Adrian Wallace sheds new light on an often overlooked risk in the creation of trusts
(taken from Issue No 17 – October 2001)
Most express trusts are no doubt created for honourable reasons. The typical Settlor will perhaps create a trust so as to achieve tax planning objectives, or to secure the transmission of his assets down the generations, or for charitable or other noble purposes. Whatever the reason for the creation of the trust, the Settlor will no doubt be told firmly by his legal advisers that once he has transferred his assets into a trust, he has surrendered dominion over them and cannot exercise any direct control over their destiny. This key feature of a trust may be viewed as a potential disadvantage by the typical Settlor. Unfortunately, there is a certain category of Settlor who may view it as a positive advantage – the type of Settlor whose purpose in creating the trust is to put his assets beyond the reach of his creditors.
In this article I am concerned at least in part with the implications for the settlement trustees when the creditors of the latter type of settlor catch up with him and make him bankrupt. As we shall see, not only will the English legal system not stand in the way of the creditors of a `rogue` Settlor who uses the settlement to hide his assets; it will (metaphorically) hold the creditors’ coat for them while they get to work on the Settlor. It is not only settlements made by crooked settlors, however, that are vulnerable to the legitimate claims of creditors. Trustees need to be aware of at least three possibilities: that their settlor may be a crook (i.e. using the trust as a deliberate vehicle for hiding his assets); or he may, unbeknown to himself, be insolvent at the time that he makes the settlement; or he may be solvent at the time of the settlement, but be declared bankrupt at some time thereafter.
The Settlor’s creditors can secure the setting aside of the settlement in each of these three sets of circumstances, though the criteria for each are very different. I propose, firstly, to set out what the relevant criteria are, and then to consider what steps, if any, the trustees can (or indeed should) take in the event of such a claim being made.
The `rogue` Settlor
Under s.423 Insolvency Act 1986, the Court can set aside any settlement (including a marriage settlement – s.423(1)(b)) if the Settlor has transferred assets into the settlement for the purpose of concealing them or putting them beyond the reach of anybody who `is making or may at some time make` a claim against him or otherwise prejudicing the interest of such a person.
Dishonesty is not the test for relief under this section. The creditor merely has to prove that the Settlor had an intention to prejudice his creditors. Whether or not there is likely to be any practical difference between the two tests is another matter. The concept of an honest intention to prejudice one’s creditors may be difficult to grasp. Both the test for dishonesty, and the test for the existence of an intention to defeat creditors, are likely to be objective in nature; if the test for dishonesty were to be subjective it would play into the hands of an objectively dishonest settlor. For instance, it would be unattractive if the assertion `I didn’t think it was dishonest of me to try to deceive my creditors` was a valid defence to a s.423claim. Nevertheless, it could be argued that Parliament has made life easier for a creditor making a s.423 application by requiring him only to prove intent rather than having to prove the Settlor’s state of mind as well.
The fact that the creditor needs to prove the intention of the Settlor does however give rise to some difficulties. How strong does the intent have to be before the Court will set aside a settlement? There appear to be two judicial schools of thought on this topic. There is what might be called the `hard` test (hard for the creditor, at any rate) of `dominant purpose`. The somewhat `softer` test of `substantial purpose` (easier for the creditor and therefore of greater concern to the trustee) has met with some judicial approval. The leading exposition of the `hard` test of dominant motive is Midland Bank Plc v Wyatt. However, in National Bank of Kuwait v Menzies, the Court of Appeal appear to have taken it for granted that all that the creditor needs to show is that the intention of prejudicing creditors is a substantial purpose of the Settlor.
It remains to be seen at what height the Higher Courts will set the bar in the future. It seems that the `dominant purpose` test is a hard test in two respects: it is a higher threshold for the creditor to cross, and it also imposes a greater burden on the Court. In order to ascertain what the Settlors dominant purpose was, the Court must not merely try to ascertain what the various purposes of the Settlor were: not to decide whether one of perhaps many purposes was more important than the other; it must also determine which one purpose was the most important in the Settlor’s mind. The Court will almost inevitably have to conduct this exercise without the assistance of the Settlor. Although the Court will decide the issue of the Settlor’s intentions objectively, and on the basis of objective facts known to the Settlor, it is one thing to try to reconstruct the information available to the Settlor at the time of the making of the settlement, and quite another to try to reconstruct his mental processes with such elaboration as to be able to ascertain with any degree of confidence what the most important factor in his mind was at the time he placed his assets in the settlement.
It would be easier, and arguably fairer (from an objective point of view), if all the creditor had to establish was that the intention of prejudicing the creditors was one of a number of reasons for the creation of a settlement, albeit a `substantial` reason. It may well be that even the most reprehensible and dishonest Settlor has mixed reasons for wanting to create a trust. The hypothetical Columbian drug baron may well wish to place his assets beyond the control of the judicial authorities of several countries; but he may also be equally concerned to make proper provision for his family and retinue in the event of his arrest and trial. Similarly, the business man who settles his fortune on discretionary trusts for the benefit of his family as his creditors close in on him may well regard himself as killing two birds with one stone: avoiding his creditors whilst at the same time fulfilling his tax planning objectives. Should the question of whether or not the settlement should be set aside really depend on the result of the elaborate and artificial exercise of trying to establish which of these two motives was more important to him at the time that he signed the trust deed? Should it not be enough to establish that the intention of prejudicing his creditors was one of the reasons for the Settlor’s making the settlement?
Trustees should remember that a s.423 application can be made even if the Settlor has not been made bankrupt. Any creditor who is able to prove to the requisite standard (whatever that may be) that the Settlor has transferred assets into the settlement for the purpose of putting them beyond the creditors reach may make a s.423 application with the leave of the Court. If the Settlor has been made bankrupt then the creditor does not need leave: s.423(5), 424(1) Insolvency Act 1986. Trustees should not therefore assume that the settlement is safe until or unless the Settlor is made bankrupt.
An honest Settlor who is or becomes insolvent
The critical factor here is the timing of the bankruptcy petition. The solvency of the Settlor at the time that he places property into the settlement is irrelevant if a Bankruptcy Petition is presented against him within two years of the transfer of funds into the settlement. By virtue ofss.339-342 of the Insolvency Act 1986, if a Petition is presented within this two year period, the trustee in bankruptcy can obtain an order of the Court setting aside the settlement without having to prove that the Settlor is insolvent at the time that he made the relevant disposition. If the Petition is presented within this period, the trustee in bankruptcy does not even have to establish that the disposition was made with the intention of prejudicing creditors.
The first two years after the settlement is therefore the period of time in which the trust is most vulnerable. Whatever precautions the trustees might decide to take to ascertain the solvency of the Settlor on accepting the trusteeship, or to ascertain the true intentions of the Settlor in affecting the transfer of funds into the settlement, they will be powerless to prevent a trustee in bankruptcy from having the settlement set aside if the Settlor goes bankrupt within the two year period.
There is absolutely nothing the trustees can do to prevent such an eventuality. At the time of the settlement, the Settlor may be guided only by entirely praiseworthy motives such as tax planning and providing for his family; and he may be as rich as Croesus, with not the remotest prospect of financial difficulties let alone ruin. If however he embarks on a series of imprudent speculations after executing the settlement, and these lead to his bankruptcy within two years, then there is nothing the trustees of that settlement can do to prevent it from being set aside, provided the trustee in bankruptcy has proper grounds for the application.
Settlements are still vulnerable to being set aside even after the expiry of the initial two year period, though the scope for setting them aside is rather more restricted than in that period
If a Settlor has transferred assets into a settlement under which his spouse, relative, husband or spouse of the relative, or business partner is a beneficiary, and a petition for the Settlor’s bankruptcy is presented within five years of the settlement, the trustee in bankruptcy can apply to set aside the settlement, again without showing that the Settlor intended to prejudice his creditors (ss.341(2), 435 (2), (3), (8) Insolvency Act 1986). Under these provisions, though, the trustees of the settlement can resist the application to set aside if they can prove on the balance of probabilities that the Settlor was solvent at the time of the settlement. In other words, it is not for the trustee in bankruptcy to prove the insolvency of the Settlor; it is for the Settlor’s trustees to prove that he was solvent.
It is for this reason that in my view it is highly desirable for the trustees of an express trust to take reasonable steps to satisfy themselves, at the time of the creation of the settlement (or at the time of transfer of funds into the settlement, if that takes place at a later date) as to the Settlor’s solvency.
Position of trustees
The Trustee may be concerned to know whether or not there is anything that he can do, at the time of the settlement, to prevent it from being set aside at some future date under the insolvency provisions. The trustee will be powerless to prevent this happening if the Settlor’s dominant purpose in creating the settlement was to frustrate his creditors (or if that was substantial objective of the settlor – see above). In particular, there is nothing that can be done to guard against the possibility of a s.423 application, or against the possibility that the Settlor may be declared bankrupt within two years of the settlement.
Getting the Settlor to declare in writing what his intentions are in creating the settlement (or more accurately, on placing money into the settlement) may however be of some assistance. If the Settlor’s declared reasons for creating the settlement are set out at the same time as the settlement is created, that will of course constitute nothing more than an additional evidential hurdle for the creditor to overcome if he seeks to argue that the real intention of the Settlor was to defeat the interests of his creditors. It would be by no means a shield against applications by creditors; after all, nobody would expect a Settlor to declare in writing at the time of the settlement that his dominant purpose in creating the settlement was to conceal his assets from his creditors.
There is however some scope for the Trustees to reduce the risk of the settlement being set aside in the event of the Petition for the Settlor’s bankruptcy being presented between the second and fifth anniversary of the placing of the relevant funds into the settlement. As we have seen, where the Petition for bankruptcy is presented within this three year `window`, the settlement will not be set aside if the trustees can prove that the Settlor was solvent at the time the funds were transferred into the settlement.
For this reason, professional trustees may wish to make discreet and tactful enquiries as to the Settlor’s means and resources, before considering whether or not to agree to act as trustees. Since the advent of the Financial Services Act 1986, investors and purchasers of financial products have become used to filling in elaborate forms containing myriads of questions about their personal financial circumstances. It may be therefore that the average Settlor will be well used to providing this type of information. Of course, there is no way of guarding against the possibility that the Settlor may have been economical with the truth in describing his liabilities, but at least it is better for the trustees to have some contemporaneous information, rather than none, if and when the Bankruptcy Petition is presented and the creditors start to knock at the door of the trustees.
There is a good argument for the trustees being entirely frank with the Settlor as to the reasons for their requiring this information. A Settlor could be told that, if he were to be declared bankrupt between two and five years from the date he transfers funds into the settlement, he could save the trust fund (and that of his intended beneficiaries) a great deal of expense if, at the time of the settlement, he were to provide the trustees with detailed information to demonstrate his solvency. The more detail the Settlor provides at the outset, the easier it will be to dissuade any would be creditors from trying to set aside the settlement in due course. If the Settlor provides no information as to his solvency or otherwise at the time of the settlement, he ought to be warned by the trustees that if he has a Bankruptcy Petition presented between two and five years from the date of the settlement, the trust fund would almost inevitably have to bear the (perhaps considerable) costs of proving that he was solvent at the time of the settlement.
Trustees costs where settlement set aside
Until relatively recently, it has been difficult to advise trustees as to their prospects of being able to recover their own costs in the event of a successful attack on the settlement by the Settlor’s creditors. The difficulty stems from the fact that there are two conflicting lines of authority.
The harsher of the two lines of authority states that trustees cannot take their costs from the trust fund, where the Settlor has been found to have defrauded his creditors, even if the trustee did not participate in the actions, and did nothing more than agree to submit to the order of the Court. In those circumstances, the limit of the Courts generosity to the trustees was to decline to make an order for costs against them. If however the trustees were perceived by the Court to have stepped out of line (for example, by refusing a reasonable offer to resolve the proceedings) they would be ordered to pay the loss. This line of authority starts with Townsend v Westcott then proceeds through Elsey v Cox, and Crossley v Elesworthy to Tanqueray v Bowles.
According to the other, more generous, line of authority, not only were the trustees allowed their costs out of the trust fund on an indemnity basis, but the beneficiaries were allowed their costs as well. This line of authority was tightened up somewhat in Merry v Poundall where it was doubted that the trustees had a right to indemnity; the view was expressed that the trustees costs were a matter for the Courts discretion. Provided the trustee took part in the proceedings merely as a stakeholder, and agreed to abide by whatever order the Court made, he could have his costs from the settlement.
The modern view seems to be that provided the trustees remain neutral and allow the `rival parties` (i.e. the Settlor’s creditors, and the beneficiaries) to fight their battles without the trustees taking sides, they should expect to recover their costs from the trust fund. In Alsop Wilkinson (a firm) Neary & others, Lightman J stated that the view that the trustees of a settlement had a duty to defend actions challenging the validity of the settlement and whatever the outcome were entitled to their costs out of the trust fund, was not correct nor in accordance with modern authority. The trustee had a positive duty to remain neutral and to offer to submit to the Court’s directions. It appears from Lightman J’s judgement that the best course of action for the trustees to take is to wait until issue is joined between the competing parties (i.e. creditors and beneficiaries), and to make a Beddoes application to the Court for guidance as to how to proceed. Premature Beddoes applications are likely to fail, as are applications for pre-emptive costs orders (i.e. an order that the trustees may be entitled to their costs in the anticipated proceedings, come what may).
The outcome of the application in Alsop Wilkinson v Neary is a salutary lesson for trustees. The trustees’ application failed, leaving the trustees to bear the costs themselves (with no recourse to the trust fund), as the Beddoes application was made in the course of the contentious proceedings between creditors and beneficiaries, rather than in separate proceedings; and the `necessary parties` (i.e. the creditors and the beneficiaries) were not before the Court on the making of the application. Furthermore, in refusing the trustees’ application for a pre-emptive costs order Lightman J sounded a further warning note for trustees. He said that where the trustees actively defend and lose in litigation resulting from creditors’ attempts to have the settlement aside, the trustees will have to pay their own and the other parties’ costs, without an indemnity from lien against the trust fund.
The trustees’ best prospects of being able to avoid personal liability for costs, and of recovery of their costs from the trust fund on an indemnity basis, will arise through observing the following principles:-
If a creditor of the Settlor applies for an order setting aside the settlement, do not take sides as between the creditor, the Settlor and the beneficiaries.
As soon as the creditors commence litigation, make a Beddoes application to the Court.
Make sure that your Beddoes application is brought in separate proceedings.
Make sure that all parties concerned are before the Court on your Beddoesapplication (i.e. make sure that you serve them with notice of the application – you do not actually have to compel their presence before the Judge).
Do not be tempted to make a `pre-emptive costs` application, however comforting you think the idea of blanket immunity for your own costs in advance of any litigation may be.
There is, in truth, little the trustee can do, at the time of the settlement or thereafter, to obviate the risk of the settlement being set aside at the instance of an aggrieved creditor. As we have seen, Parliament has given the frustrated creditor a significant armoury with which to attack an existing settlement made by the bankrupt. One can see the moral justice of this approach. Although the Court will no doubt consider itself to be under a duty to balance the interests of the competing parties, and in particular the creditors and the beneficiaries, it seems likely that the Court will in most if not all instances allow the interest of the creditors to prevail. As Lightman J said in Alsop Wilkinson v Neary .
`it seems to me that justice requires that the Settlor be just before he is generous, and that his assets should be available for his creditors before they are available for himself and his family`.
If that is to be the guiding principle – and I do not seek to suggest that it should not be – then it is easier to understand why trustees will find the integrity of settlements difficult to protect in the event of the Settlor’s later bankruptcy.
The prudent trustee can at least comfort himself that his own interests will be protected, albeit potentially at the expense of the beneficiaries. Provided he remains strictly neutral, and ensures that he makes the correct type of application at the correct time, the trustee ought in most if not all cases to be entitled to look to the trust fund for his costs in the event of any litigation concerning ownership of the trust assets following the bankruptcy of the Settlor.
Secondly, the prudent trustee can take steps at the outset, designed to minimise the prospects of a misconceived application by a creditor, by obtaining as much information that he can as to the Settlor’s solvency at the time the settlement is created.
Of course, there will be cases where the Settlor is declared bankrupt after the settlement, and the funds in the settlement are insufficient to meet the trustees legal costs. It may well be that the prospect of having to expend irrecoverable sums of money on seeking the guidance of the Court in a Beddoes application will deter the more cautious of trustees from accepting trusts where the value of the trust funds is unlikely to cover their own litigation costs. The smaller the trust fund, however, the less likely it will be that disgruntled creditors will make aggressive applications to set the settlement aside. If the Settlor is bankrupt, and his pre-bankruptcy settlements are small in value, the creditors victory would be Pyrrhic indeed if the litigation costs involve in setting aside the settlement exhausted the trust funds.
1  FLR 696
2  2 BCLC 306
3 Lloyds Bank Ltd v Marcan  1 WLR 1387, Arbuthnot Leasing International Ltd v Havelet Ltd (2)  BCC 636, Moon v Franklin  BPIR 196
4 Tanqueray v Bowles (1872) LR 14 Eq 151
5 (1841) 4 Beav 58
6 (1858) 26 Beav 95
7 (1871) LR 12 Eq 158
8 Goldsmith v Russell (1855) 5 DeGM & G 547, Ponsford v Widnall (1869) WN 81
9  1 Ch 306
10  1 All ER 431
11 Re: Beddoe  1 Ch 547
12  1 All ER 431 at 437f