TRACING INTO TRUST FUNDS

Mona Vaswani points out some of the issues involved when there is a need to trace assets
which have come into the hands of a trustee
(taken from Issue No 17 –  October 2001

 

The law of constructive trusts and tracing has given rise to some of the most significant litigation in the last decade. Its allied area, the law of restitution, is now recognised as a separate area of law and is regarded as one of the most controversial and important weapons in the courts’ armoury to protect victims of fraud.

The purpose of this article is to examine the way in which claims can affect corporate trustees and to provide a brief user-friendly framework in which trustees can deal with the problems they are most likely to encounter.

But first, some observations on the claims that may be made on the assets held by a corporate trustee. Suppose that a fraudster defrauds a victim of money and then invests the money in a unit trust. To make a claim, a victim of fraud will have to give the court grounds for its imposing a constructive trust. Before a constructive trust may arise, there must be certainty of subject matter in relation to the assets of the proposed constructive trust. A unit trust or investment trust will own securities in various companies. These securities are not specified as attributable to any one beneficiary. The trustees hold them as a whole for the beneficiaries as a whole and not in specie for any individual beneficiary. This has important implications for the sorts of claim that a corporate trustee may face. Because the assets are held for the beneficiaries as a group, someone tracing into the fund will not be able to lay claim to any securities in a specific company on the basis that his money was used to purchase those particular securities. The victim will initially be claiming ownership of the benefit of the debt currently owed by the corporate trustee to the fraudster. As we shall see, however, this does not mean that a claim will necessarily be limited to the value of the original debt. How then would the debt’s ownership be determined? To answer that question, one must consider some key concepts and look at the tracing process.

Proprietary and personal claims:
The victim will seek the return of his money either from the fraudster or from a third party who has received the money directly or indirectly from the fraudster. Claims which are based upon the victim’s allegation that the defendant is holding money which the victim still owns are called `proprietary claims`.

In other circumstances, where the defendant has received and benefited from the victim’s money but no longer has it, the victim may claim an amount equal to the defendant’s receipt or benefit.

Common law and equity:
Corporate trustees will be familiar with the two separate systems under English law of common law and equity. The rules of common law recognise legal interests in money whilst the rules of equity recognise beneficial or equitable interests.

The court will apply tracing rules to decide whether the money that the defendant holds or has received is the same money that the victim of the fraud parted with (and can therefore potentially be reclaimed). The victim’s claim will be a `tracing claim`. The victim will have to demonstrate his tracing claim using either the common law tracing rules or the tracing rules of equity depending on whether he alleges that he retains legal ownership or has an equitable interest in the money.

Common law or equitable claim?
Under the common law tracing rules the victim of fraud very soon loses legal title to the money that was taken from him when it passes through the banking system. When he ceases to be the legal owner of the money, the victim may still be able to claim an equitable interest in it under the tracing rules of equity. If he can, then this will create a potential `constructive trust` situation, where someone who receives money that he knows he should not have (a `constructive trustee`) can be treated as holding the legal interest only. The money will be regarded as trust money and the beneficial interest in it will belong to the victim who can claim its return.

Personal or proprietary claim?
Sometimes the victim of a fraud will have the choice of pursuing a personal claim or a proprietary claim. For example, where the defendant has purchased an asset with the victim’s money, the victim may choose between claiming ownership of the asset in a proprietary claim (`ratifying` its purchase by the defendant) or pursuing a personal remedy against the defendant for the amount that he received.

The victim’s choice between a proprietary or a personal claim will usually depend upon the following factors:

(i) If the asset has increased in value, the victim will more easily be able to claim the profits if he has a proprietary claim against the defendant as opposed to a personal claim only.

(ii) If the asset has fallen in value, the victim may wish to pursue a personal claim for the amount the defendant received, as opposed to the return of what he retains. This does, of course, depend upon the defendant having enough of his own money to pay a personal claim.

(iii) If the defendant is insolvent, the victim will usually pursue a proprietary claim to obtain priority over other creditors. If the money that the defendant holds belongs to the victim, it follows that the defendant has no right to use it to pay his debts.

It is possible to pursue common law, equitable, personal and proprietary claims at the same time. The victim will not usually have to choose between them until judgement in his action.

Tracing Money at Common Law
The rules of English common law aim to protect the victim’s legal title. The common law tracing rules will be applied to establish that he retained legal title at the time the defendant received the asset.

Suppose A has a bank account. B, a fraudster, draws a cheque on A’s account, withdraws cash and pays it into his own bank account. B then draws a cheque on his own account and gives it to C, who pays it into his account.

The process which started with A’s money being taken from him and ended with C’s account being credited involved A’s money changing form several times. Originally, it was a debt owed to him by his bank. It was then converted into cash, then to a debt owed by B’s bank, then into a cheque and then finally into another debt owed by C’s bank. Despite these changes, the common law tracing rules will recognise that the money in C’s bank account is the same money that was taken from A. A will be the legal owner of the money and will be able to claim its return, unless C can raise a defence.

However, under the common law tracing rules, legal ownership of money is lost when it is mixed with money which belongs to someone else. The money is said to have become `currency` and is the legal property of the person who holds it.

Suppose, for example that C’s account had been in credit by £20,000 before he received A’s money:

Once A’s money was mixed in C’s account, the credit balance would no longer be regarded as A’s property under the common law tracing rules but would instead belong to C. A would have only a personal receipt based claim against C and not a proprietary claim.

If C is a corporate trustee then the money he receives from B, the fraudster will go into a mixed account in which money from other investors is kept. A, the victim, will then only have a personal receipt based claim against the trustee for the money.

Following the other half of the transaction between the fraudster and the trustee, if the fraudster kept the money unmixed in his own account and then receives an interest in the unit trust of the trustee in return for the money of the victim, A would be able to claim that interest at common law. He would be entitled to the whole of the interest even if this were of greater value than his original loss.

Tracing Money in Equity
Whilst third parties, such as corporate trustees, might acquire a legal interest in the money, the victim may still be able to maintain a proprietary claim to it on the basis that he has an equitable interest in it under the tracing rules of equity.

The tracing rules of equity are more useful to a victim of fraud than the common law tracing rules because (unlike legal title) equitable title is not lost merely because the plaintiff’s money has been mixed with money that belongs to someone else. Often the victim will have an equitable charge or `equitable lien` over the mixed fund. For practical purposes, this is often no different from saying that he owns part of it.

To succeed in an equitable tracing claim, it is necessary to show (i) that the money was `trust money`; and (ii) that there is a `proprietary base`. The victim’s money will be regarded as trust money if it was held under a fiduciary duty, when he parted with it. The fiduciary duty can exist either (i) because of the relationship which the victim had with the fraudster prior to the fraud (in a case of embezzlement); or (ii) through the circumstances in which the fraudster obtained the money from the victim (in a case of trickery or sharp practice).

In addition to the fiduciary relationship between trustee and beneficiary (as between a corporate trustee and investors), Equity recognises the following fiduciary relationships: agent and principal, partner and partner, solicitor and client, and director and company. Cases of embezzlement by agents or directors, for example, will therefore give rise to breach of fiduciary duty and the money taken will be trust money. It is important to remember, however, that the above list is not exhaustive. Whilst, for example, a director is his company’s fiduciary, others lower in the corporate hierarchy may also be fiduciaries. The point is important since an estimated 80% of frauds have some inside involvement.

Alternatively, the fiduciary duty can arise through the circumstances in which the fraudster obtained the money i.e. by trickery or sharp practice. This might arise:

(i) where the fraudster tricks the victim into entering into a contract with him. In an `advance fee fraud`, for example, the victim is tricked into entering into a contractual loan or commission arrangement, or a `boiler room fraud`, where large numbers of victims are tricked into buying worthless shares; or

(ii) where the fraudster tricks the victim into believing that a contractual payment is due when it is not. This might happen, for example, when a fraudster presents forged documents to a confirming bank under a letter of credit or issues a fraudulent demand under a performance bond; or

(iii) where the victim makes payment under a contract which the fraudster knows he can never perform. This might happen, for example, where the fraudster is trading whilst insolvent and receives an instalment payment to purchase goods which cannot be delivered; or

(iv) where there is no contract with the fraudster. For example, the fraudster might suggest that he is collecting for a fictitious charity or diverts a payment to himself which was intended to go elsewhere.

In all of these cases, the money may be regarded as trust money at the time, or after, it is received by the fraudster.

The victim must next establish a proprietary base. He will not be able to say that the defendant is holding his money (in a proprietary claim) or has received it (with a personal claim) unless he can show (i) that it was the victim’s money to start with; and (ii) that the defendant has received the same money. There is generally no difficulty in showing that a particular sum of money belonged to the victim at the outset and courts are prepared to be flexible if the victim ought to have received the money but in fact never did.

The next question is whether the victim can claim that the defendant received the money that the victim owned or which was subject to an equitable charge in the victim’s favour. If the money has remained `pure` throughout, then this will not be difficult. If, however, it has been mixed with other people’s money then the victim will still be able to claim an equitable charge over the credit in the bank account. It is under this process that the victim may seek to claim money held by the corporate trustee. The principles described below are best divided into three separate rules.

Rule 1: The mixed fund rule
Suppose B defrauds A of a sum of money, say £100,000, and pays it into his bank account, which is in credit by £50,000.

The entire mixed fund is subject to an equitable charge for the repayment of £100,000 with interest to A. The fact that A has an equitable charge over it gives him a priority over general creditors in his claim for £100,000 if the fraudster becomes insolvent.

Rule 2: The rule in Re Hallett’s Estate
More difficult questions arise where some of the money has been spent. Suppose, in the above example, B then debits the account by £100,000.

He is deemed to have spent his own money first, and so the remaining £50,000 is subject to an equitable charge. This is because he is not allowed to argue in his own favour that he behaved improperly by spending someone else’s money before he spent his own.

Rule 3: The rule in Re Oatway
Rule 2 above (`the rule in Re Hallett’s Estate`) works in the victim’s favour, but the victim can waive it if he wants. If the fraudster’s account has been exhausted first by withdrawals to acquire assets and second by withdrawals which are dissipated, for example on living expenses, the victim will be able to claim the assets first purchased as the product of his money. The relevant interest might be an interest in a unit trust purchased by the fraudster.

Suppose the fraudster’s bank account contains a mixed fund:

Suppose £50,000 of the balance is then invested in units in a unit trust.

A second withdrawal of £100,000 is then made, which is dissipated.

If the victim chooses, the interest in the unit trust will then be subject to an equitable charge in his favour.

In cases of professional fraud, money is invariably `cascaded` into smaller parcels and then mixed with other money in the laundering process. Imagine then that B defrauds A of £100,000. He puts it into an account with £50,000 of his own money. At this point, as we have seen, proprietary common law claims will fail. B then takes out £100,000 and invests in a unit trust scheme with the money. He then dissipates the remaining £50,000. Although, under Rule 2, B will be deemed to have taken out his own money first, (i.e. £50,000 of his own and £50,000 of A’s) A can elect, under Rule 3, to claim the interest in the unit trust as the product of his money. The question is then whether he can claim only such interest in the scheme as equates to his original debt of £100,000 or whether he can claim any profit that has been made. Case law indicates that he will be entitled to any profit.

Conclusion
As can be seen, the tracing rules that can affect trust funds are complex. This area of the law has largely developed over time on a case by case basis. Given the increasing incidence of fraud, it is likely that we will see further legal developments in relation to the law of tracing.

Mona Vaswani
Partner
Asset Tracing & Fraud Group
Allen & Overy