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In the first of two contributions on Employee Benefit Trusts
Gregory Morris considers the practical implications for trustees
of this recent Chancery decision
(taken from Issue No 20  – July 2002The aggregate value of all the financial arrangements which are in the care of the Association`s members is well in excess of £1 trillion.

Although the recent case, Alan David Cameron v M & W Mack (ESOP) Trustee Limited1, was decided by reference to the construction of the relevant documents and a principle of trust law, it raises issues which may be of practical concern for many trustees of employee benefit trusts.

Mr Cameron was an employee of M & W Mack Limited (the `Company`) an importer, wholesaler and distributor of a wide range of fresh vegetables, fruit and flowers. Mr Cameron joined the Company in 1986 and by 1997 he was, in the words of the judgement, `..recognised as one of the key architects of the Company’s growing profitability.`.

In July 1991 the Company established the M & W Mack Employees Benefits Trust (the `Mack EBT`). At the time of the proceedings the defendant, M & W Mack (ESOP) Trustee Limited (the `Trustee`), was the trustee of the Mack EBT. As is often the case with employee benefit trusts, the Mack EBT had been established to hold shares in the Company which could then be used in conjunction with some form of share based incentive arrangement. Under the terms of the Mack EBT, the Trustee had the usual powers to transfer part of the trust fund for the benefit of any beneficiary. The class of beneficiaries included the past, present and future employees of the Company and their dependants.

In June 1994 the Company, in conjunction with the Mack EBT, established a share bonus scheme (`SBS`). Under the SBS it was possible for a participant to forego part of his contractual entitlement to a cash bonus in exchange for a number of shares in the Company equal in value to the bonus foregone (the `Bonus Shares`). Subject to satisfying the provisions of the SBS, in three years time the participant would be able to request the Trustee to transfer the Bonus Shares to him together with an equal number of `matching` shares. During the three year period the Bonus Shares would be held on discretionary trusts in the Mack EBT. When explaining the SBS to the senior managers, the Company spoke in terms of `earmarking` a number of shares under the scheme for a participant. The Company continued to use the concept of shares being `earmarked` and the meaning of this concept is central to the judgement in this case.

As time progressed it became clear that Mr Cameron and certain other key senior managers were crucial to the continued growth and success of the Company. The Company decided that an incentive arrangement should be adopted which provided the key senior managers with an opportunity to benefit from the continued success of the Company. As the SBS was not intended to offer significant incentives, it was eventually decided that a new incentive arrangement (the `Executive Arrangement`) should be established under which shares in the Company which were currently held by the Mack EBT should be `earmarked` for a number of senior managers, including Mr Cameron. The Executive Arrangement was, in part, intended to offer tax advantages to the participants, that is, no liability to income tax would be crystallised until such time as the participant became the owner of the shares.

At a board meeting held in September 1997 the directors of the Company approved the Executive Arrangement. The minutes of that meeting also made clear that the shares were to be `earmarked` within the Mack EBT, the shares could be withdrawn immediately by the relevant executive and no waiting periods of performance requirements would be imposed. The arrangement was tantamount to an outright gift or the shares could be left in the Mack EBT `in an environment gross of tax`.

On the same day as the Company’s board meeting, there was a meeting of the directors of the Trustee.

The Trustee considered the Executive Arrangement, in particular the proposal that had been put forward by the Company that a specified number of shares should be `earmarked` for certain senior managers. After considering the matter the Trustee resolved to `earmark` the relevant number of shares for the identified individuals including as part of the resolution an indication that such shares would be transferred to the individuals as and when requested by each of them. The Trustee did not discuss the concept of `earmarking`.

Subsequently one of the attendees at the board meeting of the Trustee wrote to the relevant senior managers explaining the importance of the incentive arrangement that had been adopted and how it was to operate. The letter to Mr Cameron (the `First Letter`), after telling him how many shares had been `earmarked`, said….`To postpone your liability for income tax, these shares will remain `earmarked` within the ESOP, although I would emphasise that you may ask the Trustees to transfer the shares into your name at any time, without restriction.…`. The First Letter went on to say that Mr Cameron would benefit from an increase in value but would not be entitled to receive normal dividend payments made to shareholders.

In October 1997 the chairman of the Trustee also wrote to Mr Cameron (the `Second Letter`) informing him that certain shares in the Mack EBT had been `earmarked` for him and that such shares `can be transferred into your outright ownership whenever you wish.`. He did go on to say that although the shares are `earmarked` they are held in the trust and are held at the discretion of the Trustee. The chairman did point out however, that it was difficult for him to think of circumstances under which the shares would not be transferred to Mr Cameron whenever he wished.

In August 1999 Mr Cameron handed in his notice and asked for the shares held in the Mack EBT that were `earmarked` for him to be transferred to him.

Following an exchange of correspondence between Mr Cameron’s solicitors and the Company, Mr Cameron was informed that the shares originally held under the Executive Arrangement would not be transferred to him, as following his resignation, such shares were no longer `earmarked` for him. As these shares were worth in excess of £140,000 Mr Cameron was keen to ensure that the shares that had been `earmarked` for him were transferred to him and hence brought an action against the Trustee.

In this case, the judge had to decide whether; as a consequence of the resolution of the Trustee, the First Letter or the Second Letter a bare trust for the benefit of Mr Cameron had been constituted. In the alternative, the judge had to decide whether Mr Cameron had been granted an unconditional option to call for the transfer of the shares or as the Trustee contended the decision to transfer the shares remained within the discretion of the Trustee.

The decision in case therefore crucially turns upon the construction of the Trustee’s resolution and the relationship between the resolution and the two letters.

A concern of the judge was whether the subjective intention of the parties was admissible as evidence. This matter was of importance as it had to be decided whether the subjective understanding of the concept of `earmarking` held by the various parties, was to play a part in the courts decision. Having considered the arguments the judge made clear that he was ignoring `…all the evidence as to what the witnesses said they meant or intended or understood by the use of the word `earmark` in the resolution or what they understood others to mean by it.`. This is a useful reminder that, in the main, it is the words on the page that are important when considering, for example a trust deed, not the intention of the parties. The judgement contains a concise and interesting discussion on these issues.

As part of his deliberations the judge considered the resolution and the rules of the SBS with great care. He concluded that until the Trustee finally exercised its discretion to decide to transfer the shares to a participant then the participant had no interest in the shares. The concept of `earmarking` was at all times subject to the exercise of the discretion of the Trustee. Mr Cameron therefore had no interest in the shares that had been `earmarked` for him and as the Trustee did not exercise its discretion and determine to transfer the shares to him, Mr Cameron had no right under the executive arrangement to receive any shares.

This judgement was not what Mr Cameron would have wanted. If, for example, he had requested the transfer of the `earmarked` shares to him before submitting his notice of resignation then it is to be assumed that the Trustee would have transferred such shares.

As the decision of the judge was made by reference to the wording of the resolution and the discretionary nature of the Mack EBT, what this case does highlight is the importance of the content of the resolution that is passed by a trustee. This in turn raises questions as to the operation of a number of various types of incentive arrangement that are commonly used by companies in conjunction with an employee benefit trust.

Many companies operate a share based incentive arrangement under which the delivery of the shares is facilitated by an employee benefit trust. These arrangements can take many forms, for example long term incentive plans, deferred or conditional share arrangements or share option plans. Under each of these arrangements participants are given the opportunity to acquire shares at some time in the future. The opportunity may be conditional upon the satisfaction of certain performance conditions. It is also reasonably common to use such concepts as `ring fenced`, `conditionally allocated`, `earmarked` or `set aside` under such arrangements.

What both companies and trustees are reminded of by this judgement is the importance of ensuring that, at least for the purposes of the resolution passed by the trustee, the parties know exactly what rights the participant has been granted or awarded.

At the one end of the spectrum will be a share option arrangement under which the trustee resolves to grant an option to the participant. The relevant rules of the share option plan will set out the terms on which the option is granted. Under such arrangements it is usually clear what rights the participant has and when he can exercise the option. If in accordance with the rules the participant exercises the option then the trust will transfer the shares to the participant.

At the other end of the spectrum is a form of conditional share arrangement under which the participant is `promised` that if certain conditions are satisfied, the conditions may include performance targets and/or continued employment, then the trustee will transfer shares to the participant. This arrangement is far closer to the Executive Arrangement adopted by the Company.

It might be thought that it is preferable for the sponsoring company in all circumstances to engineer a measure of flexibility within the arrangement such that if matters did not work out as expected the shares held in the arrangement would not be transferred to the participant. For example, as in this case, it is possible to ensure that the trustee must exercise its discretion before shares are actually transferred to the participants. The downside of such an approach however is that the employee will not have the certainty he or she may seek and may be expected to receive under the proposed incentive arrangement. For a senior executive to be offered the promise of an incentive that is intended to motivate, retain and reward him and for that executive to realise that he has no rights in respect of that arrangement can lead to a disharmony which defeats the purpose of the incentive arrangement.

The decision in this case should prompt all trustees of employee benefit trusts operating incentive arrangements to ensure that as the trustee it clearly understand the rights that the participants have been granted or awarded. In addition as the participants are beneficiaries the trustee should also consider how it is to make clear to those participants, in understandable language, the nature of the rights they have received.

Gregory Morris
Director, Tax Consultancy

1 [2002] WTLR 647