BY MATTHEW SMITH, GENERAL COUNSEL
Q: When is a trust not a trust?
A: When it isn’t treated like a trust.
In recent years, courts have shown themselves ever more willing to scrutinise the inner workings of trusts and assess in detail how they are managed and operated. They have also been increasingly prepared to invalidate trusts in which the settlor has retained such a level of effective control that the trust has lost the essential features that make a trust a trust. This line of case law should stand as a warning to trust settlors who choose to retain total control over trust assets, treat those assets as their own, deal with them without recourse to the trustee and seek to instruct the trustee only when it suits them, otherwise keeping the trustee in the dark. Such settlors may well find that the asset protection trusts they have paid so much to set up and maintain will not withstand judicial scrutiny and will no longer offer effective protection.
Background
The idea that a settlor of trust assets must relinquish control over those assets to their trustee in order for the trust to be effective is not a new one. The creation of a trust requires, and always has required, a transfer of legal ownership of property from the settlor to the trustee, who then has a fiduciary responsibility to hold and manage that property for the benefit of the trust’s beneficiaries.
Harking back to core principles of trust law, it is nearly two centuries since the common law test of the ‘three certainties’ was laid down in the 1840 case of Knight v Knight[1], which remains good law today. Knight solidified the principle that the words of a trust agreement, taken in conjunction with circumstances in place at the time of a trust’s creation, were required to evidence the settlor’s intention to create a trust – referred to as the ‘certainty of intention’. In the absence of such evidence of a settlor’s intent, a trust would fail.
A key case in this area that was to follow Knight after 150 years of incremental case law developments was that of Rahman v Chase Bank (CI) Trust Co Ltd (1991)[2]. In that case, a trust settlor had retained extensive powers over the trust fund, including the power to distribute it to himself. A Jersey court struck down the trust as a sham and held it to be invalid because of the extent of power and control that the settlor had retained over the trust assets. The fact that the settlor did not treat the trust as a trust, but rather as a holding entity for his own funds which he could manage for his own benefit as he pleased, showed that he did not have the requisite intent to create a genuine trust, and the trust therefore failed under Knight principles.[3]
The 1990s and the Rise of the Asset Protection Trust
By the time the Rahman decision had been handed down, a number of offshore jurisdictions had already introduced ‘reserved powers’ legislation in order to facilitate the operation of what was regarded at the time as a new trust ‘product’ – the asset protection trust. Such reserved power provisions[4] explicitly served to displace the presumption set down in cases such as Rahman that the exercise of other trust officer roles by a trust settlor could, in and of itself, concentrate too much power in the hands of the settlor and invalidate a trust.
As asset protection trusts gained more prominence and acceptance, the pendulum swung in favour of trust settlors being permitted to retain more extensive control over trust funds than had previously been the case. In the 1999 case of FTC v Affordable Media[5], the Cook Islands High Court upheld the validity of a trust in which the settlors had also occupied the roles of beneficiaries, protectors and co-trustees.
(It should be noted that this was not without significant cost to the settlors, however. In related US proceedings[6] in which they were ordered to exercise their power as co-trustees to repatriate trust assets, they were judged to have engineered their own removal as co-trustees, following which they claimed that they could no longer carry out the repatriation. The US court held that they had created their own impossibility and they spent six months in prison for contempt of court until the proceedings were settled. 23 years later, this case stands as a salutary warning to anyone considering acting as a co-trustee of their own asset protection trust.)
Substance Over Form
If it looks like a duck, and it quacks like a duck, then it’s probably a duck.
More recently, the pendulum has swung back towards Rahman. Courts have sent a clear message that in order to be a valid trust, a trust must in fact be operated like one. It must pass the judicial ‘sniff test’. Recent cases have seen trusts subjected to extensive scrutiny by the courts, which have peered beneath the veneer of the trust agreement to take a closer look at how trusts actually function and how the people involved in their operation interact. A key part of this exercise has been to assess not just what powers the settlor has retained, but how the settlor has exercised them, whether the settlor has exercised them in their own favour, and whether the settlor has effectively usurped the trustee’s control over the trust fund. There has been a noticeable prioritisation by the courts of substance over form.
In the 2017 case of Mezhprom Bank v Pugachev[7], the High Court of England and Wales ruled five New Zealand trusts to be invalid and held that the assets held by those trusts were still to be regarded as the personal property of the settlor/ultimate beneficial owner and therefore available to his creditors. In echoes of Knight, the court found that the settlor/UBO had lacked the requisite intention to create the trusts because of the extent of the powers and controls he had retained over the trust assets. The court judged that the trusts were more akin to nominee arrangements than trusts, and that their true effect was not to transfer ownership of assets from the settlor to the trustee, but to obscure the fact that the settlor had retained de facto ownership and control of them.
The Court was also critical of the corporate trustee of the trusts and of its effectively having turned a blind eye to the management of companies in which the trusts held shareholdings, as well as its lack of knowledge as to the assets and financial situation of those companies. The Court called time on this practice and issued a reminder that trustees have a common law duty to exercise effective oversight of companies held within a trust. If a light-touch approach which allowed a trust settlor to manage a company and deal with its assets without ever being accountable to the trustee, the company owner, ever had been acceptable, it no longer was.
A further important development came in 2020 in the case of Webb v Webb[8], in which the Privy Council ruled that two Cook Islands domestic trusts established by a settlor who occupied multiple roles in respect of those trusts were invalid due to the extent of the powers over the trust fund which the settlor had reserved to himself. The settlor was the sole trustee of the trusts and also occupied protector and beneficiary roles. He was empowered to distribute the entirety of the trust fund to himself if he so wished.
In considering not just the existence of those powers but how the settlor exercised them, the Privy Council ruled that the settlor had arranged matters in such a way that he held the trust fund on trust for himself and no-one else. As a result, all legal and beneficial interest in the trust fund was vested in the settlor. The Privy Council also ruled that the powers the settlor had reserved to himself were so extensive that, in equity, he could be regarded as having rights which were indistinguishable from ownership. As a result, the establishment of the trusts had failed to record an effective alienation by the settlor of any part of the trust fund, which was therefore fully exposed to a matrimonial property claim against the settlor.
Conclusion
You can’t have your cake and eat it too
It has been posited that the judgment in Webb would have been different had the Cook Islands trusts in question been Cook Islands international trusts, rather than domestic trusts, given the extensive reserved powers legislation set out in the Cook Islands international trust legislation[9]. However, this is to overlook the fact that the legislation provides only that a trust will not be invalidated by the mere fact of a settlor occupying multiple trust officer roles, or having certain powers. In practice, it’s going to come down to what the settlor does with those powers that will determine whether or not a trust is valid. Given the current direction of travel in the case law and the recent tendency of courts throughout various common law jurisdictions to cleave to long-established core principles of control and intention, it appears that times have truly changed.
It appears then that the days of a trust settlor being able to wield ultimate effective power over a trust and its trustees, and using a trust as a means to an end, a piece of window dressing to access an asset protection product while they treat and deal with trust assets as their own, without trustee oversight, are over. An asset protection trust which superficially ticks all the right boxes by having a separation of powers in the trust agreement but which is effectively controlled by the settlor (either directly or through their attorney), using a compliant and malleable trustee as a rubber-stamper rather than an objective professional decision-maker, will most likely prove little more than a very expensive mistake.
For anyone looking to use an asset protection trust as a truly effective asset protection strategy, a proper, proactive, pre-emptive, and fully independent trustee is a must. Rather than seeing the trustee as some kind of adversary, or perhaps a necessary evil, from whose prying eyes information must be withheld as much as possible, trust settlors should actively work in partnership with their trustee to create a mutual understanding, respect and synergy that will not only build trust and confidence but provide the best asset protection money can buy.
Because without a trustee, there is no trust.
If you wish to discuss the establishment or maintenance of a trust by a professional trustee, please get in touch with your regular Southpac contact or contact us here.
[1] (1840) 3 Beav 148
[2] [1991] JLR 103
[3] For a more detailed assessment of sham and nominee trusts, see our previous article here.
[4] See, for example, the Cook Islands International Trust Act 1984 s 13C
[5] Otherwise known as ‘the Anderson Case’
[6] 179 F3d (9th Cir 1999)
[7] [2017] EWHC 2426 (Ch), analysed in greater detail in our previous article here
[8] [2020] UKPC 22, explored in depth in our article here
[9] International Trusts Act 1984, s 13C
