Chapter 7 - Creditors and trading trusts

 

Liability of a trustee and the right of indemnity against trust assets

Liability of a trustee

A trust is not a legal entity; the trustee is the legal owner of the trust property.260 Therefore, a trustee is personally liable for all liabilities incurred in performing the trust, including debts to third parties.261 This personal liability subsists unless there is a clause in the contract with the third party limiting the personal liability of the trustee; liability can be limited to the trust assets.262 Clear and unambiguous words are needed for the court to accept that a trustee’s personal liability has been excluded. Limitation of liability through the trustee’s contract with a third party is distinguishable from any clause in the trust deed that limits the trustee’s liability to the trust assets, as the clause in the trust deed only applies between the trustee and the beneficiaries, not between the trustee and third parties.263 However, any clause in the trust deed still has implications for creditors looking to recover their debt by way of subrogation to the trustee’s right of indemnity.

Trustee’s right to indemnity

Because the trustee administers the trust property for the benefit of the beneficiaries and not the trustee themselves, it is the beneficiaries who bear the liabilities incurred in performing the trust. Accordingly, the trustee has an indemnity against the trust assets to satisfy debts properly incurred under the trust. There are two aspects to this indemnity:264

1.where the trustee expends their own funds properly for trust expenses, they are entitled to be reimbursed from trust assets, often referred to as a right of recoupment; or

2.the trustee may pay trust liabilities directly out of the trust assets, a right of exoneration.

The liabilities must be properly incurred to be covered by the right of indemnity. If a trustee has acted improperly in incurring the liabilities, they will not be entitled to indemnity from the trust assets.265 The trustee’s right of indemnity is recognised both in the common law266 and in section 38(2) of the Trustee Act 1956. Butler states that section 38(2) “essentially reflects the trustee’s right of indemnity as set out in the case law and does not derogate from it”.267 The section provides:

A trustee may reimburse himself or pay or discharge out of the trust property all expenses reasonably incurred in or about the execution of the trusts or powers; …

The trustee’s right to indemnity from the trust assets, whether by way of reimbursement or exoneration, creates an equitable interest in both the capital and income of the trust. There is some confusion over the nature of this interest and whether it creates a lien or charge.268 There is a lien or charge only in the sense that a court may order the sale of assets to enable the trustee to discharge its liability; a charge involves agreement between the parties to give the charge, whereas a lien may arise in other ways.269 The interest has the following features:270

  • it has priority over claims of beneficiaries and third parties;271
  • it arises by operation of law so it is not subject to the Personal Property Securities Act 1999;272
  • it remains attached to trust assets even if the trust assets leave the possession of the trustee;273
  • since it is equitable, not possessory, even if a trustee is removed from office, it will remain attached to the trust assets (and may remain so if the replacement trustee distributes the trust assets to the beneficiaries);274
  • where the right arises because the trustee has personally discharged the liability or intends to do so, it can be sub-charged or assigned by the trustee;275 and
  • again where the trustee has used its own money to meet the liability, it is an asset of the trustee that passes to the Official Assignee in liquidation or bankruptcy (unlike the trust assets).276

The trustee’s right to an indemnity for liabilities properly incurred in carrying out the trust extends beyond the trust property. It is enforceable in equity against the beneficiaries where the beneficiaries have capacity, have accepted beneficial ownership of the trust property knowing the relevant assets were held by the trustees, and can together terminate the trust at any time.277

 

Subrogation of creditors to trustee’s right of indemnity

Unsecured creditors of a trustee do not have a direct claim against the trust assets, unlike secured creditors who have a claim through their security. It is the trustee that is personally liable for debts properly incurred in the administration of the trust. Therefore the primary claim for creditors is against the trustee personally, not the trust assets. Creditors may recover from the trustee directly if the trustee has sufficient assets, other than assets that are held on trust. However, if the trustee has few or no assets of its own that are available to satisfy the creditor’s debts, then the creditor must look to the trust property through subrogation. Subrogation is the process by which one person, in this case the creditor, is put in the place of another, here the trustee, so that the trustee’s right of indemnity from trust assets is used to satisfy the creditor’s debt.278 The purpose of the right of subrogation is to avoid the injustice of a beneficiary receiving a windfall from credit given to the trustee that has not been repaid.279 This is of particular relevance in the context of trading trusts, as the corporate trustee of a trading trust may have very few or no assets that are not held on trust.

There is some uncertainty about whether a creditor can exercise their right of subrogation where the trustee is not in liquidation or bankruptcy. In Levin v Ikiua Heath J stated that because the creditor’s primary right is against the trustee personally, recourse to the trust assets through the right of indemnity would only be needed if the trustee had insufficient funds to satisfy the debt.280 However there is also authority to suggest that a creditor can assert its subrogation right where the trustee is not in liquidation or bankruptcy if the trust is under the administration of the court; where the trustee consents and the action does not prejudice others; or where the creditor can show that proceedings against the trustee for recovery has been or is likely to be fruitless.281

A creditor’s subrogation to the trustee’s right of indemnity is entirely derivative. This means that the creditor cannot be placed in a better position than the trustee: if the trustee’s right of indemnity is impaired, then the creditor’s subrogation claim is likewise impaired.282 This is an important issue for unsecured creditors if they are relying on the subrogation right for recovery purposes.283

Circumstances in which right to indemnity may be impaired

There are a number of ways in which the trustee’s indemnity may be impaired. There is also the possibility that the trustee may not have properly incurred the liability in the first place, and so would not be entitled to an indemnity in respect of that liability. Creditors may have no knowledge of unrelated circumstances that impair the trustee’s right to indemnity. This may effectively provide a windfall to beneficiaries and creates unfairness for creditors. If a trustee enters into a contract in any of the following circumstances, they will not have an indemnity, and consequently the creditor’s ability to subrogate to the indemnity will also be denied:

(a)if a trustee lacks the capacity to enter into the contract, under the powers in the trust deed or the general law;

(b)if a trustee has the power to enter into the contract but lacks the authority to do so, because a necessary procedure was not complied with (for example an insufficient number of trustees entered into the contract);284

(c)if a trustee is in breach of duty in entering into the contract, for example the duty to act in the best interests of the beneficiaries as a whole.285

The trustee’s right to indemnity, and the creditor’s derivative subrogation right, can also be impaired through cross-claims by the beneficiaries. If a trustee has caused a loss through breach of trust, the trustee will be liable to the trust for the amount of that loss. The trustee’s indemnity will be reduced by the amount owed to the trust fund from the trustee’s breach.286 This type of impairment is temporary and is remedied once the trustee provides compensation for the breach. Notably, if the trustee properly incurs a liability to a creditor, but there is a cross-claim by beneficiaries, the trustee’s indemnity (and the creditor’s subrogated right) will still be reduced even if the cross-claim is wholly unrelated to the contract with the creditor, and even if the cross-claim arose after the contract was entered into.287

To take a simplified example, if a trustee owed a creditor $100,000 under a contract properly entered into, the trustee would ordinarily be entitled to an indemnity for that entire amount from the trust assets. The creditor could subrogate to the trustee’s indemnity for the $100,000 it is owed under the contract. But this would not be the case in the following situations:

1.If the trustee lacked the requisite capacity or authority to enter into the contract, for instance if the trust deed did not permit making such contracts, or an internal requirement was not met, or the trustee was acting in breach of trust in entering into the contract, the trustee would be denied the benefit of the indemnity, so the creditor could not rely at all on the indemnity to recover its debts.

2.If the trustee (before or after entering into the contract) committed unrelated misconduct, such as misappropriating trust funds, or neglect of trust assets, that resulted in a $30,000 loss to the trust estate, the trustee would be liable to compensate the trust estate for this amount. The trustee's indemnity would be reduced by the amount the trustee owed the estate, so the available indemnity that the creditor could access would be $70,000.

 

Exclusion or limitation of the right of indemnity

Settlors commonly seek to modify the trustee’s right to indemnity in the trust deed itself. There seems to be general agreement that the trustee’s right of indemnity against the beneficiaries can be excluded by the trust deed, but the position is less clear regarding limitation or exclusion of the right of indemnity against trust assets. The indemnity is important to unsecured creditors: they will be significantly prejudiced if it is limited or excluded entirely, since they cannot rely on subrogation to satisfy their claims if the trustee cannot meet the liabilities personally.

There is some debate about the extent to which the trustee’s right to indemnity can be excluded or limited by the trust instrument. One view is that the indemnity can be limited or even excluded entirely.288 The alternative view is that it may not be excluded because “the right of indemnity from the assets is an incident of the office of trustee and inseparable from it”.289

The position has not been conclusively determined by a court in New Zealand and nor is it clear from the statutory scheme. In the Trustee Act, section 2(5) permits a settlor to modify “powers conferred on the trustee” by the legislation. The key question is whether the statutory right to indemnity in section 38(2) is a power of the trustee;290 if it is a power then it falls within section 2(5) and may be excluded. Writing extrajudicially, Heath J considers that the right of indemnity is likely to be something that cannot be the subject of exclusion or modification by the trust instrument.291 He acknowledges that the wording of section 38(2) may suggest that it is a “power” because the section expressly authorises the trustee to reimbursement in respect of all expenses reasonably incurred in execution of the trusts or powers; such authorisation must necessarily create a “power” for the trustee to do those things.292 But the wording of section 38(2) could suggest that it is a “right”.293 Heath J has stated:294

I consider it likely that, because the opening words of s 38(2) refer to a qualified ability to reimburse or to pay or discharge expenses “in or about the execution of the trusts or powers”, the legislature must have intended to draw a distinction between the right to an indemnity and the exercise of powers to which it may relate.

Heath J also observed that it seemed wrong in principle that a settlor could exclude the right of indemnity where to do so would be to the detriment of the trustee exercising stewardship over the trust assets.295 Further, exclusion of the right was at odds with wanting a responsible trustee to carry out the trust, and there would be no protection against loss for someone accepting an appointment as a trustee. He queried rhetorically, “what would be the purpose of excluding the right in indemnity, other than to render nugatory the claims of creditors against the corporate trustee itself?”296

The view of the authors of Equity and Trusts in New Zealand is that the right can be limited but not excluded entirely, as the trustee’s right to indemnity is an essential part of trusteeship; a trustee will be unable to properly exercise its discretions for the benefit of the beneficiaries if it has no right to indemnity for liabilities from the trust assets.297 If a corporate trustee with little private equity lacks a right to indemnity, when trust liabilities are incurred, this means that the company will invariably be insolvent.298 On whether the trustee’s indemnity in section 38(2) can be excluded, the authors consider it only arguable that the trustee’s right of indemnity can be considered a power for the purposes of sections 2(4) and 2(5).

Tesiram argues that an absence of an indemnity will not be a disincentive for natural person trustees to exercise their discretions properly, and indeed they may act more cautiously where personal liability will attach. Although it may be a disincentive for corporate trustees, this arises from the limitation of liability of the corporate entity, which is not the case for natural persons.299 His view is that the more compelling policy argument against permitting exclusion or modification of the indemnity is that:300

… because creditors can only access trust assets by way of subrogation to the trustee’s right of indemnity (unless they are secured creditors) the right of indemnity is very much part and parcel of a trustee’s office and inseparable from it.

Tesiram considers that it is difficult to see section 38(2) as providing a power that can be modified or excluded pursuant to sections 2(4) and 2(5); powers are generally either dispositive powers or those relating to the administration of the trust, and indemnities are neither.301 He thinks that there is no basis for excluding the application of section 38(2) and that attempts to do so are likely to be ineffective.302

Heydon and Leeming of Jacob’s Law of Trusts and Dal Pont of Equity and Trusts in Australia both disagree with the notion that the right of indemnity is so intrinsic to the nature of a trust that its exclusion would undermine the trust’s existence.303 Dal Pont argues that if this were so, one would expect it would be clearly signalled in statute, while instead in four Australian jurisdictions statutory exclusion is permitted outright. He considers that the right of indemnity is not of the same nature as the other “core” elements of a trust.304 Heydon and Leeming agree that (save for statutory intervention) the right at general law may be excluded, even though this may gravely prejudice creditors’ rights if the trustee is impecunious.305 Those authors note that there are many other circumstances in which the rights of a creditor of a trading trust are equally gravely prejudiced, and that if a provision excluding the trustee’s indemnity is inserted into the trust instrument for the purpose of defrauding creditors, other remedies might be available to the creditor.306

In trustee legislation in Australia, the position varies from jurisdiction to jurisdiction: in Queensland the statutory right to indemnity cannot be excluded by the trust instrument; this is also likely to be so in the Australian Capital Territory, New South Wales, and South Australia; in the other jurisdictions the legislation contemplates that the right can be excluded or modified by the trust instrument.307

In 2002 the Law Commission considered that the right of indemnity probably could not be excluded or limited.308 There is still no authority in New Zealand stating the position with certainty, but overall the balance of commentary appears to say that it probably cannot be excluded totally. The question that follows is whether this position should be stated in legislation.

GE Dal Pont Equity and Trusts in Australia (Thomson Reuters, Rozelle (NSW), 2011) at [23.120].

Ibid; Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360 (HCA) at 367.

Muir v City of Glasgow Bank (1879) 4 App Cas 337.  

See Vicki Ammundsen “The trustee’s liability – limited to assets or not?” New Zealand Tax Updater (CCH, 23 April 2009) at 1; Sovereign Homes Ltd v Meurant HC Auckland CIV-2006-404-7394, 15 May 2007.

Andrew S Butler (ed) Equity and Trusts in New Zealand (2nd ed, Thomson Reuters, Wellington, 2009) [Equity and Trusts] at 442; Dal Pont, above n 260, at [23.120].

Re O’Donoghue [1998] 1 NZLR 116 (HC).

For instance Re Johnson (1880) 15 Ch D 548.

Butler Equity and Trusts, above n 264, at 444.

Bill Patterson “Trustees’ indemnities, equitable liens, subrogation and caveats – has the law taken a wrong turn?” (paper presented to New Zealand Law Society Trusts Conference, 2011) at 287–289.

Ibid, at 287–288.

Butler Equity and Trusts, above n 264, at 446–447.

Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360 (HCA); Re Johnson (1880) 15 Ch D 548 at 552.

Personal Property Securities Act 1999, s 23(b).

Jennings v Mather [1902] 1 KB 1 (CA).

Rothmore Farms v Belgravia (1999) 2 ITELR 159.

Butler Equity and Trusts, above n 264, at 446; Custom Credit Corp Ltd v Ravi Nominees Pty Ltd (1992) 8 WAR 42; Niak v Davidson HC Dunedin CP15/98, 2 June 1999.

Levin v Ikiua [2010] 1 NZLR 400 (HC) at [112]; although Ford considers that it should not be treated as a proprietary interest: see para [8.28].

Butler Equity and Trusts, above n 264, at 131, citing Hardoon v Belilios [1901] 1 Ch 342.  However, the precise limits of the indemnity described above are not entirely certain, for instance whether the creditor’s subrogation right applies to the trustee’s right of indemnity against the beneficiaries: see Butler at 444–445.

Levin v Ikiua [2010] 1 NZLR 400 (HC) at [120].

Ibid, at [119].

Ibid, at [121].

Butler Equity and Trusts, above n 264, at 448; Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360 (HCA).

Dal Pont, above n 260, at [27.25].

Butler Equity and Trusts, above n 264, at 449.

Ibid.

Trust Law Committee (UK) “The Rights of Creditors Against Trustees and Trust Funds” (Report, 1999) at [3.9] [“Report on Rights of Creditors”]. 

Butler Equity and Trusts, above n 264, at 450.

Ibid.

RWG Management Ltd v Commissioner of Corporate Affairs [1985] VR 385 per Brooking J; however, this case was decided in the context of the Victorian Trustee Act which allows for the exclusion of indemnities); Re German Mining Co (1854) 43 ER 415 per Turner J; HAJ Ford and IJ Hardingham “Trading Trusts: Rights and Liabilities of Beneficiaries” in PD Finn Equity and Commercial Relationships (Law Book Company, Sydney, 1987) 48.

BBH McPherson “The Insolvent Trading Trust” in PD Finn Essays in Equity (Law Book Company, Sydney, 1985) 142.  See also Kemtron Industries Pty Ltd v Commissioner of Stamp Duties (QLD) (1984) 15 ATR 627 (QC) at 634.

Paul Heath “Bringing Trading Trusts into the Company Line” [2010] NZ L Rev 519 at 528.

Ibid, at 530.

Ibid, at 528.

Ibid, at 529.

Ibid.

Ibid, at 530.

Ibid.

Butler Equity and Trusts, above n 264, at 455–456.

Ibid, at 456.

Pravir Tesiram “Contracting as a Trustee: Liability to Creditors and the Use of Private Trust Companies” (paper presented at New Zealand Law Society Trusts Conference, May 2005) at 160.

Ibid.

Ibid, at 161.

Ibid.

JD Heydon and MJ Leeming Jacobs’ Law of Trusts in Australia (7th ed, LexisNexis, 2006) at [2106] [Jacobs].  The authors state that the notion “lacks a foundation in logic” but do not elaborate further.

See Law Commission The Duties, Office and Powers of a Trustee: Review of the Law of Trusts Fourth Issues Paper (NZLC IP26, 2011) at ch 1 [Duties, Office and Powers of a Trustee]; Dal Pont, above n 260, at [23.155].

Jacobs, above n 303, at [2106]. 

Ibid.

Dal Pont, above n 260, at [23.155].

Law Commission Some Problems in the Law of Trusts (NZLC R79, 2002) at 13. [Some Problems in the Law of Trusts]