Consequences of `Shams` for Trustees : An Overview
Sarah Cormack provides a view of some of the consequences for trustees if they become involved in the `trusteeship` of shams
(taken from Isssue No 13 – October 2000)
Philip Laidlow’s article published in the July issue of the TACT Review deals in some detail with the circumstances in which a trust instrument may be found to be a sham.
In this article I consider the implications of a finding of `sham` for the trustee of such an arrangement. In particular, I look at the actions which are likely to be brought against the trustees in an attempt to restore the `trust property` to its rightful owners and the consequential practical concerns for the trustees on the finding of sham such as the payment of fees and the availability of protection under exculpatory clauses contained in the sham instrument.
- THE NECESSITY FOR A COMMON INTENTION
Firstly, I think it is useful to recap the extent to which a trustee must be aware and indeed confer with the intention of the settlor in the creation of a sham trust instrument.
Diplock L J stated in Snook -v- London and West Riding Investment Limited, a sham instrument is one which:
`…is intended to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.`
As Mr Laidlow states in his article it is unfortunate that this passage has been the subject of so much attention in the context of sham trusts given the emphasis on there being a common intention to create a sham instrument. I agree that the intention of the trustee must be irrelevant to the existence of a sham arrangement and the Court of Appeal decision in Midland Bank plc –v- Wyattconfirms this view. In considering the reasoning in Snook in the context of the purported creation of a trust. D E M Young Q C stated:
`I consider a sham transaction will still remain a sham transaction even if one of the parties to it went along with the `shammer` not either knowing or caring about what he or she was signing. Such a person would still be a party to a sham and could not rely on any principle of estoppel such as was the case in Snook – the defendant there not being a party to the transaction at all.`
As Mr Laidlow commentss
`if there is no thought of sham in the mind of the trustee and the trustee fully intends to accept a trust…[but] if the settlor does not intend to create a trust…one of the core certainties is missing and there cannot be a trust`.
Therefore, in any subsequent finding of sham the trustee’s intentions at the outset may be irrelevant. This only goes to emphasise how diligent a trustee needs to be both on inception of the `trust` and in monitoring the trust and its administration during the foregoing period. This should be borne in mind when considering the issues raised in the rest of this article.
- CONSEQUENCES OF SHAM
The sham argument is commonly encountered in attacks by disappointed beneficiaries (e.g. where principles of forced heirship are at stake) or claims by taxation authorities (e.g. in the case of R –v- Dimsey and Allen). Whilst the sham argument itself will have the effect of bringing the trust to an end it will not establish the attackers’ right to the property held within the arrangement.
Therefore, once a trust instrument has been found to be a sham, the trustees will need to steel themselves for a succession of constructive trust claims and `tracing` or `proprietary` claims. They will also need to consider their own position vis-à-vis fees and expenses (both past and future) and the continued availability of protection under exculpatory clauses.
- Constructive Trusts
A constructive trust will be imposed by the courts where it is deemed that one party owes fiduciary duties to another. However,
`English law provides no clear and all-embracing definition of a constructive trust. Its boundaries have been left perhaps deliberately vague so as not to restrict the Court by technicalities in deciding what the justice of a particular case may demand.`
It is important to bear in mind, however, that equity operates on a man’s conscience and will impose the obligations of good conscience on the defendant. It is therefore irrelevant that the constructive trustee himself does not regard what he has done as morally objectionable in any way.
Consequently there are two types of constructive trust claim that may be relevant where there has been a finding of sham. These claims are personal rather than proprietary.
(a ) Dishonest assistance
Any party who dishonestly assists in keeping the assets away from the victim of fraud will be liable to make good the victim’s loss.
The defendant’s conduct will be judged in the light of the facts as he understood them to be. Therefore, a trustee will not incur liability where, through carelessness or gullibility, he failed to appreciate the true nature of the arrangement he was entering into.
However, it was held in the Royal Brunei Airways -v- Tan case that:
`Honesty is not an optional scale with higher and lower values according to the moral standards of each individual. If a person knowingly appropriates another’s property he will not escape a finding of dishonesty simply because he sees nothing wrong in such behaviour.`
Trustees should, therefore, be constantly diligent both in the taking on of a trust and in its continued administration.
(b) Knowing receipt
In order to be liable for `knowing receipt`:
`…the Plaintiff must show, first, a disposal of assets in breach of fiduciary duty; secondly, the beneficial receipt by the Defendants of assets which are traceable as representing the assets of the Plaintiff; and thirdly, knowledge on the part of the Defendant that the assets he received are traceable to a breach of fiduciary duty.`
The most important element here is the requirement that the defendant receives the trust funds beneficially. It is therefore usually difficult to prove knowing receipt in trust scenarios because a trustee does not receive the trust funds beneficially. Therefore, the trustee’s exposure for `knowing receipt` can generally only extend to any professional fees or other expenses he has drawn from the trust fund under his right of indemnity under the trust.
In relation to the third requirement, that of `knowledge`, it will be enough if the trustee deliberately blinds himself to the obvious or deliberately avoids making enquiries that an honest and reasonable trustee would make about the origin of the funds he handles
Where the trust assets are still under the control of the trustee the third party attacking the trust is most likely to bring a proprietary claim against the trustee.
Such a claim will be made on the basis that as the trust is sham the trust assets are not held on trust for those individuals named as beneficiaries in the trust instrument or those individuals who can be identified as beneficiaries in accordance with the terms of the trust instrument. Rather, the assets are held on trust for the third party making the attack (see paragraph 1 above).
Where a trust instrument is challenged on the basis that it is a sham proprietary claims under the principles of tracing will most likely be made. Remedies of tracing exist both at common law and in equity.
(a) Tracing funds at common law
English common law is primarily concerned with `legal title` and whilst the principles of common law tracing will enable funds to be tracked throughout changes in form they do not enable funds to be tracked once they have been mixed with the funds of another. One advantage of the common law tracing rules is that there is no requirement that there should be a fiduciary relationship between the two parties.
(b) Tracing at equity
The rules of equitable tracing are a great deal more flexible than the common law rules and so – if the criteria can be met – are more commonly utilised.
Where a trust instrument is held to be a sham the third party is unlikely to be claiming that the trustee himself is liable. He will be asserting that the trust property is not properly attributable to the `beneficiaries` of the sham but rather it is the property of the attacking third party and should be restored to him accordingly.
If the third party can show equitable title to the property he will be able to track his equitable interest in the trust funds in circumstances where the common law tracing rules would not have been applicable, for example, where the funds have become mixed with the assets of another.
To succeed in an equitable tracing claim it is necessary to show the existence of the following three factors:
- a pre-existing fiduciary duty between the third party and the trusteeUnless the assets subject to the claim are held in a fiduciary capacity from the outset there is no basis on which the rules of equity can apply to restore the funds to the third party (see paragraph 1 above).
`… at some stage a fiduciary relationship of some kind (though not necessarily a positive duty of trusteeship) sufficient to give rise to the equitable right of property….[but] precisely what relationships are sufficient to bring such an equitable right into existence for the purposes of the rule which we are considering is a matter which has not been precisely laid down.`
- Where there has been a finding of sham there must necessarily be a fiduciary relationship between the trustee and the third party claiming equitable title to the trust assets. The trust assets will be held on constructive trust for that third party.
- This principle was stated by the Court of Appeal in the case of Re Diplock when it was asserted that for the remedy of tracing to be available at common law there must be:
- the continued existence of the trust fund ie that the funds are traceable in equityIt is a basic principle of trust law that there must be certainty of subject matter before there can be a properly constituted and valid trust. Equally, a third party can have no equitable title in property that has ceased to exist and therefore tracing in equity will not be available in these circumstances.
- The rules of equitable tracing contains detailed principles enabling the courts to ascertain whether or not the property subject to the claim is still in existence. I do not propose to deal with these principles here. Suffice to say that the rules will enable the tracing of trust assets into mixed funds and, given that claims of this kind, usually arise in circumstances where the assets remaining are not sufficient to meet everyone’s claims.
- the absence of any defenceThe two principle defences to a claim for tracing in equity are:
- that the defendant was the `bona fide purchaser for value without notice` of the assets. This defence is unlikely to be available to a trustee where there has been a finding of sham as a trustee does not commonly give value for the trust assets even though there is unlikely to be notice; and
- that there has been an `innocent change of position`. This defence does not operate to pass title of the assets which are the subject of the tracing claim but rather to deny restitution of those assets to the attacking third party where it would be unjust for the courts to order restitution in the circumstances.
This could apply where, for example, trustees have made distributions to the beneficiaries of a valid trust.
It could also apply, in certain limited circumstances, where assets have been distributed to individuals under a sham arrangement. Such distributions are likely to be treated as having been made by the settlor if the relationship remaining between the settlor and the trustee after the trust instrument has been set aside is likely to be that of principal and nominee.
3 Trustees’ Fees
A professional trustee will be particularly concerned with the costs of running and participating in actions arising from a finding of sham. A pertinent question therefore is the status of the administrative provisions contained in the sham instrument once the dispositive provisions have been struck down by the court. Within this will be the question of whether a professional trustee may retain the fees and expenses properly paid to it from the trust fund prior to the finding of sham or whether such sums will also fall to be the subject of a tracing claim (as we have already seen in paragraph 1.2 above).
Whilst this does not appear to be a question that has been addressed by the courts as yet the answer must turn on the true nature of the relationship between the settlor and the trustee once it has been established that the trust instrument is a sham. Given that the likely alternatives would seem to either that the trustee either holds the trust property on bare trust for the settlor or is merely the settlor’s nominee there must be an argument that it is simply the dispositive provisions contained in the sham instrument that are struck out by the finding of sham. If this is right the administrative provisions contained in the instrument will subsist to govern the continuing relationship between the settlor and the trustee.
However, there must be a question as to the level of fees recoverable in these circumstance given that the fees charged for adopting the fiduciary role of trustee in relation to a fully blown trust are unlikely to be appropriate where the trustee is acting merely as a bare trustee or a nominee.
This is a question that surely must be decided by the courts on a case by case basis, but in circumstances where the settlor has been the perpetrator of the sham and the trustee is an innocent party, it is hard to see any justification for reducing the fees.
4 Trustees’ exculpation clause
Whether or not the professional trustee will retain the protection of any exculpation clause contained in the instrument will also be a concern.
Again, the issue is not one that has been considered by the courts directly and must be one which turns on the continuing relationship between the trustee and the settlor and the trustee’s role in a funding of a sham.
C ROLE OF THE TRUSTEE
For completeness it is useful to consider the stance a professional trustee should take during litigation of the kind outlined in this article.
As a general rule a trustee should remain neutral when the validity of a trust is under challenge. This principle was most recently confirmed in Alsop Wilkinson -v- Neary. Lightman J held in that case that it was the duty of a trustee to remain neutral and not to take part in the proceedings. The reasoning behind this assertion stemmed from the fact that a trustee has a mere bare legal title to trust assets. The trustee holds the trust assets on trust for whoever happens to be the beneficiary of those assets. Where the trust is under challenge the trustee is not in a position to support one potential beneficiary over another in these circumstances and so should remain impartial until the court has weighed up the arguments for the competing claims and come to its decision.
This stance may well be alien to a professional trustee whose natural inclination will be to defend the trust from attack vigorously in all circumstances.
In some circumstances the trustee may be aware of a potential claim. This could leave the trustee in a difficult position. On the one hand the trustee knows of a potential claim which could lead to the beneficial ownership of the trust assets being challenged whilst the trust instrument, as it stands, provides that various distributions are to be made to specified beneficiaries.
The trustee will be conscious not to expose itself to liability by making these distributions in the face of potential litigation. However, a refusal to make distributions and a subsequent finding in favour of the validity of the trust may also leave a trustee open to liability – for breach of trust. What then should a trustee do when faced with this quandary?
The answer must surely be that a trustee should go to the court for advance directions in these circumstances. If the court directs that the trustee should make the distributions in accordance with the terms of the trust instrument the trustee will be protected against any future successful tracing claim by a third party (or indeed a beneficiary of the trust) made in conjunction with a finding of sham.
The moral is, therefore, that in order to protect itself from this myriad of potential claims a professional trustee must take all steps possible to ensure that he is aware of the true nature of the trust he is taking on. Nor can this diligence cease once the documentation has been signed. A trust must be constantly vigilant in his monitoring and administration of the trust lest he bear the consequences.
Sarah Cormack, is an assistant solicitor, Tax and Financial Planning Department, Macfarlanes