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Trusts and attempts to avoid creditors

One of the reasons for setting up a trust is to set aside property as separate from one’s personal assets. One of the benefits of this is that assets which are held in a trust are protected from creditors, for example should the settlor become insolvent or be declared bankrupt. However, there are limits on such protection as explained below.

A recent BBC Panorama programme highlighted that bankruptcy isn't always what it seems. Some of Britain's biggest bankrupts are going to great lengths to hide their money while declaring themselves bankrupt to escape their debts. Doubtless, some of the ways of hiding money involves trusts. Sometimes a “proper” trust may be created but with the specific intention of avoiding creditors; in other cases there may only be an appearance of a trust.  In other words, there may be a sham. In either case the Courts are likely to set such a trust aside. All financial advisers need to be aware of when this can happen.

Trusts and protection from creditors

It is well known that, for a trust to be legally effective, the settlor must divest himself of the beneficial ownership of the trust property. This is especially important where the settlor is one of the trust beneficiaries or has reserved extensive powers for himself. If the trustees do not assume proper control over the trust property and simply follow the settlor’s instructions, the chances are the trust will be declared to be a sham or a mere illusion (there is only a subtle difference in law between the two). There have been a number of cases where a trust has been declared to be a sham and therefore not valid. 

As for trying to avoid creditors, even if a trust is not a sham, there is no absolute protection.  Namely, there will be no protection for trust assets if at the time of making the transfer to the trust the settlor is already insolvent (or becomes insolvent as a consequence of the transfer) or the transfer is made with a view to avoiding creditors. The statutory basis for this in England and Wales is in sections 339-423 of the Insolvency Act 1986.

Generally, transfers made more than 5 years before insolvency will be "safe" but there is no time limit if the intention was to defraud creditors.

Trusts to avoid creditors

A good example of what happens if property is transferred to a trust to avoid creditors is the case of  IRC v Hashmi & Hashmi [2002] EWCA Civ 981 [2002] . Mr Mohamed Akram Hashmi’s tax affairs were under investigation by HMRC.  Before his death he had set up a trust for his minor son and transferred his interest in a property to it.  HMRC applied to the High Court to have the trust deed set aside under the Insolvency Act 1986.  The High Court granted the application.  The property transferred to the trust was beneficially owned by Mr Hashmi and no steps were taken to protect his son’s interest in the property until after Mr Hashmi’s death.

On appeal to the Court of Appeal the point at issue was whether the High Court had been correct in finding that the transfer by Mr Hashmi to the trust should be set aside.  The Court of Appeal decided that, on the evidence before them, the High Court had been entitled to hold that a major factor in Mr Hashmi’s decision to set up the trust was the possibility of putting the property beyond the reach of creditors, including HMRC. It was not necessary for the proscribed purpose to be the dominant purpose; it was sufficient if it was a real substantial purpose.

There was another more recent case involving a so-called  “deed in the drawer” , i.e. a case in which the  trust deed was produced by the debtor only after the creditor had moved to enforce its security. This was the case of  Swift Advances PLC v Anjum Ahmed and Parveen Ahmed [2015] EWHC 3265 (Ch) 165.

The creditor made  an application under section 423 of the Insolvency Act 1986 to set aside a deed of trust on the grounds that it was a transaction entered into at an undervalue, “a real and substantial” purpose of which was to put assets beyond the reach of a creditor, or to otherwise prejudice the interests of creditors.  The trust was created by Mr Ahmed in favour of his wife, the second defendant, giving her beneficial ownership over two properties against which it was alleged that he subsequently secured loans.

The judge noted that the deed of trust created a “trust of land” but Mr Ahmed had not complied with the Land Registration Act 2002 or sought the advice of a conveyancing solicitor or the Land Registry. He held that in such circumstances an inference could be drawn that a reason for not doing so was to keep knowledge of the transaction private and within his control. This might be sufficient on its own to establish the required purpose under section 423, although in this case it supported other evidence to the same effect. The “trust” was set aside.

Sham trusts

A recent decision in JSC Mezhdunarodniy Promyshlenniy Bank and another v Pugachev and others [2017] EWHC 2426 (Ch) demonstrates the willingness of the Courts to strike down sham trusts. It is worth looking at it in detail for a number of reasons.

The Pugachev decision is interesting as it comes soon after the Panama Papers and Paradise Papers and the considerable publicity given recently to tax avoidance involving hiding assets offshore. It is also interesting because the claimants based their case on three separate arguments so as to cover all the angles. In the event they won on all three counts.

The Facts

The facts of the case were as follows:

Mr Sergei Pugachev, a Russian national, founded Mezhprom Bank in Russia in 1992.   Following the 2008 financial crisis the bank suffered losses and was ultimately declared insolvent in 2010. The Russian state agency, Deposit Insurance Agency (DIA), was appointed as liquidator.

Between 2011 and 2013 Mr Pugachev settled over US $95 million of his assets in five New Zealand discretionary trusts.

Although the majority of the assets had notionally been settled on trust by Mr Pugachev’s son, Viktor, the assets originated from Mr Pugachev (indeed the judge decided that Mr Pugachev should be treated as the settlor of the trusts as Viktor was in effect acting as his nominee).

The trusts held assets largely for the benefit of Mr Pugachev, his partner and their minor children.

The trusts were governed by New Zealand law and were set up with the assistance of a New Zealand solicitor. The solicitor and his wife were directors of the companies that acted as trustees.

There was in fact an earlier case involving these trusts brought in the New Zealand Court where the original trustees had been removed with the agreement of the Court. Although the New Zealand court suggested that it considered the trusts to be neither illusory nor shams, this was apparently based on deficient and incorrect information given to the New Zealand Court.

Mr Pugachev was the protector of each of the trusts, with Viktor named as successor protector. The trust deeds provided that Mr Pugachev’s protectorship would automatically terminate in circumstances where he was “under a disability”, a term which included when Mr Pugachev was subject to the claims of creditors. The protector’s powers were unusually extensive and included powers to:

  • veto the distribution of income or capital from the trusts;
  • veto the investment of the trust funds;
  • veto the removal of beneficiaries;
  • veto any variation to the trust deeds;
  • veto the release or revocation of any power granted to the trustees;
  • veto the early termination of the trust period;
  • appoint and remove trustees, with or without cause;
  • add further beneficiaries; and
  • veto an amendment to the trusts by the trustees. 

Back in Russia the DIA alleged that Mr Pugachev had misappropriated Mezhprom Bank assets prior to the liquidation and in 2015 the Russian Court gave judgment against Mr Pugachev in the sum of approximately US $1 billion. Mr Pugachev fled Russia and moved to England. (Hence the case was heard in the English Court).

DIA began enforcement proceedings in England and obtained a GBP £1.1 billion worldwide freezing order against Mr Pugachev's assets. He was also sentenced to two years' imprisonment for contempt of Court which he has not served as he fled to France.

The argument

Mezhprom Bank and the DIA (the claimants), sought to "bust the trusts" and enforce the judgement against the assets of the trusts on three separate bases: 

  1. The trusts were illusory and of no substance because the trust deeds, properly construed, did not divest Mr Pugachev of his beneficial ownership in the trust property;
  1. Alternatively, the trusts were shams and of no effect because the common intention was that the assets would continue to belong to Mr Pugachev; and
  1. In the alternative to the first two claims, if the trusts were effective and divested Mr Pugachev of ownership of assets, they should be set aside under section 423 of the Insolvency Act 1986 because the intention was to prejudice the interests of Mr Pugachev's creditors.

The judgment

As indicated above the High Court agreed with all three arguments.

Re: Illusory Trusts

The Court concluded that these were bare "illusory" trusts. Mr Pugachev was the settlor, discretionary beneficiary and protector of the trusts. He retained extensive control because he could dismiss the trustees and veto how they exercised their powers, and consequently retained beneficial ownership of the assets he put into the trust.

Re: sham

The Court decided that it was a sophisticated and subtle form of sham. The intention was for Mr Pugachev to retain ultimate control, but to hide this control from third parties by giving a false impression that he had only limited powers as protector. The second protector, Viktor, acted on his father's instructions and, whilst the other beneficiaries (his children) would benefit from the trust, they only did so through the decisions of Mr Pugachev. In addition, the New Zealand solicitor who acted as director of each of the trustee companies had no independent will from that of Mr Pugachev.

Re: Section 423

The Court found that if the trust deeds did divest Mr Pugachev of his beneficial interests in the assets, then it was with the purpose of hiding his control of the assets in the trusts from his creditors and so should be set aside.

Comment

Given the extensive powers that Mr Pugachev reserved for himself it is not really surprising that the Court found against him, especially given the specific facts and circumstances, which are probably not that common. However, there are some important lessons here for all  potential settlors, namely that the  retention of excessive control over a trust arrangement may lead to successful claims by third parties that the settlor has never successfully divested himself of the beneficial ownership of  the relevant assets.

Clearly, it is possible, in principle, to protect assets from creditors by setting up a suitable trust. However, it is also clear that the mere existence of a trust does not by itself offer any protection. Where land is involved it is also important to remember to record any changes of beneficial ownership in the Land Registry, and that avoidance of creditors need not be the "main motive" of creating the trust for the transaction to be set aside. The reality of the situation will be of paramount importance and the Courts will carefully examine all the evidence.