Consequences of `Shams` for Trustees : An Overview
Richard Wilson takes a critical look at the risks for trutees in lending money to beneficiaries of discretionary trusts as part of IHT saving schemes
(taken from Issue No 14 – January 2001)
Most corporate trustees will be aware of the IHT saving device which involves the establishment of a nil rate band discretionary trust by a testator, combined with additional provisions permitting the executors to satisfy the legacy creating the trust by accepting a binding promise from the surviving spouse (one of the beneficiaries) to pay the sum to the trustees, thereby leaving the sum at the disposal of the surviving spouse.
The advantage of such an arrangement is clear from an IHT perspective: the surviving spouse is permitted to use and enjoy the trust property without being deemed to have an interest in possession in the trust property which as a consequence is not deemed to form part of the surviving spouse’s estate upon his or her death. This type of arrangement avoids the creation of rights such as those which caused the problems in Lloyds Private Banking v. CIR as it is open to the trustees (theoretically at least) to demand payment of the sum due from the spouse, or seek the recovery of the trust property which is in his or her possession. The word ‘theoretically’ is used as more often than not the debt is left outstanding until the death of the surviving spouse.
From a tax planning perspective, therefore, arrangements of this sort are extremely attractive, as they enable the full nil rate band to be used upon the first death, yet also enable the surviving spouse to have full use of the nil rate band trust assets without the creation of an interest in possession. The popularity of the scheme is therefore not surprising.
However, the position of the trustees is not so straightforward. They find themselves in the somewhat curious position of having the entirety of the trust fund ‘invested’ in a debt owed by the surviving spouse, which invariably yields little or no interest or capital growth. The question which this article considers is whether as a consequence they are in breach of their duties concerning the investment of the trust fund.
Before considering the problems which arise, it is necessary to set out in more detail the mechanics of the scheme itself2.
The testator gives the full amount of the nil rate band to the Will Trustees `on trust to invest it in exercise of the powers of investment given to them …`. This is supplemented by certain additional provisions. The first of the additional provisions enables the executors to require the trustees to accept in place of all or any part of the sum representing the nil rate band a binding promise of payment from the surviving spouse. In order to secure this promise, they may charge all or any part of the sum on any property given by the will to the spouse absolutely. In addition the trustees are given the power to lend any money held by them to the spouse.
These basic provisions are amplified by further, administrative provisions. The key provisions are that the trustees may require security for any debt created (by the acceptance of the binding promise by the spouse and/or any money loaned by them to the spouse, or by the charging of the spouse’s property). All debts created are expressed to be repayable by the spouse upon demand by the trustees. Further, the trustees may impose such terms (if any) as they think fit as to interest and as to the spouse’s personal liability. The trustees may also leave the debt outstanding for as long as they think fit, and refrain from exercising their rights in relation to it and waive the payment of all or any part of it or of any interest due.
Finally, considerable protection for the trustees is included in the will by way of an exoneration clause which provides that the trustees are not liable if the spouse is (or becomes) unable to repay the debt; if any security which has been required from the spouse becomes inadequate; or for any other loss which may occur through the exercise (or decision not to exercise) any power given. It is the last of those exemptions which is the widest and perhaps the most important in this context.
It is not difficult to see the way in which the additional powers are used in practice: the legacy is invariably satisfied by the acceptance of a binding promise by the spouse (sometimes secured, sometimes not) in respect of which interest is not payable (or perhaps payable at the rate of inflation). Repayment is often required only upon the death of the spouse.
Potential Breaches of Duty
(1) The Duty to invest the trust fund.
It is trite law that trustees are under a duty to invest the trust assets and that a failure to do so will render the trustee liable to account for the loss caused by such failure3. The question to be considered is therefore this: if the trustees leave the trust fund in the hands of the spouse (albeit in return for the creation of a debt), are they ‘investing’ the trust fund? The answer will depend upon the terms upon which the loan is made.
The definition of an investment in the trust context is not a particularly clear one. Historically, the definition of an investment has been drawn widely. In Re Wragg4P.O. Lawrence J stated that:
‘the verb `to invest` when used in an investment clause may safely be said to include as one of its meanings `to apply money in the purchase of some property from which interest or profit is expected and which property is purchased in order to be held for the sake of the income which it will yield`; whilst the noun `investment` when used in such a clause may safely be said to include as one of its meanings `the property in the purchase of which the money has been so applied.`’5
In Re Wragg, P.O. Lawrence J was not seeking to give an exhaustive definition of the terms ‘invest’ or ‘investment’, and therefore it would be a mistake to assert that investments must be income producing, and indeed this has been recognised in later authority6 which has shown that an ‘investment’ may produce capital growth as opposed to income7
On any analysis, however, it would seem that it is necessary for an ‘investment’ to yield (or be intended to yield) some return for the trust, whether it be income or capital. Whether the debt created in the case of a loan to the spouse constitutes such is, of course, a question of fact in each case. Where the trustees require the spouse to pay interest on the sums advanced, the debt will almost certainly be within the definition of ‘investment’ as an interest bearing chose in action. Indeed, the amount of interest payable will be of minimal importance in this regard: if there is some income being produced it will constitute an ‘investment’ though perhaps not a very good one for the trust.
In situations where interest is not charged, and there is no provision for any repayment of an increased capital sum by the spouse, it is extremely difficult to see the debt created is an investment. Accordingly the trustees would appear to be guilty of a prima facie breach of their duty to invest the trust fund. The trustees are, however, saved from exposure to a claim by the other beneficiaries by virtue of the clause which provides that they may impose such terms, and/or leave the debt outstanding for as long as they think fit. Such a clause clearly extends the trustees’ powers so as to permit them to make a loan on whatever terms they choose, and for whatever period. It therefore negatives the duty to invest the trust fund which the trustees would otherwise be subject to. Therefore notwithstanding the fact that the loan may not constitute an ‘investment’, the trustees will not be culpable for making it.
(2) Duty to act fairly or without undue partiality
Although the making of a loan to the spouse is permissible whether or not it constitutes an ‘investment’, it does not follow that it will always be appropriate for them to make such a loan, particularly where it is made on especially favourable terms as to interest, repayment and security. The mere presence of powers in a trust does not, in itself, justify the exercise of them as trustees are subject to what is in effect an overriding duty to act `… in the best interests of the present and future beneficiaries of the trust…`8 The beneficiaries’ best interests will, ordinarily (but not always), be their financial interests9. Most importantly of all, the powers given to trustees must be exercised `..fairly and honestly for the purposes for which they are given and not so as to accomplish any ulterior purpose..`10
Where the trust fund consists of a loan to one of the beneficiaries at a favourable rate of interest (for example, at the rate of inflation), can it be said that the trustees are acting in the best interests of the beneficiaries as a whole? In my view it must be doubtful. Of course there is no duty upon trustees to actimpartially between beneficiaries1 but what they must do is act fairly, or withoutundue partiality2.
The making of the loan to the surviving spouse does not, in itself, mean that the trustees are acting without the requisite degree of fairness or with undue partiality. Again, this is a question of fact. Whilst the making of a loan at a discounted (or even nil) rate of interest is clearly conferring a benefit upon the spouse over and above the other beneficiaries, the trustees may be entirely justified in conferring such a benefit. If they do so, however, they must ensure that they go through the appropriate decision making process. This process requires them to consider all relevant factors, and to exclude irrelevant, improper or irrational factors. Any challenge to the choice made by the trustees must be based on the impropriety of that decision, not merely the result.
In making the decision, one factor which is likely to be of particular relevance is the relative financial positions of the various beneficiaries. If it can be shown that the spouse is in clear need of preferment on financial grounds the trustees will have a sound justification for so preferring her. Also of relevance will be any reference to the spouse being ‘principal beneficiary’ or any other direction that the spouse’s interests be considered paramount by the trustees. It almost goes without saying that where the testator has effectively set out a hierarchy amongst the beneficiaries, the trustees cannot be criticised for complying with it. But, in circumstances where the trustees cannot find reasons to justify favourable treatment being given to the spouse, doing so may well constitute an act of undue partiality, and result in the other beneficiaries seeking to call the trustees to account.
(3) The duty of care
Trustees are under a duty to take reasonable care and skill when investing the trust fund. Prior to 1st February 2001, beneficiaries could rely upon the equitable duty of care and skill: for a trustee to act with the diligence and care expected of the ordinary prudent man of business13. With the commencement of the Trustee Act 2000 on 1st February 2001, comes a new, statutory duty of care, whereby trustees are expected to act with the care and skill considered to be reasonable in the circumstance. Of particular relevance are the special knowledge and expertise which a trustee holds himself out as having4, and where the trustee is acting in the course of a business or profession, any special knowledge or expertise expected of a member of that business or profession5.
The extension of the trustees’ powers so as to enable them to make the loan to the spouse on such terms as they think fit, and for such period as they think fit will not serve to absolve them of their duties of care and skill. The presence of a power does not enable it to be exercised negligently16. Thus trustees must ensure that they do not merely accept the loan as having been made and thereafter neglect to consider the position of the trust fund and its investment. As noted above, it may well be appropriate for the trustees to make or keep such a loan, but doings must be the result of a conscious decision to do so, justified by reference to the relevant circumstances as noted above. A failure to react to a change in the circumstances (e.g. the spouse receiving a sudden cash windfall) may leave the trustees open to a claim for breach of their duty of care.
In the foregoing discussion I have identified two instances where trustees appear to be susceptible to claims by beneficiaries in relation to investment duties. The position is further complicated by the use of exoneration clauses in the standard precedent. The first of these clauses, extending the trustees’ powers to enable the loan to be made has been dealt with above. However the precedent contains further clauses excluding the trustees liability for losses occurring: (a) if the spouse is or becomes unable to repay the debt; (b) if a security is or becomes inadequate; or (c) for any other loss which may occur through the exercise or choosing not to exercise any power.
The exoneration clause is clearly intended to have a wide scope, but it is important to note that all such clauses are to be construed contra proferentem, that is to say against the person seeking to rely upon them7. As a matter of construction it would seem that the exoneration clause will be sufficient to exclude liability for a loss caused through exercising the powers in a way which is held not to be fair as between the beneficiaries (e.g. granting an interest free loan where it is unfair to do so). But, as regards breach of the duty of care, it would seem that trustees will often still be liable. Whilst a careless or negligent exercise of the power will fall within the scope of the clause (‘when exercising…’) if the trustees’ breach is a failure to consider the position of the trust investments, and thereby leaving the loan outstanding longer than they should, they are neither ‘exercising’ nor ‘choosing not to exercise’ the powers referred to: they are merely neglecting to manage trust investments with the requisite care and skill. Consequently the terms of the exoneration clause will not protect them.
A further headache for the trustees is caused by the decision of Millett LJ (as he then was) in Armitage v. Nurse18. The decision in Armitage is notable in two respects: firstly it clarified the permissible scope of trustee exoneration clauses i.e. that all liability except for dishonest conduct may be excluded; and secondly it established that where trustees rely on the presence of an exoneration clause as a justification for acting in a way which is not otherwise permissible or in breach of duty, they act dishonestly and consequently lose the protection of the exoneration clause.
The second aspect of the decision is extremely important in relation to the arrangements being discussed here. When considering the issue of fairness or undue partiality, the trustees cannot consciously act in a way which breaches the duty outlined above, relying on the presence of the exoneration clause which is wide enough in scope to protect them as to do so will, on the basis of Armitagebe dishonest. Therefore the only case in which the trustees will be protected will, in fact, be where they seek to make a decision as to what is a fair application of the trust fund but fail to do so. They cannot consciously act unfairly or in a way which is unduly partial.
One further, important point to note in relation to exoneration clauses is that the law relating to them is likely to become more restrictive. During the passage of the Trustee Act 2000 through Parliament the Lord Chancellor gave an undertaking to refer the issue of trustee exoneration clauses to the Law Commission19. Proposals have already been made by the Trust Law Committee to restrict the permissible scope of such clauses20 and prevent professional trustees from relying upon them2. Clearly, if such a reform would have serious implications for the potential liability of trustees carrying out the arrangements discussed in this article.
The arrangements discussed in this article are clearly attractive to testators and their spouses from an IHT perspective, however there are issues of considerable importance for trustees which they must be aware of. Trustees cannot afford to neglect their duties to act fairly and without undue partiality, or their duty of care. Whilst the inclusion of exoneration clauses is intended to protect them in this regard, the scope of the clauses, coupled with the decision in Armitage v. Nurse means that the protection given is far from complete. Consequently, trustees who accept appointments for trusts of the sort dealt with in this article should think very carefully about the scope of the duties to which they are subject and take the necessary steps to ensure compliance. A failure to do so will bring the possibility of disgruntled beneficiaries and litigation – a troublesome combination for the trustee.
Barrister of 9 Stone Buildings, Lincoln’s Inn.
1  STC 559
2 The scheme may be found in many mainstream works, many incorporating precedents for use by the draftsman. In this article I have based my observations on the precedent provided by the Butterworths Wills, Probate and Administration Service
3 See Stafford v. Fiddon (1857) 23 Beav 386; Moyle v. Moyle (1831) 2 Russ & M 710.
4  2 Ch. 58.
5 ibid. at 64-65.
6 See, for example, Harries v. Church Commissioners  1 WLR 1241 at 1246D per Sir Donald Nicholls V-C.
7 This is of course something familiar to trustees, especially where a settlement has a life tenant and remainderman, and consequently investment has to produce a fair balance of income and capital growth.
8 Cowan v. Scargill  Ch 270 at 286H-287A per Sir Robert Megarry V-C.
9 ibid. at 287B.
10 ibid. at 288D-E.
11 See Edge v. Pensions Ombudsman  3 WLR 79 at 100.
12 See Nestle v. National Westminster Bank  WTLR at 795; Edge v. Pensions Ombudsman  3 WLR 79. See also John Mowbray QC: Choosing Among the Beneficiaries of Discretionary Trusts  PCB 239 for a full discussion of what is meant by the term ‘undue partiality’.
13 See Speight v. Gaunt (1883) 9 App Cas 1.
14 Trustee Act 2000, s.1(1)(a).
15 ibid. s.1(1)(b).
16 See Paul Matthews: The Efficacy of Trustee Exemption Clauses in English Law  Conv. 42.
17 See Photo Productions v. Securicor  AC 827.
18  Ch.241.
19 Hansard, 14th April 2000, para. 394.
20 Trust Law Committee: Trustee Exemption Clauses, June 1999