Does the bankruptcy of a personal trustee or appointor of a discretionary trust expose the trust assets?

In an important decision for the large number of discretionary (family) trusts in Australia, the Supreme Court of New South Wales has considered whether a family trust structure is a sufficiently robust firewall to protect the family trust assets against claims by a trustee in bankruptcy appointed to the personal Trustee or Appointor of a family trust.

The decision is Lewis v Condon; Condon v Lewis [2013] NSWCA 204 which was handed down on 4 July 2013 by the Court of Appeal.

The decision gives the beneficiaries of the family trust the comfort that if the personal Trustee or Appointor of the family trust becomes bankrupt, this does not breach the firewall that a family trust structure provides to protect the family trust assets. As a result, the trustee in bankruptcy cannot seize the family trust assets for the benefit of creditors.

The facts

The Kenthurst Investments Trust was settled in 2001, by Deed. It had a corporate Trustee. It was a discretionary trust where Colleen Lewis was the ‘first corpus beneficiary’, and her daughters Louise and Melissa were the ‘second corpus beneficiary’. Colleen Lewis was the Appointor. A property at Kenthurst was purchased by the trust the day the trust was settled. Part of the purchase funds were contributed at Colleen’s direction, and the balance purchase funds were borrowed from an external financier.

In 2005, Colleen disclaimed her interest as a beneficiary of the trust, retired as Appointor, and was appointed as the new Trustee of the trust. In 2006, the Family Court ordered that the title to the Kenthurst property be registered in Colleen’s name. The resolution of the Family Court proceedings and the avoidance of Land Tax liability appear to have been the reasons why the corporate Trustee retired and Colleen became a personal Trustee.

In 2010, Colleen took a loan from the ANZ Bank secured by mortgage against the property. Colleen defaulted and the ANZ Bank obtained an order for possession, as a precursor to sale.

In May 2012, a sequestration order was made against Colleen and Mr Schon Condon was appointed trustee in bankruptcy. He became the registered proprietor of the property.

Mr Condon submitted that he could ignore the trust because it was a sham, and therefore he held (the surplus proceeds from the sale of) the Kenthurst property for the benefit of creditors.

Louise Lewis submitted that the property remained a trust asset.

Was the trust a sham?

Most of the judgment of Appeal Justice Leeming (McColl JA and Sackville AJA concurring) dealt with the issue of whether Kenthurst Investments Trust was a sham. The Court decided it was not a sham, for these reasons –

The trust was not a sham in 2001, when the property was purchased. Although there was an ‘improper purpose’ in creating the trust, namely to conceal Colleen’s interest in the property in Family Court proceedings current with her former husband and also to evade taxation, the trust had apparent legal consequence… It is perfectly regular for a settlor or a third party to contribute to the purchase price of the property which is to be held on trust; to the extent that Colleen did so, that does not in my view compel a conclusion of a sham. [paragraphs 73 and 74]
The trust did not become an “emerging sham” in 2005 and 2006 when Colleen was appointed as new Trustee, nor in 2010 when Colleen borrowed against the property and used the funds for private purposes – While she became the registered proprietor, she did so with full knowledge of the terms of the Trust. Colleen’s legal title was subject to the terms of the trust. [paragraph 84]

What effect did the sequestration order have on the trust?

The first consideration was the effect of the sequestration order on the title to the property.

The Court stated that - upon making of the sequestration order, Colleen’s interest in the property vested forthwith in equity in Mr Condon under s 58 of the Bankruptcy Act 1966 (Cth); and that Mr Condon was entitled to become the registered proprietor of the property by registering a transmission application pursuant to s 90 of the Real Property Act 1900 (NSW).

The next consideration was the effect of the sequestration order on the Trust itself.

The court stated that – it is clear law that those statutory vestings do not destroy any trust of which the bankrupt was a trustee. [paragraph 92] The Court relied upon s 116(2)(a) of the Bankruptcy Act 1966 (Cth) which excludes from vesting, property held by the bankrupt in trust for another person; and s 82 of the Real Property Act 1900 (NSW) which excludes recording notice of trusts on the Land Titles Register. Therefore the trustee in bankruptcy held title to the property subject to the existing equities.

The final consideration was the effect of the sequestration order on the power of appointment of a trustee, if it were exercisable by Colleen as Appointor of the trust.

The Court stated that – The power to remove and replace a trustee is precisely that: a power, not property. And the Court quoted with approval what Davies J stated in Re Burton: Wily v Burton [1994] FCA 1146 that a power to remove a trustee and appoint a replacement was not property falling within s 116 of the Bankruptcy Act 1966 (Cth). [paragraphs 94 and 95]

Did a Louise have standing to bring proceedings, as a beneficiary?

In accordance with the maxim that equity will not let a trust fail for want of a trustee, the Court held that there were special circumstances such that Louise had standing to sue.

The special circumstances were: that it was uncertain if the trust had a current Trustee; the fact that Colleen was bankrupt; the fact that Colleen had disclaimed her interest in the trust property; and finally that Louise was the person best placed to advance the claim.

Conclusion

If the personal Trustee or Appointor of the family trust becomes bankrupt, the family trust assets are protected against seizure by the trustee in bankruptcy. The trustee in bankruptcy is unable to breach the firewall that the family trust structure provides around the trust assets or to destroy the trust, except in the exceptional circumstances that the trust has been set up, or is operated, as a sham.

Therefore, family trusts (discretionary trusts) continue to provide robust asset protection for family trust assets from claims by trustees in bankruptcy.

This article was first published by Cordato Partners in Lexology which is an international innovative, web-based service that provides over 200,000 company law departments and law firms around the world with a depth of free practical know-how on specialist areas of law © Copyright 2013 Sydney