The introduction of ATED1 in the UK has led to more trustees of family trusts holding UK residential real estate directly, rather than via an underlying company, creating additional risks and complications for both creditors and trustees.
A BVI trust provides commercial certainty via a unique legislative framework which gives protection to both parties, allowing commercial transactions to proceed speedily and cost effectively.
As every law student learns in their first Equity and Trusts lecture, a trust is not a legal person. A trustee contracts as principal in its capacity as trustee and is personally liable on that contract.
Of course, as the same law student will also have learnt, the trustee has a right to be indemnified from the trust fund in respect of those liabilities, provided – and this is the heart of the problem – that the trustee has acted properly in accordance with the terms of the trust in incurring them. In practice, the creditor will be more interested in satisfying any claim from the trust assets and may be relieved to learn that it has a right of subrogation to the trustee's right.
So far, so good. But as subrogation is a derivative right – the creditor is substituted for the trustee with regard to the claim - it can be no greater than the trustee's right. As a result, it creates a number of significant risks for creditors because the right of indemnity depends on the trustee having acted properly. If it has not, the creditor must fall back on suing the trustee personally. That is not much help if the trustee does not have the funds to meet the claim, nor if the contract contains a provision limiting the trustee's liability to its right of reimbursement from the trust fund. It is true that the creditor might, with the aid of the same law student - now a capable trust lawyer - negotiate those provisions so that the trustee gives appropriate personal warranties and indemnities. In our experience, however, those kinds of provisions are not often included and in any event, suing the trustee personally in what will almost certainly be contested proceedings is not an attractive option.
The Risks for Creditors
Which takes us back to the trustee's right of indemnity from the trust fund and the creditor's right of subrogation to it. The trustee's liability may have been improperly incurred for any one of three reasons:
(1) Lack of capacity. The Trustee may not have had the power to enter into the agreement.
(2) Lack of due authorisation. The relevant power may not have been exercised in accordance with a procedure internal to the trust (such as obtaining the consent of a protector).
(3) Breach of equitable duties. The power may have been exercised in breach of the trustee's duties, either in relation to their powers of investment or ancillary powers (such as a power of delegation or to supervise agents or a failure to take into account relevant considerations and ignore irrelevant ones).
All three areas (and particularly the third) will require detailed investigation to ascertain whether the trustee has properly incurred the relevant liabilities. Those investigations will be time-consuming and expensive, and the depth of the required enquiries may not find favour with the trustees or the beneficiaries.
None of this is conducive to certainty in commercial transactions.
But that is not all. There are two additional risks for trustees unrelated to the transaction itself, which makes things even worse for the unsuspecting creditor:
(4) Unconnected Indebtedness of the trustee to the trust. For example, the trustees may have committed a breach of trust in relation to some other transaction which may have occurred either before or after the relevant agreement. It is impossible to eliminate this problem entirely.
(5) Change of trustees. If a new trustee is appointed, the creditor's rights against the new trustee will be derivative rights exercisable via the old trustee's right of indemnity against the new trustee, which may itself be reduced or extinguished if the new trustee is indebted to the trust for any reason.
There are two further risks for third parties receiving property from trustees:
(6) Proprietary remedy for breach of trust. Beneficiaries can assert their beneficial interest in trust property which has been applied in breach of trust (or property representing it) against third parties, via the processes of following and tracing.
A third party in receipt of trust property paid in breach of trust has a defence if it can show that it is a 'bona fide purchaser for value without notice'. But what is 'notice' for these purposes? Unfortunately, it is not entirely clear how far the doctrine of 'constructive notice' – being deemed to have notice of those matters which would have been ascertained if reasonable enquiries had been made - applies in this context. So the nature and extent of enquiries which a third party must make is uncertain. One approach2 is to ask whether there is a recognised practice of making enquiries in transactions of the kind in question, but our experience is that widely differing approaches are taken where trusts are involved,3 so even if this is the correct way forward, it does not necessarily assist a great deal.
(7) Knowing receipt. Beneficiaries also have personal remedies against third parties who receive for their own benefit trust property transferred in breach of trust, provided there is the sufficient degree of knowledge on the part of the third party. The degree of knowledge required is not settled, but similar principles are likely to apply as in the case of the proprietary remedy.
Where the trustee incorporates an underlying company and that company enters into the transactions instead of the trustee, as is traditionally the case with most family trusts, those issues are much less acute, although any ancillary obligations entered into by the trustee (such as a guarantee of a loan taken out by the underlying company) will be subject to the same rules. But there are circumstances in which this is not possible or advisable – unit trusts established for the Japanese market, for example - and ATED is now providing another incentive for trustees to dispense with the underlying company in certain circumstances.
The BVI Solution
BVI trust law provides a unique solution to these problems. Part X ("Part X") of the BVI Trustee Act (as amended) (the "Trustee Act") contains a number of provisions which address these issues providing a much greater degree of certainty and protection, both for trustees entering into commercial transactions and the third parties who contract with them.4 Part X applies to all BVI trusts created on or after 1 March 2004.
Limiting and Excluding the Trustee's Personal Liability
There are two key provisions designed to protect trustees. They only apply if the trustee has acted properly in the exercise of its powers in entering into the contract.5
Limitation of Personal Liability
Firstly, where the trustee discloses its fiduciary capacity (or the third party is otherwise aware of it) the trustee is personally liable only to the extent of the value of the trust fund when the payment falls due.6 For these purposes, the trust fund is treated as including any property which has been distributed since the contract was entered into, subject to any contrary provision in the contract.7
Exclusion of Trustee's Personal Liability Entirely
The second provision only applies if the trust expressly provides for it.8 If it does, the trustee is not personally liable at all under any contract with a third party properly entered into by the trustee in the trustee's fiduciary capacity, if the trustee disclosed that it was acting in a fiduciary capacity or the third party was otherwise aware of it.
But what if the contract is not governed by BVI law? Might there be a risk that the courts in that jurisdiction will not give effect to the statutory limitations or exclusions of liability? It is thought that the risk of that is small: the Guernsey Court of Appeal recently held that the trustee's liability to a third party in contract should be governed by the law of the trust9 but other jurisdictions may conceivably take a different view, so an express provision in the contract may be advisable to avoid this potential problem.
Protection of Third Parties Dealing with Trustees
Direct Recourse to the Trust Fund
If the trust so provides,10 the third party has direct rights against the trust fund, not by way of subrogation to the trustee's rights. The third party's rights are asserted against the trustee in its fiduciary capacity.11
Clarifying and Limiting the Extent of Third Party Investigations Required
Part X clarifies and limits the enquiries the third party needs to make.12 It does so by deeming a contract to be properly entered into by the trustee if it appears to the third party, after reasonable enquiry, that:
(a) the trustee has power to enter into a transaction of the kind in question; and
(b) if there are any requirements for the exercise of that power, the trustee has complied with them. (the "Deeming Provisions")
Importantly, it goes on to state that 'reasonable enquiry' does not extend to enquiry as to whether the exercise of the power would be in breach of any duty of the trustee, apart from any duty to comply with any requirements for its exercise. So the test should be a fairly easy one to satisfy in practice. There is no need to ensure that the trustee is not in breach of any duty in entering into the contract, so the third party can negotiate in the usual commercial manner without worrying about its having to keep an eye out for the trustee breaching its own duties.
Indebtedness of the Trustee Disregarded
Where a trustee has incurred a liability to a third party under a contract properly entered into13 by the trustee, the third party has a right of indemnity in respect of that liability against the trust fund and against distributed property or its traceable product, to which rights the third party shall be subrogated.14 In computing the amount of the indemnity, any indebtedness (unrelated or otherwise) of the trustee is disregarded. If section 97 also applies,15 the third party has direct rights of recourse against the trust fund.
In this way, the risks identified at 3 and 4 above are solved.
Protection of Third Parties from Claims in Respect of Receipt of Trust Property
Property acquired by a third party by virtue of a transaction is taken free and discharged from the trust and the creditor is not concerned to see the property acquired by the trustee from the third party if properly applied.16
Thus, provided the third party carries out the basic due diligence outlined above, it will be a bona fide purchaser for value without notice and no beneficiary will be able to assert a claim for knowing receipt or a proprietary remedy even if the assets were transferred in breach of trust, thus neatly addressing risks 6 and 7 above.
Additional Powers to Protect Creditors
Part X also permits additional powers to protect creditors to be conferred on trustees of a BVI trust.17 These only apply where the terms of the trust expressly so provide (but are routinely included in well-drafted BVI trust deeds). Where they do apply, a trustee may, for the protection of a lender who lends money or assets to the trustee, restrict or impose conditions on the exercise of:
(a) powers of investment or other powers in the management or administration of trust property;
(b) rights of beneficiaries to actual receipt of trust property to which they have or may become entitled; and
(c) powers relating to the appointment, retirement or removal of trustees.
This addresses the problems arising from future changes of trustees – risk number 5 above.
It also allows creditors to be given additional comfort that the trustee will not be able to take actions which will prejudice the creditor's rights. The creditor will have trust law remedies in respect of breaches, rather than relying solely on contractual remedies, which are, as we have seen from the above analysis, often unsatisfactory.
Trustee Statutory Charge
Another optional provision18 permits the trustee to grant security for contractual liabilities to a third party, including a "trustee statutory charge" which, unless agreed otherwise, has priority over:
(a) rights of persons under the trust;
(b) trustee's right of indemnity against the trust fund; and
(c) creditor's claims against the trust fund not secured by a fixed charge or right in the nature of a fixed security over any trust property.
It is subject to any fixed charge or right in the nature of a fixed security over any trust property and subject to any trustee statutory charge entered into at an earlier time.
By the simple expedient of using a trust governed by BVI law,19 the trustee can exclude its personal liability (provided it has acted properly in the exercise of its powers) and a creditor (provided it carries out simple due diligence on the trustee's powers and requirements for their exercise) can have direct rights of recourse to the trust fund, without having to be concerned about any breach of trust by the trustee.
This will promote much greater commercial certainty and should save everyone time and legal fees whenever trustees enter into commercial obligations directly. As we expect to see more trustees enter any contractual obligations directly due to ATED, rather than using an underlying company to do so, we expect the use of BVI trusts to grow.