In an important judgment published last week, the Royal Court of Jersey has provided guidance to trustees and other holders of fiduciary powers in relation to the exercise of powers when a trust is considered to be “insolvent”. Counsel in the case was unable to find any relevant authority on this subject in any other trusts jurisdiction, so this may well be one of the first cases to deal with this issue.

Whilst noting that to talk about a trust being insolvent, as such, is strictly a misnomer, since a trust is not a separate legal entity and cannot as a matter of law be insolvent, the Court noted that it was a useful shorthand, and provided its guidance accordingly. The case concerned the purported exercise by the settlor of a trust of a power to appoint additional trustees. The trust had a number of creditors, including the settlor herself, and others including some connected to settlor’s family or to other trusts established for the family. Unconnected creditors were current and former trustees. The court used the word “creditor” in the sense that claims were being asserted against the trust, although such claims had not been admitted in any formal insolvency process.

The court confirmed the principles to be applied in relation to the exercise of fiduciary powers, including the circumstances in which a fraud on the power can arise, and reiterated the observation of the court in the Jersey case of Re Bird Charitable Trust that the various examples cited in that case “are really all examples of the underlying principle that a power [can] only be exercised for the purpose for which it was conferred and in accordance with its terms.”1

The court also confirmed that a fiduciary is under a duty to act in the best interests of the person to whom the fiduciary obligation is owed and in concluded that that “once there is an insolvency or probably insolvency of a trust, the trustee and all those holding fiduciary powers in relation to the trust can only exercise those powers in the interests of the creditors.”

This is an important point. Insolvency brings about a shift towards the interests of the creditors, so that it is the creditors as a class (and not a majority of them) rather than the beneficiaries who have the economic interest in the trust. As to the test for insolvency, the court confirmed that in a case such as this, it is the cash-flow test that applies, as for an individual or a company, i.e. that the trustee is unable to meet its debts as trustee of the trust out of the trust property, as they fall due.

The fact that the trust’s assets may exceed its liabilities on the balance sheet test is irrelevant as would normally be the case with a deceased’s estate, for example - creditors cannot be expected to wait until the assets are realised. 

The analysis may be different with a commercial or structured trust arrangement where it is likely that a trustee will have fewer discretionary powers and the interests of creditors will likely be more prominent because of the commercial nature of the structure. 

Having found that the power to appoint new trustees, held by the settlor, like all other fiduciary powers in relation to the trust, had to be exercised in the interests of the creditors as a whole, the court considered that it had to ascertain objectively the settlor’s purpose and intention in exercising it. Her own evidence showed that the purpose of appointing the two new trustees was, through majority voting, to enable her chosen trustees to take control of the trust, and this in her interests and those of the beneficiaries and the majority (connected) creditors. The appointments were therefore not made in the interests of all of the creditors of the trust and the fact that a majority of the creditors consented to the appointment did not assist. Accordingly the appointment of the additional trustees was set aside.

In summary:

  • In the context of a trust, the test for insolvency is the cash-flow test.
  • Once there is an insolvency (or probable insolvency) of a trust, the trustees and all those holding fiduciary powers (protectors and the like) can only exercise their powers in the interests of the creditors.
  • For that reason, a trustee of an insolvent trust would be wise to exercise its powers either with the consent of all of the creditors, or under the guidance of the Royal Court of Jersey.