The concept of an ‘insolvent trust’ is somewhat of a paradox. A trust is not a separate legal entity in the way that companies are and, as such, cannot be insolvent in the technical sense. Trustees legally own assets in a trust for the benefit of beneficiaries.

In this article, partner Tim Symes and trainee solicitor James Boissier explain what creditors need to know about insolvent trusts and how they can best manage them.

What is an ‘insolvent trust’?

Although there has been no consideration in the English courts of what test should be applied to determine the insolvency of a trust, the Jersey court has confirmed that an ‘insolvent trust’ situation arises when the trustee cannot meet its liabilities to creditors from the trust property. This is known as the ‘cashflow test’.

Given the unsettled position in England, there remains scope for the other test for insolvency, the ‘balance sheet test’ (where liabilities exceed assets), to become applicable, either as well as or instead of the cashflow test.

How is an English trust dealt with under English Law?

There is a lack of English law authority dealing with how an English law trust should be administered once it has become insolvent. The available case law involves trusts governed by Jersey and Guernsey law.

The Privy Council case of Equity Trust v Halabi [2022] UKPC 36, on appeal jointly from the Courts of Appeal of Guernsey and Jersey, considered a dispute between former and successor trustees as to their respective entitlements to be indemnified out of the available trust assets. The question for the Privy Council was which trustees had priority not only between themselves but also between themselves and other creditors.

The Privy Council held that all former and current trustees’ claims ranked equally (pari passu). They also agreed that the claims of non-trustee creditors were subordinated to those of the trustees but ranked above the beneficiaries of the trust.

Notably, the Privy Council emphasised that the lower courts in Jersey had decided the case on the basis that there are no material differences between the law on trusts in England and Jersey. This case is, therefore, likely to be highly persuasive in the English courts.

Implications for creditors of insolvent trusts

The combined effect of the Privy Council’s judgment is that a creditor’s claim will become increasingly diminished not only by a reduced pot due to the trustees taking what they are owed first (via their indemnity from the assets) but then having to share that reduced pot with other creditors.

Options available to creditors

The unfavourable position of creditors of an insolvent trust emphasises the importance of taking pre-emptive action where possible. This action might include taking steps to seek to control or limit the outflow of monies to beneficiaries or trustees and identifying at the earliest stage any signs of distress being experienced in the management of the trust.

Additionally, any creditor proposing to contract with a trustee for the supply of goods or services on behalf of the trust should fully understand how they will be treated if the trust assets or income cannot sufficiently indemnify the trustees such that they cannot discharge their creditors in full or on a timely basis.

Even once a creditor finds themselves unpaid by an insolvent trust, they should actively seek to interrogate the current financial position of the trust and the reasons for payment not being forthcoming, including why its assets or income have diminished to such an extent as to prevent the trustees from paying their creditors.

Where creditors are concerned about an imminent dissipation of assets either by distributions to beneficiaries or payment of liabilities, they should urgently explore legal remedies to protect their position pending launching any substantive claim for redress.

Where creditors are providing significant ongoing supply on credit terms, they should be ready to ask the trustees direct questions about the trust’s asset and liability position. They should treat any request for an extension of credit terms as a potential sign of distress necessitating protective steps.