October 30, 2019 Vibha Vallabh

PASSIVITY IS NEITHER PROTECTION NOR DEFENCE

BY VIBHA VALLABH

It is a truth universally acknowledged that the settlor of a trust should not meddle in trust affairs. The tussle between settlor desire for control and proper trustee independence is an ancient one.

The role of trustee is somewhat precarious at the best of times, and yet, trust fundamentals remain unchanged since the Crusades. Over the course of time, the adoption of new fashionable industry practices has seen this creature evolve in order to accommodate the settlor’s every whim. But settlor desire has come a cropper in two recent legal judgments. However with a bit of inventiveness, settlor desires can accommodate traditional fundamentals and vice versa.

Both cases provide insight into the approach taken by the courts with regard to passive trusts, and perhaps serve as a warning of things to come as more courts adopt the precedents set by these two cases. This is particularly relevant, as law governing the trusts in both cases exist, even though courts in different jurisdictions held sway over their outcomes.

Going Back to the Fundamentals

The first case is Mezprom Bank vs Pugachev [2017] EWHC 2426 (Ch).

Pugachev is a Russian oligarch who lived in London. He is the settlor, beneficiary, as well as the protector of five New Zealand trusts settled by declaration. The total value of assets held in the trusts was US$95m at the date of judgment.

Pugachev founded Mezprom Bank in Russia in 1992.. During the GFC, the bank went into liquidation. The bank was declared bankrupt and the Russian Court ruled personally against Pugachev for the sum of US$1bn. The Russian order was recognised by an English Court pursuant to the Cross Border Insolvency Regulations 2006. The Claimants applied for an order in England to bring the trust assets located in England within the scope of a worldwide freezing order. This was initially refused but upon appeal was successful.

The Hon. Mr Justice Birss did not consider the trusts to be shams, and instead looked at their true effect. He concluded that the settlor never had the intention of creating the trusts because of the extensive powers Pugachev held within them; which could, if used, ensure that the assets reverted back to him. The trusts were merely dressed up as nominee or agency agreements because Pugachev did not divest his interest in the assets to the trusts, they always remained Pugachev’s personal property, leaving the door wide open for the Claimants to enforce their Russian liquidation order.

In coming to this conclusion, the Judge focused on the substance of the trust over form and on the following:

(i) He considered Pugachev to be the ultimate beneficial owner of the trusts, despite his son also settling assets into them. He did not think that Pugachev’s son would be in a financial position to contribute such assets and, in fact, concluded that he was acting as nominee for his father.

(ii) Under the trust deed, Pugachev had the power to direct the sale of the residential property.

(iii) The Judge observed that trust deeds often include a protector (as these trusts did), which may provide for the power to remove and appoint trustees, and a power of negative consent. However, in this case, he considered the Protector had both those powers and then some more. Such powers are not fiduciary in nature but they can be; this issue was considered irrelevant. Instead, the distinction should be made as to whether the protector, who is also a discretionary beneficiary, could lawfully act in a selfish way in favour of himself and against the interests of other discretionary beneficiaries, compared with a power which could only be exercised properly for furthering the interest of discretionary beneficiaries.

(iv) The Judge thought that the powers given to Pugachev as protector were personal as, in substance, the deeds allowed Pugachev to retain his beneficial ownership of the assets. If the protector’s powers were limited and ceded control of the assets to the trustee without the power to get them back, then he would not be the beneficial owner of the assets.

(v) The fact that the power of removal of trustees was expressed to be “with or without cause” is significant. The Judge was critical of this point, saying that by the deed stating that the removal of a trustee may be without cause seems to negate any idea that the power is subject to a limitation of any kind. Context is important: had the protector not been the settlor (nor discretionary beneficiary), then he could see that the words would not have been read the same way.

(vi) In considering substance over form of the trusts, the Judge found that the trusts fulfil Pugachev’s true intention, which was to retain control of the assets. The Judge found that at all material times Pugachev regarded all the assets in the trusts as belonging to him, and intended to retain ultimate control. The point of the trusts was not to cede control of his assets to someone else; it was to hide his control of them.

As a side note, the Judge was critical of the evidence provided by the director of the New Zealand corporate trustee. He pointed out that although the trustee knew of the assets held in the trust, it had no knowledge of what was occurring in relation to them. The trustee sought reliance on the fact that, strictly speaking, the trust assets were just shares in a company, which ultimately held the property. The Judge said that this will not do. It does not reflect the manner in which the trustee actually undertook its duties at the time because the deeds do not include an anti-Bartlett clause to oust the trustee’s duties to inquire into the affairs of trust-owned companies.

Inventiveness Gone Wrong

 The second case of note is Zhang Hong Li and another v DBS (Hong Kong) Ltd and others, CACV 138/2017 which was decided in Hong Kong. The trust was established in Jersey with a Jersey trustee (DBS Trustee). The trust held a British Virgin Islands holding company (Wise Lords), which held a portfolio with DBS Bank. The holding company had a corporate director (DHJ Management) and a nominee director (DBS Corporate). The investment advisor to the holding company was one of the co-settlors (Ji).

The holding company took a high risk approach to investments, namely various foreign exchange products. The portfolio was leveraged with a loan from DBS Bank. To begin with, the portfolio was making a profit; however, by August 2008, the loan was US$96.37m which amounted to 73% of the total portfolio value of US$131.8m. In the aftermath of the GFC, there was a net reduction of 70% of the holding company’s net asset value. The settlors successfully claimed against the trustee, corporate director, and nominee director of the holding company, for breach of trust. The trustee was not permitted to rely on indemnity provisions within the trust deed on grounds that the trustee’s breach of duty had directly caused the loss of trust assets, which directly led to a diminution in the value of assets held by Wise Lords’ portfolio. Where it had been found that there was a breach of trust, the liability was gross negligence and remained personal to the trustee, therefore as such cannot be transferred to the current trustee.

Both the lower court and appeal court found that the trustee was negligent in its duty of care with regard to the trust assets, despite the trust agreement having an anti-Bartlett provision. This would ordinarily mitigate this duty if the assets were managed by someone else, thus not requiring the trustee to conduct business of the trust with the same care as an ordinary, prudent man of business would extend towards its own affairs. However, this did not occur in this case. The court imposed a higher standard of duty: the trustee must exercise a high-level supervisory role.

The Appeal Court, a panel of five judges, held that whilst the trustee had no duty to pre-approve each investment made by the holding company before Ji made it, the trustee and the director of the holding company had high-level supervisory roles to override Ji’s investment decision made by the holding company beforehand. This is despite the fact that neither the trust deed nor the law required this.

The Judges explained that the trustee ought to have exercised overarching supervision; regularly monitoring and being responsible for ensuring that the value represented by the overall trust fund was subject to appropriate control, review, investment expertise, and management. They noted that the trustee never reversed any of the 519 transactions that had been entered into by the holding company.

They also noted that the purpose of the trust deed did not match the investment risk, which the documents reflected was for confidentiality, caring for children, succession planning, and avoidance of estate duty and asset protection.

It held that although the trustee had an anti-Bartlett clause that stated the trustee has no obligation to obtain information regarding the holding company, it still should have done so as a shareholder of it.

The high-level supervisory duty arises when the trustee chooses not to exercise the power to interfere in the business of the company, or elects not to seek information when no reasonable trustee should refrain from doing so. The failure to do so amounts to a breach of trust. Therefore, the trustee should have approved the investments [not approved] with the power to override the investment advisor’s (co-settlor) decision and reverse the transaction she advised for the holding company, rather than everyone doing as she had commanded.

The Court found that not only did the trustee fail to discharge a high-level of supervisory duty over the investments made by the holding company, but the nominee director of the holding company failed to discharge its duty as director. They further found that the trustee was liable for the acts and omissions of the nominee as they considered them their agent, and not an administrative conduit despite the fact that the trustee was not always informed of their actions.

It also said that the trustee’s breach of duty had directly caused the loss of the trust assets, in that they directly led to the diminution of the value of assets held by Wise Lords’ portfolio. These breaches of duty had directly led to the losses being suffered by Wise Lords’ portfolio.

Additionally, the trustee failed to perform the role it had assumed and a high-level of supervision, in order to ensure that the trust asset is subject to appropriate control. The task to be performed by the trustee involved more than rubber-stamping the transactions.

Finally, the Court said that it was a matter of common sense that, to properly discharge the task, the trustee must have at least kept itself informed of the prevailing financial conditions. The financial crises did not happen overnight. The trustee ought to have exercised more caution before giving approval for the impugned transactions.

The Court considered the function of the corporate manager of the holding company, including its nominee company and its actions, was tantamount to either wilful misconduct on their part, or by such acts of omissions, DHJ acted in such a negligent manner that could be described as “serious and flagrant.”

The Court held that DBS Corporate, as nominee director of Wise Lords, owed the duties of a director to Wise Lords despite only providing directorship services pursuant to a Services Agreement. It has to discharge its duties as a director, to act bona fide in the best interests of the company, and exercise reasonable care, skill, and diligence in the performance of their functions and management of the company’s affairs.

Therefore, the directors of Wise Lords, DHJ, and DBS Corporate were the same person, despite DBS Corporate being its agent, just as the Court found that DHJ and the trustee also were. DHJ breached their duty of care as a director. A director has fiduciary obligations to act bona fide in the interest of the company. This breach of duty amounts to gross negligence directly caused loss of the assets held in Wise Lords’ portfolio.

Despite DHJ and Ji entering into a Services Agreement, the Court held that DHJ could not rely on the indemnity provision therein to exempt it from liability, because their actions constituted gross negligence on the part of DHJ and that of their agent, DBS Corporate.

A director has fiduciary obligations to act bona fide in the interest of the company. This breach of duty directly caused loss of the assets held in Wise Lord’s portfolio.

In comparing the structural and management styles of the trust in the DBS case, the approach is very similar to what the settlor and trustees do, namely:

(i) The trust deeds have an anti-Bartlett provision (this is legislatively provided for in certain jurisdictions);

(ii) The assets of a trust are held by a holding company which are administered passively by the trustee, without knowledge of the trustee;

(iii) It provides corporate directors of the holding company, which also acts passively in its role;

(iv) It provides nominee directors, which also acts passively in its role;

(v) The trustee, director of the holding company, or nominee director do not carry out a high level of supervision when all parties choose not to exercise the powers to interfere in the business of the company, or seek information when no reasonable trustee should refrain from doing so.

(vi) The assets held in trust are not subject to appropriate control, and the trustee rubber-stamps transactions.

It is interesting to query whether the Court would have decided differently had not all the parties to the structure been in house and part of DBS Bank. Monitoring each other would have been impractical if all parties to the structure were independent of each other. Would they have been equally liable? Who would have been held liable?

The Way Forward

How the trusts were managed and administered in the above cases is not unusual. Often, industry practice takes a passive approach to managing trusts assets, placing measures that allow a trustee to do so. As indicated by the two significant cases noted, the courts are becoming less tolerant of such practices, and any protection the trustee may have had from mitigating their risks through adoption of a passive role may no longer hold.

Adjusting for the approach of those cases, trustee companies must take a more active role in managing trusts by adopting practices that allow this to occur. This may include, but is not limited to, the following:

(i) The trustee must take a high level supervisory role of a trust where the parties (trustee, corporate director, or nominee director) choose not to exercise their powers to interfere in the business of the holding company.

(ii) The trustee must seek information on the assets from clients and take an active role as a shareholder of the holding company ought to.

(iii) Any corporate director or nominee director provided by the trustee company must take a more active role as a director of a company ought to.

(iv) Transactions must not be rubber-stamped on a no-questions-asked basis.

(v) Trustee company databases must reflect full information on the assets being administered, including those held by holding companies.

(vi) Indemnity agreements must be entered into with the settlor and the beneficiaries of the trust for each transaction.

(vii) Widen the anti-Bartlett provision by excluding trustee liability for (withholding) not withholding approval for investments recommended by the investment advisor.

(viii) State protector’s powers being fiduciary so they are not personal.

(ix) Before on boarding of a client, if it appears that the settlor has too much control to an extent that the trust assets could revert to him/her if they exercise their powers, then a warning notice must be sent to the client informing them of this.

(x) Generally, trustee companies should start implementing measures where they, as trustees, take a more active role as opposed to being passive.

If the risk of a case being brought against the trustee, for a breach of trust, will be reduced; and chances that an order of restitution will be made against the trustee, personally, would be slim.

The Pugachev and DBS cases show that a settlor cannot have their cake and eat it too. Trustees should implement the above recommendations and adopt a high level supervisory role over assets held by the holding company of the trust.

How Settlors and Trustees can co-operate within traditional constraints

The following structure is devised with the Pugachev and DBS judgments in mind. It allows a client to have some degree of control, new and modern but at the same time protecting the integrity of the trust. It operates through the agency of a Nevis Foundation.

The Nevis foundation is unique, unlike those found in civil law countries where its purpose is limited. It can act as a holding or trading entity for assets which will be directly managed and administered by its board member(s). The Nevis foundation is a hybrid creature comprised of a trust and company. It operates like a company except without shareholders. The foundation must have a purpose and may also have beneficiaries that have no beneficial rights as they would in a trust so can be removed at any time especially in an event of duress.

In this structure the Cook Islands trust will be a beneficiary of the Nevis foundation. The foundation can manage its active high risk assets without having to exercise a high level supervisory role. As the foundation is not a trust, there are no fiduciary duties imposed on the management board so anti- Bartlett provisions are required.

The foundation should periodically make distributions down to its beneficiary, the trust, for safe keeping. In an event of duress at either end, the foundation simply removes the trust as a beneficiary. It can then stand alone with all the assets that were transferred to it. The trust must be administered and managed with the principles discussed in mind but the assets will be at less risk as all the activity takes place in the foundation.

The truth universally acknowledged that the settlor of a trust should not meddle in trust affairs remains unchanged, but appropriate settlor influence has obtained legitimacy by a different route.

Vibha Vallabh

Vibha Vallabh is the General Counsel for Southpac Group and is responsible for the oversight of the legal teams.
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