The decision in Mezhprom v Pugachev, which was handed down on 11 October 2017, has potentially wide-ranging ramifications for trustees and the private client industry more generally.
Although the judgment is a first instance decision and may be appealed, the approach taken by the judge in this case to the analysis of powers conferred on protectors is an important development.
In particular, the decision makes it clear that, as a matter of construction, the same powers may be considered personal in the hands of one protector but become fiduciary in the hands of another protector. The case may also be said to pave a smoother path for claimants to challenge the validity of a trust on the basis that the settlor retains so much control that the true beneficial ownership of assets has not transferred to the trustees, even in circumstances where a sham cannot be proven.
Sergei Pugachev is a Russian entrepreneur, and the founder of what was once Russia’s leading private bank (Mezhprom). During the global financial crisis, Mezhprom received emergency assistance from the Russian Central Bank. The claimants (including the Russian deposit insurance agency (DIA), an arm of the Russian State) asserted that a significant proportion of the funding provided was misappropriated by Mr Pugachev, and could be traced to trusts settled by him. Mr Pugachev claimed that the Russian State’s pursuit of him was politically motivated, and resisted the claims.
The claimants brought three alternative claims:
- the trusts were “illusory” and Mr Pugachev had not therefore successfully divested himself of beneficial ownership of the assets (in fact the judge did not favour the term “illusory” and dealt with this claim as a matter of construction); or
- the trusts were shams and Mr Pugachev remained the beneficial owner of the assets; or
- in the event that the first two claims failed and Mr Pugachev was not the beneficial owner of the assets, s.423 of Insolvency Act 1986 (transactions defrauding creditors) should be applied to set aside their transfer to the trustees, thereby returning the assets to Mr Pugachev’s estate for the benefit of his creditors.
The judge found for the claimants in respect of all three claims. The decision in respect of the illusory trusts / construction claim is undoubtedly the most interesting element of the decision, but the court also provided some useful clarification of the circumstances in which a sham may be established.
Although all of the trusts were declared under self-standing trust instruments, the judge found that they were identical in all substantive respects, and any differences (for example relating to a power held by the protector of the trust owning an indirect interest in a London property to direct the sale of that property) did not affect the analysis. He further found that, although the majority of the assets had notionally been settled on trust by Mr Pugachev’s son, Viktor, Mr Pugachev should be treated as the settlor of the trusts as the assets emanated from him and Viktor was in effect acting as Mr Pugachev’s nominee.
The trusts, which were expressed to be discretionary, held assets largely for the benefit of Mr Pugachev, his partner and their minor children.
The trusts were governed by New Zealand law and set up with the assistance of a New Zealand solicitor, Mr Patterson. Mr Patterson and his wife were directors of the companies that acted as trustees. These were private trust companies and, before the trial in this action, the trustees had been removed with the agreement of the New Zealand court. The approach that had been taken by the New Zealand court suggested that it considered the trusts to be neither illusory nor shams, but the judge in England dealt with this inconsistency with his own findings by pointing out that the facts given to the New Zealand court were deficient (and in some cases wrong).
Mr Pugachev was the protector of each of the trusts, with Viktor named as successor protector. The trust deeds provided that Mr Pugachev’s protectorship would automatically terminate in circumstances where he was “under a disability”, a term which included when Mr Pugachev was subject to the claims of creditors. The protector’s powers were unusually extensive (although not uniquely so) and included powers to:
- veto the distribution of income or capital from the trusts;
- veto the investment of the trust funds;
- veto the removal of beneficiaries;
- veto any variation to the trust deeds;
- veto the release or revocation of any power granted to the trustees;
- veto the early termination of the trust period;
- appoint and remove trustees, with or without cause;
- add further beneficiaries; and
- veto an amendment to the trusts by the trustees.
In light of these extensive powers it is difficult to see how the trustees could act without the consent of the protector on any matter likely to affect the trusts in an important way. That being said, save in the case of the powers to appoint and remove trustees and to add further beneficiaries, the powers were principally negative. The trustees initiate, the protector approves – that is the theory.
The “illusory” trust claim
A critical issue analysed in detail in relation to this claim was whether or not the powers held by the protector were fiduciary or personal. If fiduciary, Mr Pugachev would be under a legal obligation to exercise them in the best interests of the beneficial class as a whole and not for his own selfish purposes. As such, in settling the trusts, Mr Pugachev may be said to have divested himself successfully of his beneficial ownership in the trust assets.
The judge found that, on the basis of the facts of this particular case, the powers were personal and not fiduciary. As such, Mr Pugachev was not bound to consider the interests of other beneficiaries in exercising his powers and he could act selfishly in his own interests. Given the extensive nature of his powers as protector, he could in practice block any action he did not like and remove any trustee who refused to do his bidding. As he was also a beneficiary, he could therefore ensure that the trust assets were held for his benefit alone.
Under those circumstances the judge held that Mr Pugachev had not divested himself of beneficial ownership of the assets when settling the trusts. The proper construction of each trust instrument was therefore that the assets were, in effect, held by the trustees on bare trusts for Mr Pugachev, offering him and the assets no protection from his creditors.
In classifying the protector’s powers, the extensive and wide-ranging nature of the powers conferred on the protector were clearly highly relevant. However, of equal relevance was the fact that Mr Pugachev was not only the settlor, but also the protector and a beneficiary of the trusts. Mr Pugachev, as settlor, had vested in himself the protector powers and, as a beneficiary, he could be expected to act in his own best interests in exercising those powers.
The decision makes it clear that whether or not a power is personal or fiduciary is not simply a question of the nature of the power or of the breadth of the powers conferred. In theory then, the same powers may be considered fiduciary in one case and personal in another, or may be considered personal in the hands of one (self-interested) protector but become fiduciary in the hands of another protector, who has no beneficial interest in the trust assets.
In reaching his decision, the judge noted that he considered the term “illusory” to be somewhat misleading and unhelpful. It was clear that Mr Pugachev wanted to create a trust and he did, in fact, create a trust; he just did not succeed in creating it on what, on the face of it, appeared to be the express terms of the trust deeds. It has been rare for trusts to be construed as illusory by the courts. There have been findings in certain cases as to illusory trusts, but in circumstances where the settlor was also the trustee.
In this case the judge, marking somewhat of a departure from past authorities, was clear that his conclusion on this claim was not the same thing as a finding of sham: In his view, on a true construction of the trust deeds, the powers conferred on Mr Pugachev as protector were personal and the trusts (albeit not shams) did not successfully divest Mr Pugachev of the beneficial ownership he had in the assets transferred into them.
The "sham" claim
In order for a trust deed to be a sham, it must be created with an intention to mislead. The judge did not consider the trust deeds in this case to be shams because they fulfilled Mr Pugachev’s true intention as settlor not to divest himself of control of the assets. There was therefore no difference between the trust documentation and Mr Pugachev’s intentions.
However the judge stated that, if he was wrong as to the construction claim and the proper approach to construction of the trust deeds was that the protector’s powers were fiduciary (with that, in turn, leading to a conclusion that Mr Pugachev did divest himself of control of the assets), then the trust deeds were alternatively a sham. This is because, in this scenario, there would have been a difference between the trust documentation (which successfully divested control) and Mr Pugachev’s intentions (which were to keep it).
A potential difficulty the claimants faced in the sham claim was demonstrating that the trustees had an intention common with Mr Pugachev to mislead (since in order for a sham to exist, both parties to a deed must intend to create a sham). In considering what constituted a common intention, the court held, applying family cases such as A v A, that reckless indifference as to what is being agreed is enough to constitute common intention. On this basis he found that Mr Pugachev intended to use the trust deeds to create a false impression as to his true intentions and the trustees went along with that intention recklessly and thus could be said to have a common intention.
This case may well be one which in time is seen to be restricted to its own facts, which are on any view quite unusual and fairly stark. In particular, this case was one of many involving Mr Pugachev and the Russian State in various jurisdictions. In other such proceedings, Mr Pugachev had been handed down a sentence of 2 years’ imprisonment for contempt of court, a sentence he had not served by virtue of being resident outside of the jurisdiction.
Nonetheless, the approach to the construction of the trust instruments and the sham doctrine in this instance is interesting and will carry lessons for the future. Perhaps the most important lesson is that settlors must be alive to the risk that the retention of excessive control over a trust arrangement (whether through the use of a protectorship regime, which on its face appears to create a fiduciary office, or in some other way) may lead to successful claims by third parties that the settlor has never successfully alienated the relevant assets.
Such risk is not limited to the finding of a sham: A third party may now be able to attack a trust on the basis that, on an objective interpretation of the trust deed, the settlor retains the beneficial interest (and without needing to prove a common intention to deceive). Such third parties could include the tax authorities of a relevant jurisdiction, meaning that the trust loses its advantages from a fiscal perspective. That point may be critical in circumstances where the new post-6 April 2017 trust protections regime for non-domiciliaries who are deemed domiciled in the UK is in place.
An interesting question will be the interaction of this decision with the reserved powers laws which many non-UK jurisdictions have introduced into their trust legislation. These explicitly permit the reservation of extensive powers to the settlor, and it is unclear whether an English court would respect those powers in a case similar to this. The fact that the powers were permitted under local law was not the issue in this case. However, the interplay between local law, and the attitude of an English court, particularly to reserved powers, remains an open question. The safest approach must be to limit reserved powers where possible.