Episode 19 – Fiduciary Structures Under Attack, Do’s & Don’ts
In our nineteenth episode, Stuart Paterson, Partner, Head of Middle East Disputes at Herbert Smith Freehills, joins Yann Mrazek, Managing Partner at M/HQ, to discuss the Do’s and Don’ts in using Fiduciary Structures for Asset Protection.
[Yann Mrazek] Foundations, trust – unfairly vilified?
[Stuart Paterson]
Trusts have a poor reputation in the court of public opinion, in particular in the UK and many other countries with high levels of personal taxes. They are widely and simplistically seen as vehicles to hide property, avoid taxes and otherwise to conduct one’s affairs furtively, behind closed doors, often in far-away offshore jurisdictions and probably for unlawful purposes. They are also associated with the young and idle rich, who live a champagne lifestyle from the proceeds of a trust fund established by prior family generations. These colorful impressions have been exacerbated by several leaks of information, such as the notorious ‘Panama Papers’ that revealed information about high-profile individuals using offshore structures and trusts for a range of purposes some of which were unlawful and the vast sums that are invested into such structures.
However, the general public suspicion towards the use of offshore trust structures is of course not the whole picture. Many wealthy individuals use offshore trust structures, not for tax evasion or similar nefarious purposes, but for succession planning; the passing of wealth from generation to generation and other lawful reasons. As the English High Court commented in a decision in April 2020 “The use of complex offshore corporate structures or trusts is not, without more, a ground for believing that they have been set up, or are being used, for wrongful purposes… There are lawful reasons – privacy, security, tax mitigation – why very wealthy people invest their capital in complex offshore corporate structures or trusts”. So I think it reasonable to say that the mere use of a trust or foundation should not be something that raises suspicion, but the many examples of wrongdoers flagrantly misusing trusts has, inevitably, damaged their perception. People have used trust structures since at least Roman times to manage wealth and to pass wealth from generation to generation. There are numerous other legitimate reasons why clients may wish to use trust or foundation structures. E.g.
In many countries pensions and other investment funds are established as trusts and are a key feature of the financial services landscape; and Similarly, trusts and foundations are often used to fund and structure the activities of charities.
[YM] Improper uses of trusts/foundation, give us some examples!
[SP]
There are many instances where fiduciary structures have come under attack due to the way in which a trust has been established. A good example arose in a Cayman court case that reached the UK Supreme Court regarding trusts that had been established by a settlor who later became insolvent following proceedings in which he was found to have misappropriated assets from a Turkish bank.
It is not uncommon for the settlor to reserve certain powers to themselves in connection with the trust, for example to add or remove beneficiaries. In this case, the settlor placed substantial assets into the trust with himself and his wife as beneficiaries. However, he reserved the power to himself to revoke the trust at his own discretion. He could therefore return to himself legal ownership of the property placed into the trust.
Certain creditors sought to access the trust property on the basis that the Court could grant to a receiver an equitable execution order over the power of revocation, ie the insolvent settlor’s right of revocation would be exercised on his behalf pursuant to the court order in order to access the assets for the benefit of creditors. Treating this power of revocation as a form of property, so that it could be the subject of a form of equitable relief, was, therefore, a novel way to attack a fiduciary structure and illustrates the court’s willingness to prevent wrongdoers from, if you like, having their cake and eating it – putting property into trust but having the power to take it out again when it suits them.
We have also recently seen an individual, knowing his creditors were closing in, decide to give up all of his powers as settlor of the trust (so as to prevent them from being exercised by a trustee in bankruptcy) by assigning those powers to other persons. In one case we are involved in, an individual settlor tried to assign all of his powers to the trustee, so that when his creditors, for sums in the region of 3 billion USD, sought payment, he could claim he had removed himself from the trust structure; he claimed he was no longer a beneficiary, and had no powers in relation to the trust anymore. None of these efforts were successful. There were a few different reasons for that:
- As a matter of formalities, certain acts relating to the trust (such as the removal of a beneficiary) had to be recorded in a Deed. They were not. The rule is strict so the relevant acts were of no effect.
- Also, his attempt to assign powers did not work, because certain of the powers could only be sensibly exercised by the settlor, not the trustee (such as the power to remove/replace the trustee). Although the facts of this particular case we’ve been working on may be quite specific, there are general trends that show that trust-related powers are an important tool when attacking fiduciary structures and crafting those powers sensibly is important to ensure that a trust stands up to scrutiny.
[YM] and what about the illicit uses of trusts e.g. sham and Illusory trusts?
[SP]
There are of course a number of cases seen where the trust is a sham, meaning, where, on the face of it, it may appear to be a 50-page long trust deed which looks legitimate, none of the parties involved ever intended it to operate in the manner set out in the document. The Pugachev case on illusory trusts is probably the biggest recent case on the topic.
A short summary of what the judge said is that if one were to look at the way the trust worked, even on paper (suggesting it does not necessarily need to be a sham), and reviewed the powers everyone involved has, which in this case was all the powers the settlor had, and grouped them all together and looked at the fullest extent of the powers, one would come to the realisation that the beneficiary is still in control of all his assets and despite appearances, the beneficial interest never passed.
In this case the judge looked at things like who can decide who is hired or fired as a trustee, who can decide who gets distributions out of the trust fund, who can decide on investments and what happens to trust assets, and who can add and take away beneficiaries. When you look at all of these powers in the round, it begs the question of what is left for the trustee to do – are they genuinely acting as the legal owner of the trust property?
The conclusion reached was the individual had not really given away anything as he still had control of all the assets largely to the same extent as he had controlled it before. So whilst it was not a sham trust, as it was intended to work exactly as it was set out on paper, the ultimate effect of this was that the person had not disposed of their beneficial interest so they could effectively “look through” the trust structure.
[YM] Firewall provisions: what are the benefits? what are their limitations?
[SP]
There are also surprising limits to the effectiveness of trusts as asset protection vehicles, depending on what jurisdiction the trust has been formed, and where the assets are located.
Different jurisdictions have different levels of asset protection built into their statutes. Most of the offshore countries have a section in their trust statutes that effectively reads if there is anything to do with the set-up of the trust it has to be determined by the relevant jurisdiction’s courts (ie. if it is Jersey trust it has to be determined by Jersey courts, if it is a Bermuda trust it has to be determined by Bermudian courts). It also tends to be the case that these courts are faithful to upholding their own trust structures. These types of laws are otherwise known as “firewall legislation” and attract a lot of commentaries as they are seen as an additional layer of protection around trusts. And to some extent they are. However, the protection offered may be actually quite limited in practice.
Some jurisdictions have very aggressive firewall/asset protection laws, such as the Cook Islands, who pride themselves on asset protection structures. For most countries, there are insolvency clawback periods, so if one settles an asset in trust within the 12 months prior to going bankrupt or becoming insolvent, that transaction is liable to be set aside, but not afterwards – 12 months is a very short period and in the Cook Islands, this period is significantly shorter than in other jurisdictions, regardless of whether the transaction was conducted fraudulently to defraud creditors or it was done legitimately in aid of setting up a proper structure.
The issue with firewall legislation is that it is only as effective as where the assets are located. The trust is just a wrapper, so if the assets are in a bank account in London, but it is a Bermuda law trust, you can have whatever asset protection laws or firewall legislation you like in Bermuda, but a creditor could go straight to English Courts, the location of the asset, instead of wasting time engaging with the law that governs the trust structure. As a result, individuals may set up trust structures in offshore systems of law that try very hard to protect assets and give the impression they cannot be touched, when in practice, all of that can be undermined very quickly if your asset is placed somewhere that has a more evenly balanced legal system. Most of the world’s wealthiest individuals do not want to keep their money held in a bank account in the Cook Islands.
Key take-aways
- Sound rationale
- structure to meet objectives
- Assess carefully
- tool
- jurisdiction
- provider
- Seek advice!
- key parties
- control/governance