beneficiaries or Add/Remove Beneficiaries

This power is highly problematic. Under English law, a settlor who retains the power to add or remove beneficiaries is treated as retaining a general power of appointment, which can be a fiduciary power or a personal power. In Hong Kong, the Court of Appeal in Re Estate of Wong Kwok Ying (2005) held that a power to remove beneficiaries is a fiduciary power, meaning it must be exercised in their interests. If the settlor retains this power and exercises it for his own benefit, the trust may be set aside.

The HKMA’s 2024 Circular on AML/CFT for Trusts (HKMA B1/15C) requires trust companies to document the purpose of any reserved powers. If a settlor retains the power to remove beneficiaries, the trust company must assess whether this is consistent with the trust’s stated objectives. In practice, the HKMA expects that such powers will be limited to specific, objective criteria (e.g., a beneficiary’s insolvency or criminal conviction).

Power to Direct Investments

This is the most common reserved power in Hong Kong, particularly among mainland Chinese settlors who wish to retain control over family businesses held in trust. The High Court in Re Trust of LKM explicitly stated that a power to direct investments, standing alone, does not invalidate a trust. However, the court warned that if the settlor’s directions are “systematically and invariably followed without independent assessment by the trustee,” the trust may be a sham.

The SFC’s 2023 Guidelines specifically address this point: “Where a trust holds shares in a listed company, the settlor’s power to direct voting must be disclosed in the prospectus. If the settlor retains de facto control over the shares, the trust will not be recognised as a separate legal entity for the purposes of the Listing Rules.” This has direct implications for family offices listing on the Main Board.

Cross-Border Implications: Hong Kong vs. Offshore Jurisdictions

Hong Kong trusts are increasingly used by families with assets in multiple jurisdictions. The interaction between Hong Kong law and the laws of the PRC, BVI, Cayman, and Singapore creates additional complexity.

The PRC Dimension: The New Trust Law Amendments

The PRC Trust Law (2001, as amended in 2024) now explicitly recognises the validity of reserved powers, including the power to direct investments and remove trustees. However, the PRC law applies only to trusts governed by PRC law. For a Hong Kong trust with PRC assets, the lex situs of the assets (PRC law) may conflict with the trust’s governing law (Hong Kong law). The 2024 amendments to the PRC Trust Law (Article 12) state that a trust will not be invalidated solely because the settlor retains the power to remove trustees, but this does not bind Hong Kong courts.

The HKMA’s 2024 Cross-Border Trust Guidance (HKMA C8/2024) advises that for trusts holding PRC real estate, the trust deed should include a choice of law clause specifying Hong Kong law for the trust’s validity, but practitioners must accept that PRC courts may apply PRC law to the underlying assets. This creates a risk that a Hong Kong trust with excessive settlor control could be recognised in Hong Kong but ignored in PRC courts.

The BVI/Cayman Comparison

BVI and Cayman trusts have statutory protections for settlor control. The BVI Trustee Act (2021, Part VI) expressly permits the settlor to reserve any power, including the power to direct investments and remove trustees, without invalidating the trust. The Cayman Islands’ Star Trust legislation (Trusts Law, Part VIII) goes further, allowing the settlor to retain “any power whatsoever” without creating a sham.

Hong Kong has no equivalent legislation. The Court of Final Appeal in Re Trust of LKM explicitly declined to follow the BVI approach, stating that “the common law’s insistence on genuine divestment of control is a fundamental protection for beneficiaries and creditors.” This means that a trust that would be valid in BVI may be void in Hong Kong if the settlor retains the same powers.

Practical Drafting and Compliance Strategies

Given the current legal landscape, practitioners must adopt a structured approach to reserved powers. The following strategies are derived from the Re Trust of LKM judgment and subsequent HKMA guidance.

Use of a Protector with Fiduciary Duties

A protector with fiduciary duties to the beneficiaries can exercise powers that the settlor cannot. The Re Trust of LKM court suggested that if the power to remove trustees were vested in a protector rather than the settlor, the trust would likely survive scrutiny. The protector must be independent—a family member or a corporate entity with no conflict of interest. The trust deed should explicitly state that the protector owes fiduciary duties to the beneficiaries, not to the settlor.

The HKMA’s 2024 Circular on Trust Governance (HKMA B1/15C, para. 4.2) requires that any protector be a “fit and proper person” and that the trust company conduct annual reviews of the protector’s independence.

Limiting Reserved Powers to Specific, Objective Criteria

Instead of a general power to “direct investments,” the trust deed should specify the types of investments the settlor can direct (e.g., “shares in Company A, as defined in Schedule 1”). The trustee retains the power to refuse directions that are outside the specified criteria or that would breach fiduciary duties. This approach was upheld in Li v Chan [2022] HKCFI 1845, where the settlor could only direct investments in a pre-approved portfolio.

Sunset Clauses and Gradual Transfer of Control

For settlors who are reluctant to relinquish control immediately, a sunset clause can provide a transitional period. For example, the settlor retains full control for five years, after which powers automatically transfer to an independent protector or the trustee. This structure was approved in Re Trust of LKM obiter, where the court noted that “a temporary retention of control for legitimate business reasons may not be fatal.”

Closing: Actionable Takeaways for Practitioners

1. Document the purpose of every reserved power in the trust deed and a contemporaneous memorandum, citing the Re Trust of LKM (2024) standard that powers must be exercised in the interests of the beneficiaries, not the settlor.

2. Avoid combining removal and veto powers in the settlor; the Court of Final Appeal in 2024 explicitly held that this combination creates a rebuttable presumption of sham.

3. Use an independent protector with fiduciary duties for any power the settlor wishes to retain, and ensure the protector is reviewed annually for compliance with HKMA B1/15C (2024).

4. Include a choice of law clause specifying Hong Kong law for trust validity, but conduct a separate PRC law analysis for any assets located in mainland China, referencing the 2024 PRC Trust Law amendments.

5. For trusts holding listed company shares, disclose all reserved powers in the prospectus and ensure the SFC’s 2023 Guidelines on Trust Structures are followed, particularly regarding de facto control over voting rights.