Isle of Man: Insolvent Trusts: Do Creditors Trump Beneficiaries?

To talk of an insolvent trust is, of course, a misnomer, a trust is not a separate legal entity and cannot, as a matter of law, be insolvent. Trustees enter into commercial agreements with third parties in their own names and, in the absence of limited recourse provisions, trustees will be personally liable.

Nevertheless, in a recent judgment, Representation of the Z Trusts [2015] JRC 196C, the Royal Court of Jersey stated that whilst the term “insolvent trust” was a misnomer, it was a useful form of shorthand to refer to the situation where a trustee is unable to meet its liabilities as and when they fall due out of the trust fund i.e. in accordance with the “cash-flow” test.

The Royal Court equated trusts to individuals or companies in the ongoing conduct of their business and activities as opposed to an estate, where the affairs of the deceased are being wound up finally. In respect of the latter, it is relevant that the assets may exceed the liabilities on a balance sheet basis. Whereas in respect of trusts, just like companies and individuals, solvency on the balance sheet test is irrelevant if the debtor cannot pay his or its debts as and when they fall due.

The case concerned two trusts that had been established by C and were “insolvent”. As a result, they were being administered under the direction of the Court. C and her family, being the beneficiaries of the trusts, argued against the imposition of a formal “insolvency regime” (by way of the appointment of an insolvency practitioner) as this would result in disproportionate costs being incurred and the forced sale of family assets. Instead, C sought to exercise her power under the trust deeds to replace the current trustees with new trustees who would undertake a wider restructuring, seeking to resolve the cash flow problem and protect the family assets.

By way of further analogy to companies, the Royal Court confirmed that insolvency shifts trustees’ fiduciary duties, ordinarily owed to the beneficiaries, towards the creditors who now have the economic interest in the trust. This also extends to third parties owing fiduciary duties in respect of the trust, for example a protector. On insolvency, trusts must be administered for the benefit of creditors as a class (and not simply a majority) and any failure to do so could give rise to creditor claims directly against trustees.

Accordingly, in view of the trusts being “insolvent”, C was required to exercise her fiduciary powers for the benefit of the creditors and not the beneficiaries i.e. either with the consent of all the creditors or under direction of the Court. C’s appointment of the new trustees was therefore set aside on the basis that she did not have the consent of all the creditors or the approval of the Court and her decision had been taken in the interests of the beneficiaries with the intention of avoiding “insolvency” rather than in the interests of the creditors.

That case did not confirm what the appropriate insolvency regime is for trusts. This issue was however addressed by the Royal Court in its latest judgment, Representation of the Z Trusts [2015] JRC 214.

The Royal Court held that the starting point in the case of an “insolvency” or probable “insolvency” of a trust is for the Court to supervise the administration of the trust in the interests of the creditors as a body, by way of directions to the trustee.

In this case, the trustees had the power to appoint an insolvency practitioner to assist them in the winding up of the trusts and delegate powers to that practitioner and therefore the Court could direct the trustees to do the same.

The Court further noted that there was no example of it directly appointing an insolvency practitioner to conduct the winding up of an “insolvent trust”. Nevertheless, the Court held that in principle it did have the power to make such an order under its inherent supervisory jurisdiction (which would in effect be tantamount to appointing the insolvency practitioner as receiver of the trust assets). The Court provided examples of lay trustees being ill-equipped to wind up the trust or where the trustees had a real conflict which would make it impractical to conduct the winding up even under the direction of the Court, when it might be appropriate to appoint a receiver to conduct the winding up.

Because the present case did not involve claims from third party creditors, all pressing for the claims to be paid, there was little point in engaging a formal process of examining, admitting or rejecting claims. On the contrary, the majority of the creditors were connected and opposed a formal regime which they said would destroy any real value left in the trusts. Instead, the Court gave directions in respect of each trust for the trustees to deal with each of the claims.

Whilst the concept of an “insolvent trust” is not new, the Royal Court’s guidance on when a trust is insolvent, what a trustee’s or other fiduciary’s duties are in those circumstances and also on the considerations surrounding the appropriate “insolvency regime” will be welcome guidance to trustees, albeit that is clear that there is no universal approach to be taken and each case will depend on the circumstances.

In the absence of authority to the contrary, these cases are likely to be followed by the Isle of Man Courts.

In view of this, Trustees should take the time to consider whether they have taken all possible steps to avoid financial difficulties prior to them occurring and in the event of “insolvency” or potential “insolvency” must consider seeking the guidance and protection of the Isle of Man Court.

Where appropriate, an application to the Isle of Man Courts should be made for the Court’s assistance and supervision. As in the case of the Z Trusts, such an application should seek the Court’s direction on matters including ascertaining the identity and value of creditors, the realisation of trust assets, the order of priority for any payment to creditors and in appropriate circumstances, subject to the terms of the trust deed, the appointment of an insolvency practitioner.

DQ has a large specialist trust and private client team consisting of three directors, a senior associate, two associates and a trainee. Our specialist team has extensive experience of advising clients in relation to the establishment and structuring of trusts and foundations, estate planning, trust and estate litigation, international tax investigations and TIEA requests.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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