When Trusts Go Wrong, Part 2


The other day I was reading a legal newsletter sent me by a brother. The newsletter was from Brookfileds Lawyers and went on to say: - 


 How Exposed is a Trust to the Economic Fortunes of the Settlor?

When a trust is established it usually begins its life with no assets.  The assets are typically acquired by the trustees borrowing, either:

  • from the settlor by means of an interest free loan; or
  • from a financial institution with the settlor (not the trustees) meeting loan repayments.

This means the economic health of the settlor and the trust are intertwined from the beginning.  In good times there are no problems with such arrangements but in the current economic situation there is the real possibility that, if the settlor experiences hard times, the trust may not be able to meet its financial obligations.


Issues for Trustees

Issues for trustees arising out of such circumstances may include:

  • the settlor is no longer employed or the settlor's business has failed and therefore has no cashflow to continue servicing the trust's financial obligations.
  • loan repayments that were being made by the settlor on behalf of the trustees are not being paid.  The trust has no cash resources itself to make these payments and the trustees may find themselves personally liable to make the loan repayments.
  • the trustees may have given a guarantee and/or security for loans made to the settlor by typically, a bank.  The trustees, by entering into these obligations, may be securing against trust assets all the borrowings of the settlor, including such things as credit card debt.  The trustees may find that they are liable for all the debts of the settlor and his/her family to the bank.

Trustees and the Settlor Beneficiary

In making decisions the trustees are required to balance the differing needs of the beneficiaries, including children who are beneficiaries.  The trustees, in making such decisions, must give consideration to relevant factors and exclude from their consideration matters which are irrelevant, which may include the pressing financial needs of one beneficiary.  Trustees cannot be criticised if they appear to prefer the claims of one beneficiary over another but this preference must be based on a proper exercise of the trustees' powers.

Although the settlor may have been funding the trust, the trustees have an obligation to all the beneficiaries of the trust.  The settlor's position as "funder" does not give him or her any special rights or consideration under the terms of the trust deed.

The trustees may be forced to sell the family home to repay outstanding debt.  Is this in the best interest of the family, who are likely to all be beneficiaries of the trust?

The settlor may make demand for repayment of the outstanding loan made by the settlor to the trustees.  Do the trustees have the funds to repay?  Would they ever have had the funds to repay without selling the family home?  If the terms of the settlor loan do not restrict the right to make demand for repayment, the trustees may have no way of protecting the assets of the trust.

The trustees may be under pressure from the settlor to make a distribution from the trust to the settlor in the settlor's capacity as a beneficiary.  In such a case the trustees must balance the settlor's needs with those of the other beneficiaries.  For example, will it help child beneficiaries if their parents receive the trust's assets in order to avoid bankruptcy?


Obligations to Beneficiaries

The obligation to consider the needs of all the beneficiaries of the trust is a fundamental aspect of a trustee's obligations.

Trustees are charged with what is termed an "irreducible core of obligations".   These obligations require the trustees to perform the trusts as set out in the trust deed honestly and in good faith for the benefit of the beneficiaries.  This irreducible core of obligations applies to all trustee actions.  Trustees, when exercising any powers granted to them under the trust deed, must consider this duty to do all things for the benefit of the beneficiaries.  This is what the trustees must turn their minds to when making trustee decisions.

The trustees may often find themselves in a position of conflict with the settlor, who in his/her position as "funder" of the trust consider they have some special rights to the trust assets.  However the trustees must consider all the beneficiaries and their respective needs and requirements


Settlor Bankruptcy

It is upon the bankruptcy of the settlor that the extent of the interdependence between the trust and the settlor can be exposed.  A debt owed by the trustees to the settlor is an asset of the settlor and therefore the Official Assignee ("OA") can step into the settlor's shoes and demand repayment. 

The OA may also investigate the operation of the trust.  In a recent case (Official Assignee v Wilson (2008)) the OA sought to overturn a trust by having it declared as a sham and/or the alter ego of the settlor as he had controlled the trust. 

The trust had been settled by Mr R who was neither a trustee nor beneficiary of the trust.  The OA argued that four property transactions entered into by the trust were invalid because the transactions were carried out at the direction of and in the interest of Mr R.  The OA claimed this was evidenced by:

  • the sale of a trust property to Mr R;
  • the trustees borrowing more funds than required to purchase a property and the additional funds being used to repay Mr R's personal debts;
  • Mr R's attempt to use the trust property as security to raise money for his personal use;
  • the poor administration of the trust.

The Court of Appeal held that the evidence did not indicate that the trust was a sham.  The Court held that a sham trust arose where there was a common intention between the settlor and the trustees to create a trust that was not genuine.  The Court held that the documentation in this case was consistent with the intent to create the trust.

Although the sham argument did not succeed, which highlights the protection a trust can provide, the Court did criticise the shambolic way in which the trust was administered.  The Court considered that the poor management and administration of a trust may be evidence of a breach of trust.  This is more concerning for trustees, as if there is a breach of trust which results in a loss to the trust fund, it is the trustees personally who may be liable to make up that loss.


Avoid a Shambles

In hindsight there may be questions raised as to why some trusts were ever established, particularly when there was little or no possibility of any benefits being received by beneficiaries because of the precarious financial situation of the trust. 

The current economic difficulties will result in a greater degree of investigation of trusts – their structures, administration and management.  These investigations will be undertaken with a high degree of vigilance, whether it be an investigation by the liquidators, the Official Assignee, the Inland Revenue Department, other Crown agencies or beneficiaries.

In our view the real risk for trustees is not from a sham trust, but from a trust that is a shambles.  Trustees must take care with ongoing trust administration. Good trust administration with decisions properly recorded and annual accounts being prepared will assist if a trust is under investigation (but then how often do people really want to do this?).