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Introduction - Definition
Traditionally the following entities have been used to conduct business -
• Sole Traders
• Partnerships
• Companies
Over past recent years it has become more common for the trading entity to be a Trading Trust. A Trading Trust is a trust which is formed for the purpose of carrying on a business.
The obvious advantages of trading through such a trust are -
• The ability to distribute profits and assets to beneficiaries
• The ability to organise the tax affairs of the trust so that beneficiary income is distributed to beneficiaries at lower tax rates and thus reduce the total tax payable
• The flexibility of a Trading Trust
Trading is conducted by a trustee who carries on the business under the authority of a trust instrument.
Because the concept of Trading Trusts in New Zealand is comparatively recent there is very little literature and there appears to be no books relating to the insolvency of Trading Trusts in New Zealand. This paper discusses the insolvency of a Trading Trust from the view of an insolvency specialist. Because of the very nature of a Trading Trust it is clear that there are special considerations.
Obvious questions cover such matters as -
• In the event of insolvency is it the trust which is in liquidation or the trustee?
• What assets come under the control of the liquidator or receiver?
• Who could be made liable in respect of the insolvency of a Trading Trust?
• What is the position of a debentureholder?
• How is a Trading Trust placed in liquidation?
Liquidations and Receiverships
In all liquidations and receiverships the role of the insolvency practitioner is similar -
• The insolvency practitioner must ascertain what assets are under his/her control
• The insolvency practitioner must take those assets into his/her custody and preserve those assets
• The insolvency practitioner must realise those assets to the best advantage
• The insolvency practitioner must examine creditors and their claims and work out who those creditors are and rank them in order of priority
• The insolvency practitioner must distribute what cash he has in order of the various priorities. In the event of receivership the insolvency practitioner has no authority to pay any creditor with a lower priority than that of the debenture under which the insolvency practitioner is appointed
In the case of a Trading Trust the role of the insolvency practitioner is exactly the same. There are however, problems addressing such issues as -
• What are the assets of a Trading Trust?
• Who are the creditors of a Trading Trust?
• Who may be held liable in the event of the failure of a Trading Trust?
The purpose of this paper is to address such issues.
What is meant by the Insolvency of a Trading Trust
It is not proper for an insolvent entity to continue to trade and incur credit. Indeed any such trading might well invoke personal liability on those parties who induce the entity to continue to trade whilst it was insolvent. Because of this it is important to be able to recognise the insolvency of a Trading Trust. In the case of a Trading Trust even though trading is conducted through a trustee, the trustee will be deemed to be insolvent if the trust through the trustee cannot meet its debts as they fall due, or the liabilities of the trust exceed the assets of the trust.
The Nature of the Trustee
Trading Trusts are invariably conducted by a trustee which is a company. The reason for the trustee to be a company is that a personal trustee would have unlimited liability - a corporate trustee has limited liability.
The Nature of the Trading
All trading is conducted in the name of the trustee. In law the trust fund is not an entity. Courts will take no regard to the existence of a trust. Debts are incurred in the name of the trustee, assets are purchased in the name of the trustee, debts are discharged in the name of the trustee. The assets might belong in law to the company trustee but they are not its property in equity.
The Liability of the Trustee
The trustee is personally liable for all the trading debts incurred by him. Because the trade debts are the trustees own debts, the creditors remedy is against the trustee personally and no one else. A creditor has no direct remedy against the trust assets and these cannot be reached by process of execution. Creditors have no right of action against the beneficiaries, neither do they have any right of action against the settlor. It is the trustee who is liable to the creditors and no one else.
Liquidation of the Trustee
The corporate trustee can be placed in liquidation in the same manner as any other company and on the same grounds. The trustee can be placed in liquidation by either the shareholders or the Court. In certain circumstances the directors may place the trustee company in liquidation. The most likely reason for the company being placed in liquidation is of course the inability of the trustee company to pay its debts as they fall due.
The rules conducting the liquidation are the same as any other liquidation and the liquidator has -
• The same rights of examination of people having knowledge of the company
• The right to take action against officers of the company to make them personally liable for the debts of the company
Assets Available to the Liquidator
Assets available to the liquidator are divided into two groups -
• Those assets, if any, owned by the trustee
• Rights of indemnity
In most circumstances the trustee will own no assets and will be relying upon its indemnity from the trust.
Under the liquidation the trustee is entitled to retain trust assets for the purpose of satisfying trust liabilities. In essence, the liquidator through the trustee company has a lien over the assets of the trust. The lien has with it a right of sale.
Trustees Right of Action Against the Beneficiaries
There is a right which imposes on a beneficiary a personal obligation enforceable in equity to indemnify a trustee against liabilities incurred by the trustee for expenses properly incurred. The obligation of the beneficiary is founded on the principle that the person who gets the benefit of a trust should share its burden.
The right of action against the beneficiaries belongs to the trustee and would be available to any liquidator of that trustee. The person who has the indemnity (the trustee) is entitled to an order to indemnity as soon as his/her liability has crystallised as an actual present and enforceable debt.
It is not necessary that the trustee should have actually paid or discharged that liability before exercising the right. What exists is a true right of indemnity rather than a mere right of recovery.
The right of a trustee to be indemnified by the beneficiary exists only if the beneficiary is absolutely entitled. The right of the trustee cannot be enforced and is not available where the trust is in favour of discretionary beneficiaries. Discretionary beneficiaries cannot be made liable. If however, a beneficiary is entitled as of right and there is no discretion involved then it is clear that the beneficiary can be made liable to the trustee or to the liquidator of that trustee.
There is an exception to the general rule. If the beneficiary is an infant or a life tenant then there is no right against the beneficiary personally. For a beneficiary to be liable that beneficiary must be a beneficiary sur juris.
If there are multiple beneficiaries who are absolutely entitled then in the words of the Privy Council -
"absolute beneficial owners of property must in equity bear the burdens incidental to its ownership…"
Other cases have determined that the burden must be met in proportion to the interest.
The general rules are -
• A sole beneficiary is always bound to indemnify the trustee
• Beneficiaries who are entitled to the trust as of right are always bound to indemnify the trustees
• Discretionary beneficiaries are not bound to indemnify the trustees
• Where there are beneficiaries who are entitled to proceed to the trust as of right and also discretionary beneficiaries then only those beneficiaries who are entitled to the proceeds of the trust as of right have to indemnify the trustee
• The right of indemnity where there are several beneficiaries as of absolute right is for the beneficiaries to pay in proportion to their shares in the interest. If any beneficiary is in partnership with an insolvent beneficiary who is unable to pay, the partner is liable to meet it
• There is a general rule that if a beneficiary assigns his interest, the assignee takes the interest subject to the risk of insolvency. The assignor remains liable even after the assignment for all debts falling due after the assignment. There is a parallel to this in general insolvency law whereby it shares are transferred and there is unpaid capital in respect of those shares, then the liquidator may look not only to the present holder of these shares but to any past holder of these shares
It is possible of course to expressly exclude the liability of beneficiaries. There are circumstances, however, where such exclusion may not be binding -
• The beneficiaries might incur liability by an independent request to the trustee thus overriding the availability of the exclusion.
• The beneficiary might be stopped from relying upon the exclusion if the beneficiary has encouraged the trustee to act on the basis that the excluding provision will not be relied upon.
The question then arises as to the liability of the beneficiaries in the event of insolvency -
Young J. in McLeans v. Burns Philp Trustee Company Pty. Ltd. stated that the Courts could not allow such clauses to be "used as a cloak for fraud". His honour said:
"…where there is a discretionary trust which is so geared to enable a person to avoid his creditors by hiding behind the vehicle of the trust, equity would not allow that to happen".
It would seem that it would be prudent for the beneficiaries of Trading Trusts to be discretionary beneficiaries rather than beneficiaries who are absolutely entitled.
Right of Action Against the Trust Assets
A trustee has a right to be indemnified out of trust assets in respect of those liabilities incurred by him in the course of his authorised activities as trustee. The right of indemnity covers all costs and expenses properly incurred. Under trust laws the assets are the property of the beneficiaries. The right of indemnification is a right to resort to the assets in order to discharge the liabilities. Trust assets include both the income and the capital of the trust. The trustee through the indemnity has been shown to have a right in equity in his favour over the trust assets.
I understand that some trusts deeds state that the trustee has no right of indemnity out of trust assets. This may be effective in some jurisdictions but is not the case in New Zealand. In New Zealand there is a statutory right to trustees indemnification.
Section 38(2) of the Trustee Act 1956 states as follows:-
"A trustee may reimburse himself or pay or discharge out of trust property all expenses reasonably incurred in or about the execution of the trust or powers; but, except as provided in this Act or any other Act or as agreed by the persons beneficially interested under the trust, no trustee shall be allowed the costs of any professional services performed by him in the execution of the trusts or powers unless the contrary is expressly declared by the instruments creating the trusts:
Provided that the Court may on the application of the trustee allow such costs as in the circumstances seem just."
The wording of "properly incurred" has been suggested to mean "not improperly incurred". The trustee can lose its right of indemnity if it acts in excess of the trust powers or if it is in breech of its duty of reasonable care and diligence. This is not unlike the case of a receiver acting. Whenever a receiver accepts a position, that receiver obtains an indemnity from the debentureholder. The indemnity does not extend to cover negligence on behalf of the receiver or a breech of duty of reasonable care and diligence.
It would follow from this that in the event of a liquidation of a company trustee then the liquidator will have immediate access to the trust assets. In saying this it is acknowledged that section (2)(5) of the Trustee Act 1956 could be said to apply. This appears on the surface of it to allow parties to modify rights of indemnity. Section (2)(5) of the Trustee Act 1956 is somewhat ambiguous. The right to indemnity is not only a statutory right but a right in equity. It seems probable that despite any clause in the trust deed that the Courts would uphold the trustees right to be indemnified out of the assets of the trust. In any event the subsection talks about the powers conferred on or under the Act by a trustee. It is hard to argue that a right to indemnity is a power.
The Hon. Mr Justice McPherson has suggested that although there might be an express provision excluding the trustees right of indemnity against trust assets it is difficult to conceive of a trustee who, while bound to incur liabilities in the course of trading, is nevertheless precluded from applying trust property to discharge those liabilities. In the view of the Hon. Mr Justice McPherson and other commentators, the right of indemnity from the assets is an incident of the office of trustee and inseparable from it.
Alienation of Trust Assets
It might well be of course that at the time a liquidator is appointed all assets have been distributed to beneficiaries. This position is covered by section 60 of the Property Law Act. This makes every alienation made with the intention of defrauding creditors voidable. For the Section to apply there must be actual intent. The section does not extend to any property received in good faith. Such a disposition could also be in breech of the trustee's duties.
Other Rights of Indemnity - Right of Indemnity Against the Settlor
In certain circumstances the trustee may be able to look towards the settlor for payment of the debts of the trust. There are two circumstances in which this can happen -
• It is possible that the settlor may have promised to indemnify the trustee in consideration of the trustee accepting the role of trustee
• There may be circumstances where the trustee has looked to payment towards the settlor in the past, and the settlor has in essence put more money into the company so debts can be paid
In such circumstances then it could be held that by his behaviour the settlor had agreed to indemnify the trustee.
The most likely circumstance in which a settlor could be made liable for the debts of the company is where the settlor has retained wide powers over the trustee. All liquidators are familiar with the circumstance whereby certain persons can be made liable without limitation of liability for the debts of a company. Included amongst the people who can be made personally liable are the officers of the company. Included under the definition of officers of a company is a person under whose instructions the directors are accustomed to act. If it can be shown that the trustee company was accustomed to act under the directions of the settlor then in my view there is no doubt that the settlor could be made personally liable for the debts of the company.
There is case law to support this, and the case law suggests that even though the trust deed may contain an express exclusion of the settlors' indemnity that clause may not be sufficient to exclude the settlor from personal liability. It was determined in Balsh v. Hyham (1728) to P. Wms 453
"that if the settlor is also a beneficiary under the trust then the settlor is bound in equity and at law to indemnify the trustee."
There is further case law to suggest that even if the settlor was not an original beneficiary, then he may be liable to indemnify at a later date if he obtains an interest by assignment.
Restriction of the Trustees Right to Indemnity
Although Section 38(2) of the Trustee Act 1956 gives the trustees the right to indemnification against trust property there is another clause, Section 2(5) which allows parties to modify any such right. It would appear that in certain circumstance the settlor might have an opportunity to challenge the liquidators right to the assets. In such circumstances the Courts would need to balance the conflicting requirements of the creditors and of the settlor. It would appear that for the Courts to favour the settlor in whole or in part, then the settlor in most circumstances would have to show that the trustee did not act with due care and should thus lose his right to indemnity. This of course would lead to the almost automatic situation where there would be a clear case for the liquidator to take against the directors of the company to make them personally liable. Section 13 of the Trustee Act 1956 states as follows -
• A trustee must invest prudently
• Where trustee have special skills by reason of his or her profession, employment or business, the standard of care is extended to what a prudent person engaged in that business, profession or employment would exercise in the managing the affairs of others (s13C)
• The test of prudence can be excluded in the trust deed (s13D)
• In exercising his power of investment, the items set out in Section 13E should be considered and the trust document complied with (s13G)
If it could be shown that the trustee did not do the things as provided for in Section 13E of the Trustee Act 1956 then it would seem that the Court might favour the settlor.
How would a Trust be Placed in Liquidation
As stated earlier in this paper it is not the trust which is placed in liquidation but the trustee. The trustee is invariably a company. The trustee can be placed in liquidation in the same way as any other company. Modern insolvency law provides that a company is placed in liquidation by the appointment of a named person or persons as liquidators of that company. Consistent with all insolvency law the trustee company can only be placed in liquidation by two parties -
• By the shareholders on the passing of a special resolution which must be signed by 75% in value and 75% in number of shareholders
• By the High Court on the application of a creditor or shareholder or director or some other person having an interest in the company
Priority of Creditors in the Event of a Liquidation or Receivership
In general the priorities in the event of a liquidation or a receivership come in the following order -
1. Liquidators or receivers fees
2. Wages, Holiday Pay and Deductions
3. GST and PAYE
4. Unsecured Creditors
It seems reasonably clear however, that in the case of a Trading Trust the priorities are not necessarily the same. This is because the assets in equity belong to the Trust.
Section 312(1) of the Companies Act 1993 states as follows -
"[Order of priority] The liquidator must pay out of the assets of the company the expenses, fees, and claims set out in the Seventh Schedule to this Act to the extent and in the order of priority specified in that Schedule and that Schedule applies to the payment of those expenses, fees and claims according to its tenor."
It is clear that the provisions of Section 312 of the Companies Act 1993 apply only to "assets" that are beneficially owned by a company and that are available in a winding up for division amongst the creditors generally. Such assets cannot include assets held in trust. It would therefore appear that the normal priorities may not apply and that things such as wages and GST and PAYE rank equally between themselves and equally with unsecured creditors. The position is uncertain.
It would appear that in Australia the liquidators follow the priorities even though there is a body of legal opinion in Australia which suggests that they do not apply. I have not found any New Zealand cases on the issue. I am pleased to advise that the situation of a liquidator of a trustee is quite different from that of the other preferential creditors. A liquidator of a trustee company is entitled to claim remuneration costs and expenses from the trust assets (Re Francis James Nominees Limited (In Liquidation) (1988) for NZ CLC 64,279 and Re Landbase Nominee Company Limited (In Liquidation); Re Landbase Securities Limited (In Liquidation) (1989) for NZ CLC 65,043.)
Change of Trustee on Insolvency
It has been suggested to me that there can be a clause in a trust deed which would provide for the automatic removal and replacement of a trustee if a trustee were to be placed into liquidation. In effect the trustee would be removed from the trust before the trustee was able to exercise his rights of indemnity. The question then arises as to whether that the removed trustee will still be able to be indemnified out of the assets of the trust. The point was clearly covered in a paper presented at the 20th Australian Legal Convention by R. P. Meagher Q.C, New South Wales. R. P. Meagher stated as follows -
It would seem that no such removal from office would prejudice his rights of indemnity, for two reasons:
a. Removal from office clearly could not destroy the trustee lien, and
b. Most of the cases dealing with the creditors - rights to subrogation to the trustee - rights of indemnity treat the rights as subsisting after the trustee has been removed from office.
Receiver Appointed Over a Trustee Company
Assets of a company within the context of the Companies Act means assets to which the company is beneficially entitled. It is for this reason that assets held by the company in trust are not assets of the company. The question arises then as to whether there can be a debenture over a trust. If the trustee company were to borrow money for its own purposes unconnected with the trust then even though the trustee company had purported to charge the trusts assets the charge would not be binding upon those assets and any attempt to appoint a receiver in relation to those assets would be ineffective. In effect the debenture would only be effective in so far as the trust company had assets of its own which did not belong to the trust.
If however, borrowing is authorised by the trust and undertaken for the purposes of the trust and there is a power in the trust to create a charge over trust assets to secure the borrowing then the debenture is effective.
The debenture will effectively be a charge against the trust assets and any receiver will have access to those assets as a matter of right and not as a matter of indemnity. The usual rule applies. Although the assets coming into the hands of the receiver belong in law to the company they are not the company's property in equity. Creditors have no direct access to those assets and cannot levy any execution against them. This again raises the problem of what priorities apply. It would seem that the position in respect of a receivership is more certain than that of a liquidation. In the case of a receivership it seems more likely than not, that in a receivership they do apply. This is certainly the view taken by Blanchard who states that the question was touched on by Needham J in
"Re Byrne Australia Pty Ltd who seemed to lean in favour of such a solution."
CONCLUSION
The Insolvency of Trading Trusts in New Zealand is in a state of infancy. Whilst there have been some notable cases many of the issues have yet to be tested.
There is a wealth of information which has come from Australia and whilst it is probable that New Zealand will follow Australia, it is by no means certain.
DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.