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Trading trusts

  • Author : Richard Wakeham
  • Date : April 2011
ABOUT THE AUTHOR: Advocate Richard Wakeham is an Associate at Sinels Advocates, Jersey

The legal concepts of trusts and companies are well established and certain. This certainty becomes lost when the two combine to create a ‘trading trust’. This article considers the recent decision of the Court of Appeal of New Zealand in the case of Levin v Ikiua [2010] NZCA 509 relating to a particular trading trust.

What are trading trusts?

Trading trusts are a hybrid of trusts and companies designed to protect assets. Usually, the structure will include a discretionary trust with a corporate trustee and beneficiaries comprising the settlor and his family. The trustee will probably be vested with the family trading business as its trust property, but will not have any assets of its own. While it may offer tax efficiencies and effectiveness, the trading trust could easily operate to prejudice trade creditors.

Trade creditors may be prejudiced if the trustee (as is usual) does not notify creditors that it is acting as trustee. Therefore, the trustee will be personally liable to trade creditors and, should the trustee be liquidated, the trust property will be ring-fenced for the beneficiaries.

The facts and issues dealt with in Levin v Ikiua

Mr Ikiua and Mr Apa (‘the Directors’) were joint owners and directors of a company (Oceania) that provided rehabilitation case management services to the Accident Compensation Corporation (ACC) pursuant to a fixed-term contract. The Directors incorporated a further company named OPC Managed Rehab Limited (OPC), which was owned by Oceania but controlled by the Directors. OPC then entered a similar fixed-term contract with ACC in relation to the provision of rehabilitation case management services to ACC (‘the contract’).

Consistent with tax and accounting advice received in late 2000, OPC declared itself trustee of its business undertakings, namely the contract, and the trading trust was created (‘the Trust’). The beneficiaries of the Trust were three further trusts: one for each of the Directors’ respective families and a charitable trust. The Directors were trustees of these underlying trusts.

ACC were not informed of the creation of the Trust and continued to trade with OPC. The contract continued for a time and a new contract was entered between OPC and ACC in 2001.

The contractual relationship terminated in 2002 and ACC conducted an audit of the sums paid to OPC. ACC considered that it had overpaid OPC the sum of NZD695,190 and claimed the monies back by statutory demand, which led to the liquidation of OPC.

The liquidators reviewed OPC’s affairs and issued proceedings against the Directors claiming that they had knowingly operated an ‘empty shell’ policy intending to defeat the claims of OPC’s creditors. The liquidators claimed, among others things, the following.

1. That OPC’s business undertaking had not been validly settled on trust

The liquidators argued that there had been no valid settlement because:

athere was no written or oral declaration of trust;bOPC’s conduct was insufficient to demonstrate an intention to declare a trust;cOPC failed to execute a sale and purchase agreement transferring the business undertaking from OPC itself to OPC as trustee of the Trust (as it had been advised to); anddthe alleged declaration was unlawful as it breached the non-assignment clause in the contract.

Despite the Directors claiming that they had orally declared the Trust, the Court accepted the liquidators’ assertion that there was no written or oral declaration of trust. However, the Court found that there was sufficient evidence of OPC’s conduct to demonstrate that OPC intended to declare a trust over the business undertaking. In particular, the Court relied on the following matters, which took place after the purported declaration had taken place: (i) OPC filed a business cessation notice with the Inland Revenue Department (IRD); (ii) OPC filed nil taxation returns with the IRD; (iii) the Trust applied for an IRD number; (iv) the Trust applied for GST and employer registration; (v) the Trust’s financial statements showed the business undertaking as a Trust asset; (vi) the trading income was shown as the Trust’s income; and (vii) OPC’s minutes described its trading activity as being undertaken as corporate trustee for the Trust1.

As to the argument that the Trust failed because OPC had neglected to follow the advice to execute a sale and purchase agreement, the Court relied on the decision of Turner J in the case of Milroy v Lord2, where it was made clear that a Court will not intervene to perfect an imperfect instrument3. Unsurprisingly, the Court held that the legal owner of an asset may retain legal ownership of an asset and at the same time declare a trust of that asset in favour of another. The Court also found that there was no requirement to execute documentation to transfer equitable title to a chose in action such as a contract. The Court therefore rejected the liquidators’ claim on the basis that there was no need for OPC to execute a sale and purchase agreement to declare the trust such that the failure to follow the advice to do so did not mean that the declaration was imperfect.

The claim that the non-assignment clause had been breached failed because a declaration of trust is not an assignment such that the restriction did not bite.

2. That OPC retained a beneficial interest in distributed monies

The liquidators claimed under the New Zealand insolvency statute4 that the distributions to the underlying trusts were made for inadequate consideration and sought to claim those monies back. While it was accepted that the distributions were paid to ‘insiders’ (persons either sufficiently connected with or related to a director or a person with control over the company) so as to enliven the appellate court’s jurisdiction, the transactions could not be set aside because the monies were held as trustee and were not available to the creditors on liquidation. The Court indicated that the better argument may have been that the initial declaration of trust over the business undertaking was an impeachable transaction inasmuch that the same constituted an asset of OPC at that time. The appellate court emphasised that once a trust had been declared over the business undertaking, the distributions of trading profits were unchallengeable because there was no obligation on the Directors to obtain fair value in exchange for those dispositions.

On appeal, the liquidators also claimed that OPC as trustee had an interest in the trust property distributed to the beneficiaries commensurate with its entitlement to an indemnity in respect of expenses properly incurred in the administration of the Trust. The Court readily accepted the principle but the claim failed because the liquidators failed to show that OPC was entitled to any indemnity at all.

3. That OPC’s directors were personally liable for the distributions

The liquidators claimed that the Directors were in breach of a number of statutory and common law directors’ and fiduciary duties in their management of OPC. The trial judge had largely rejected this claim because the Directors had acted in good faith, with due care and with proper regard for OPC’s creditors’ interests (because known creditors were paid or provided for before distributions were made). The trial judge found that the Directors had naively but honestly created and administered the Trust in accordance with accounting and legal advice.

While it may offer tax efficiencies and effectiveness, the trading trust could easily operate to prejudice trade creditors

However, the Directors were found to be in breach of directors’ and fiduciary duties in respect of all distributions made after they were notified of ACC’s allegation that overpayments had been made. The Directors were personally liable for distributions made subsequent to this time (totalling NZD8,000.80).

The appellate court upheld these findings and noted that the Directors could not have ‘reasonably anticipated’ the late emergence of a disputed liability given the invoicing and payment systems in place as between ACC and OPC.

Discussion and conclusions

Although Levin suggests that trading trusts are a valuable wealth management tool, the case involved laypeople acting honestly under professional advice. The position is different for professionals and distinct issues arise for those taking on the office of director of the corporate trustee of a trading trust. Those willing to do so must be alive to the possibility of settlements onto trust and distributions from trusts being impeached for being made preferentially or at an undervalue. Additionally, the directors must be mindful of the possibility that they might incur a criminal and/or civil liability for wrongful and fraudulent trading where it is reasonable to anticipate that disputed debts might arise.

The directors must also consider the company’s right to be indemnified from the trust assets for properly incurred expenses. The future potential requirement to make a call on that indemnity could stifle the effective administration of the trading trust inasmuch that it will be difficult to determine whether to make a distribution, and, if so, in what sum, and whether any security ought to be required.

Clearly, professional directors of trading trusts must be astute to manage carefully the discharge of their duties if they are to avoid a potential personal liability in the long run.

At paras 10 and 43.
(1862) 4 De GF & J 264 (CA) at 274-275.
By way of example, this means that a Court will not treat an inchoate attempt to transfer legal title to a trustee as operating as a declaration of trust.
s.298(2) of the Companies Act 1993.

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