Trusts are inherently vulnerable to internal and external attacks from numerous sources, including the settlor, their spouse or civil partner, the beneficiaries, former trustees, other power holders, creditors, third parties, taxing authorities or even sovereign wealth funds.
In this article, Trust and Probate Litigation partners Marcus Parker and Emma Holland, and International Arbitration partner Alejandro Garcia, identify the types of attack and the reasons for them. They also share tips for trustees to reduce the risk of and fallout from such attacks. In particular, the tips aim to help prevent protracted litigation, which, despite being expensive and uncertain in terms of outcome, can often have devastating effects on the parties involved.
What type of attacks?
Attacks may come from within or from outside a structure. External attacks are more likely to be foreseeable. They may include, for example, creditors recovering unsettled debts, divorcing spouses and civil partners arguing that the settlement should be characterised as nuptial, or tax authorities pursuing unpaid taxes.
Potential attacks from within the structure are perhaps less predictable, but there are usually tell-tale signs, for example, complaints from disgruntled beneficiaries. A settlor’s death often triggers family disharmony. If the settlor or a power holder starts to lose capacity, the structure can find itself in a state of paralysis if there is a dispute as to the extent to which capacity is retained.
Why are trusts so vulnerable to attacks?
There are several reasons, including:
- The creation of a trust results in the settlor divesting themselves of control of significant assets to an unconnected (albeit usually professional) trustee. If the relationship between the trustee and the settlor/beneficiaries breaks down, the trustee may be accused of failing to act in the best interests of the beneficiaries. Also, with discretionary trusts, difficulties can arise where the settlor’s wishes are unclear, particularly where there are no other appointed power holders (such as a protector or appointor) to assist the trustee. In such situations, the trustee can be left to make difficult decisions with little guidance. Decisions are then challenged, often culminating in applications to the local court.
- The beneficiaries of a trust are usually the family of the settlor. Family members may fall out, particularly after the settlor’s death or incapacity. Divorces happen. Fights over the trust assets, as a result, are common.
- Overly involved settlors can cause significant issues by appearing not to have divested themselves of control of the assets properly, ranging from potential tax implications to exposing the trust to allegations of sham or attacks by creditors.
- Trust investments can fail, and liabilities can arise. Global investments made by the trustees through the trust’s underlying entities may be susceptible to governmental intervention or inaction that harms the value of the underlying assets or interests.
- Power holders (other than the trustees) are frequently family members or trusted advisors and, in our experience, will often be more aligned with one group of beneficiaries than another. Their decisions may be susceptible to challenge.
So, where should a trustee start in analysing how susceptible the structure is to a potential attack? The answer is by asking questions, spotting the potential issues and addressing them early.
- Ask questions and lots of them
Several questions should be asked to ascertain whether a trust can withstand stress. These may include:
- Has the settlor properly divested themselves of the assets? Did they own the assets in the first place? Are there any challenges that could impact the ownership of the trust assets, for example, claims made by creditors?
- How is the trust structured? Why? Where are the underlying entities? What assets do they hold? Who are the officers of the underlying entities? (Often, we see unnecessary complexity, which may at one point have had a justification but no longer serves any purpose other than to make the structure more unwieldy, expensive and vulnerable to claims.)
- Is there a protector, appointor or other power holder (other than the trustee)? What powers do they have, and how have they exercised these in the past?
- Does the settlor retain powers? How are these exercised?
- Is there a letter of wishes? What does it say? How often is it updated?
- Is there a family business, and who controls it? Are certain family members more involved with it than others?
- Is there inequality in the trustee’s treatment as between the beneficiaries?
- How do trustees make and record decisions? What information have they shared with beneficiaries? How well do the trustees know the beneficiaries?
- Are there any potential capacity issues for power holders? Are there provisions or arrangements in place to deal with these?
- Addressing the issues – what to do and when?
While trustees frequently identify a problem coming down the tracks, they may prefer, understandably, to steer well away from it, fearing that by highlighting it, they will exacerbate it. While there may be sense in that sentiment, it ignores that, more often than not, the trustee can address or mitigate the issue discreetly, avoiding ructions with the beneficiaries, settlors or other power holders.
It sounds obvious, but fundamentally, many problems can be avoided if the trust is properly established and administered well.
a) On set up (ideally before any claim is intimated)
Obtaining sound legal (and tax) advice before implementation of the trust structure is crucial. This review and analysis will depend on the specific circumstances of the family and the nature of the assets to be transferred and should also involve asking many of the questions above and more.
Where a settlor-directed trust is considered appropriate, it makes sense for it to be governed by the law of a jurisdiction that recognises the settlor’s ability to reserve powers, but considerable care is still required.
Trustees should consider where any claim is likely to be brought. That will depend on multiple factors, including the trust provisions in respect of governing law and jurisdiction. If it appears likely (due, for example, to where the underlying assets are located) that a claim could be brought in a civil law jurisdiction that doesn’t recognise trusts, the trustees should be alive to the risk that the trust will be mischaracterised and possibly even viewed as transparent so that the assets are treated as belonging to the settlor.
b) Proper administration is vital
Often, complaints relate to the extent to which beneficiaries are benefitting from the trust. Regardless of the nature of the complaint, before responding to a disaffected beneficiary, a trustee will want to consider the nature of the beneficiary’s interest, the beneficiary’s level of knowledge of their interest and the trust generally, and their entitlement to trust information. A beneficiary will almost certainly be entitled to see core trust documents and accounts, so ensuring these are up to date and ready for production is sensible.
The trustee will want to ensure that its decisions, including those relating to distributions, stand up to scrutiny. Although trustees are usually not obliged to share their reasons for their decisions with beneficiaries, they may not be able to resist disclosure to other power holders (or the court). Accordingly, efforts should be made to ensure the trustee has all potentially relevant information before it to avoid allegations that they have failed to take into account relevant considerations. For example, before making decisions regarding distributions, the trustee will want to ensure it has information about each beneficiary’s personal financial situation and residence and domicile status. The recent Privy Council decision in Grand View v Wong highlights the importance of ensuring powers are exercised for a proper purpose.
Where a trustee has made investments, particularly in overseas jurisdictions, they should consider what steps can be taken to avoid future problems. Concerns are frequently raised regarding managing and investing the trust’s assets. It can be more difficult for trustees to comply with their duties in certain situations. For example, arguments in respect of the suitability of the assets may be raised when the assets held are unusual. Or, there may be allegations that the trust fund is insufficiently diversified where there is a lack of liquidity, or the major asset is the family business. Underlying family businesses will often give rise to tension, particularly where certain beneficiaries are more involved or benefit to a greater extent from them than others.
One option many trustees overlook is to consider the use of bilateral investment treaties or similar instruments (there are in the region of 3,000 around the world) to protect the trust’s assets against political risk. In summary, many such treaties grant wide-ranging protections against disproportionate, discriminatory or arbitrary treatment by a state (ie the executive, judicial and legislative powers), its bodies and agencies. Further, many of these treaties entitle an aggrieved party to seek full compensation for all its losses before an international tribunal. In many cases, a trustee will be able to attract these significant protections by investing (or reinvesting) through companies established in a country that has concluded a bilateral investment treaty with the country where the investment is made.
c) A claim has been intimated – is it too late?
Early advice from a trust litigator is essential. The following steps will turn on specific circumstances; no two disputes are the same.
Where a claim is made and the trustee was not in place from the trust’s inception, it should double-check the documentation by which it was appointed was executed properly. It will also want to ascertain to what extent it is responsible for the liabilities of any former trustees. We would also expect such an exercise to be undertaken by any incoming trustee. The recent Privy Council decision in Re the Z Trusts relating to so-called ‘insolvent trusts’ needs to be taken into account.
Where a divorce is on the horizon, trustees should be alive to the potential for assertions that the trust is or has become nuptial in character. They should also carefully consider the potential ramifications of participating in such proceedings (in some situations, it may be appropriate to ask the courts of the trustee’s home jurisdiction for directions).
The need for stress testing
Part of acting in the beneficiaries’ best interests is to be vigilant in respect of the possibilities of attacks on the structure and to actively consider how best to insulate the trust from such risks.
One way of doing this is for the structure to be ‘stress-tested’. This does not involve a wholesale review of all documentation. Rather, it involves applying a ‘litigator’s eye’ to the structure (or particular parts of it) and advising where there are vulnerabilities that may give rise to attacks and how the risk of these could be mitigated.
As Benjamin Franklin said: “By failing to prepare, you are preparing to fail.”
If you have any queries in respect of stress-testing, trust disputes or bilateral investment treaties, please let us know, and we would be happy to address them.
You can find further information regarding our expertise, experience and team on our Trust and Probate Litigation page.
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