The $9 billion National Council for Social Security Fund (NCSSF) in Beijing has yet to decide whether to operate under the aegis of the country's recently created trust law. This has surprised its foreign advisers and the Fund's decision will have weighty consequences, not just for itself but for the nation's entire emerging pensions system.

This is one of a host of question marks hovering over the trust law, says Iain Batty, partner at law firm CMS Cameron McKenna, who has advised various Beijing ministries on designing its trust law via a mandate from the Asian Development Bank. It also is unknown whether fund management companies or yet-to-be-established voluntary supplemental funds (i.e. third-pillar pension system funds) will choose to operate under the trust law.

But the NCSSF is more of a puzzler because a year or so ago, "It seemed a done deal," Batty says. The NCSSF was established just two years ago by the State Council, which also promulgated the trust law, so it seemed natural that the NCSSF would adopt it.

But first, what is the trust law, and why is it important?

Trust law is found in common law nations such as the United States, the United Kingdom, Hong Kong, Singapore and Australia. It is not typical of civil law nations such as China or France (although Japan, a civil law jurisdiction, does also use trust law). Civil law nations rely on a written code of laws rather than judicial interpretations to make law. It is mainly for historical reasons that they have tended not to use trust law.

In civil law nations lacking a trust law, pension funds are usually created as foundations or mutual insurance companies. They lack transparency and are open to abuse once the assets are separated from the beneficiary. The assets are controlled by the asset manager. These systems, common in emerging markets, are old and out of favour.

What trust law does is separates the legal owner of an asset from the beneficiary of that asset. In other words, the trustee owns the assets and is responsible for them, but does not benefit from them or use them for personal use. Rather, the trustee has been given the assets by the settlor (the body setting up the trust) for safekeeping and management. In the case of pension funds, the beneficiaries are the member participants. The point of trust law is to ensure the members' interests are protected.

While members will own the assets, they have very limited rights on how to use them before retirement. Under trust law, the investment fund structure would resemble the unit trusts found in Hong Kong: a settlor's trust deed creates the fund (in this case the settlor is a fund management company, but it could also be a company setting up a provident fund or a body such as the NCSSF), with the trustee as the legal owner and the beneficiaries the underlying investors, and the independent trustee oversees the execution of the fund's policy by the manager.

If there is no trust law, then investment fund structures resemble those now found among China's fund management companies: the fund is a corporate vehicle in which the manager solely determines and executes the investment policy, and where a custodian holds the assets but does not monitor what the manager is doing. All power goes to the manager, and it is quite easy for them to embezzle or misuse assets.

So if a fund company operated under a trust law, it would be subject to independent scrutiny and greater accountability. Chinese fund managers would not be able to readily engage in the market-ramping activities that have marked the industry. Provided investors understand this distinction, a trust structure should give them more confidence in the fund industry, and it will help raise the industry to international standards.

It is clear, then, why the Chinese regulators wanted to introduce trust law. It is uncertain, however, whether any fund management companies would elect to use it; Batty says this is a decision up to individual settlors.

Batty says China's government has been amazingly bold and farsighted in adopting trust law for asset ownership. Until then, it allowed trust management (letting a third party manage someone else's assets) but this issue concerns ownership. The law was passed in record time, mainly because it is obscure and not understood, so various bureaucracies didn't bother to stick their fingers in it. The final version, however, poses serious problems.

The first, and perhaps most serious, is simply that China lacks a history or understanding of what trust law means. The legal nicety that the person controlling assets cannot actually benefit from them, or use them as he pleases, is alien among regulators, judges, money managers and participants alike.

"One can have a law but you need an understanding and a culture for it," says Batty. "Will people appreciate that if they have hundreds of millions of dollars placed in their name, they can't do what they like? Will the judiciary, particularly in the outlying areas, appreciate the distinction? I do have a concern that perhaps they will not."

Underlying this cultural problem are several flaws in the law itself. Batty stresses that overall China has come a long way and made some courageous moves in implementing a trust law, but nonetheless the final version must be amended.

Critically, the law says "in managing trust property, the trustee shall bear a duty of care to the same extent as managing his original property" - in other words, the trustee must take care of the assets as if they were his own.

"The problem is people don't treat their own property very well," Batty says. It is critical that for this trust law to work, China must adopt a prudent person rule found in the common law countries, such as in America's ERISA law. What this imposes is that trust duties are carried out by people with expertise, and if the trustee lacks that expertise, he must seek it from others. "Prudence is the key word," Batty says. "What is prudence?" Common law nations tend to have decades or centuries of case law that can inform people what prudence means - all of which is lacking in China.

This means China needs to provide more detailed statutory guidance. The government has a two-pronged task, to first embed the principle of prudence in the trust law, and then to define what prudence connotes. There is no sign yet that the government is doing this.

Other problems with the trust law remain. One is called 'self dealing' and means the law can allow trustees to benefit from the assets at the expense of the beneficiaries - contrary to the entire spirit of trust law. While the Chinese law does say a trustee can't use the assets for his own good, it says nothing about trading assets to an affiliate or family member. "If a trustee sold assets cheaply to his brother, it would not be contrary to China's trust law," Batty says.

In addition, the Chinese version has too many exemptions allowing trustees to evade liability, lacks more means for beneficiaries to take action against trustees, allows for trustees to be forced to serve in that capacity, and gives considerable leeway for settlors to intrude into the trust operation. This last flaw means the fund manager, the company setting up a pension fund or the NCSSF has room to meddle in the management of the assets to a degree not found in common law nations. Given the other problems listed above, they can get away with it.

Batty suggests some of these provisions may be political, to allow the government to maintain control over the assets. One example is that China doesn't allow trustees to also be beneficiaries. While this does eliminate a potential conflict of interest, it goes against practice in Western countries, which feel the problem is outweighed by the benefit of greater accountability.

Other problems in the trust law are not political and are simply mistakes, Batty says. But combined with the lack of understanding among top regulators, judges and market participants, the trust law is not going to accomplish what it set out to do.

That said, the very existence of the law is a huge step forward. It does provide a minimum of accountability and transparency, and embeds the principle of fiduciary responsibility on people controlling pension assets. Indeed, if the NCSSF did not adopt the trust law, then its assets would go on being under the State Council and treated like taxes raised by ministries. There is no legal framework for these assets at the moment. Given the size - $9 billion and growing - this is obviously a danger to reforming China's pension system. That in turn makes it a danger to creating stable, long-term capital markets. Nonetheless, the government may be reluctant to give up control of the assets.

It is quite possible, however, that the NCSSF will ultimately adopt trust law. First of all, the flaws explained above would still give the government some ability to intervene and dictate how the assets are used.

Secondly, the NCSSF's internal debate on the trust law may not be as ominous as it seems. Stuart Leckie, regional chairman for Hewitt Associates and a pensions adviser to China, notes the NCSSF still has even more basic questions to resolve. Although it is clear that the NCSSF will outsource at least some assets to domestic fund management companies, it has not yet determined who, exactly, is considered a beneficiary.

"The NCSSF was conceived as a fund of last resort in case the provinces ran out of money for pensions," Leckie says. "So are the beneficiaries the provinces, or the cities and municipalities under them, or the individual members? And is the money coming out of the NCSSF to be in the form of a grant to the provinces or a loan? They need to decide these things before they can decide to use trust law. They have told me they would like to 'act like a trust' - whatever that means."