The Court of Appeal's recent decision in Clayton v Clayton1 as been described as redrawing the landscape on trusts and divorce.2 The decision has already generated discussion within the legal community because the Court decided that a settlor's power of appointment could be relationship property. The Court went on to determine that the value of the appointment was the net value of the trust's assets.
The decision is also important because it is the first New Zealand case where the concept of an "illusory trust", as distinct from a "sham trust", has been considered. It is this aspect of the decision which I intend to discuss in this article.3
Mr and Mrs Clayton separated in 2006 after 17 years of marriage. The proceedings concerned the division of relationship property under the Property (Relationships) Act 1976. The case concerned various trusts settled during the parties' marriage. Three of the trusts gave rise to nine questions in the Court of Appeal but only one trust is relevant to the issue I wish to discuss.
The Vaughan Road Property Trust ("VRPT") was settled in 1999 by way of a declaration of trust by Mr Clayton as trustee. He is the settlor and sole trustee. The discretionary beneficiaries include Mr Clayton as the principal family member, Mrs Clayton as his wife, and the children are the final beneficiaries.
The VRPT was described as operating as a banker. It has largely borrowed from BNZ to advance loans to other entities.
I intend to set out the provision of the trust deed only as they relate to the reasoning of the courts.
The Family Court decision
In the Family Court Judge Munro held that the VRPT did not meet the basic elements of a trust and was therefore illusory.4 The effect of this finding was that the VRPT's property was owned both legally and equitably by Mr Clayton, and was therefore relationship property.
In particular, Judge Munro was concerned with three issues. Firstly, he reasoned that the provision conferring the trustee unfettered discretion, read with a provision allowing the trustee's interests to conflict with his duties to the VRPT trust fund "negated the beneficiaries' ability to call the trustee to account in the exercise of his discretion"5. It was therefore held that the beneficiaries had no rights under the deed enforceable against the trustee.
Secondly, the Judge Munro held that, unlike an administrative power to appoint and remove trustees, the power of revocation in the trust deed was a dispositive power which could be exercised selfishly without regard to the interest of others.
Finally, the Judge Munro held that the VRPT deed and the manner in which it had been administered indicated that it is a convenient structure for commercial purposes, carrying few hallmarks of a trust.6
The High Court decision7
For reasons that differed from those given in the Family Court, the High Court held that the VRPT was not a sham, but it was illusory.
The High Court Judge, Rodney Hansen J, rejected the argument that the VRPT trust was a sham on the finding that it was clear that Mr Clayton intended to create a trust and intended to do so for legitimate business purposes.
The Judge did not agree with the Family Court's reasons for finding that the VRPT was illusory. In particular, the Judge did not accept that the provisions granting unfettered trustee discretion and allowing conflicts of interest eroded the trustee's core obligations.
The decision relied on Millet LJ's well cited discussion in Armitage v Nurse on the "irreducible core" of a trustee's duty:8
Unless a trustee is accountable to the beneficiaries for these core obligations, then no trust exists.
Notwithstanding his disagreement with the reasoning of the Family Court, the Judge concluded that certain provisions in the VRPT trust deed "led irresistibly to the conclusion that Mr Clayton indeed retained powers tantamount to ownership of trust property".9
The Judge was particularly influenced by the High Court decision of Winkelmann J in Financial Markets Authority v Hotchin10.
In Hotchin the Financial Markets Authority ("FMA") was seeking certain orders in respect of property held in two trusts associated with Mr Hotchin. In both the two trusts under consideration, Mr Hotchin was settlor and he held the power to appoint and remove beneficiaries and trustees. He could therefore appoint himself sole trustee and a discretionary beneficiary, and because the deeds conferred unfettered discretion upon the trustees to distribute the property without considering the interests of any beneficiary, including future beneficiaries, the FMA argued that Mr Hotchin "retains such control that the proper construction is that he did not intend to give or part with control over the property sufficient to constitute a trust".11
However, Winkelmann J found that the existence of a clause that prohibited self-benefit defeated such an argument. Mr Hotchin could not use control as a trustee to distribute trust property to himself, nor could (Winkelmann J found) the trust deed be amended to remove the self-dealing prohibition.
In contrast, the VRPT trust deed expressly permits a trustee who is a beneficiary to exercise any power or discretion in his or her own favour. Accordingly, the Judge distinguished Hotchin and held that:12
Court of Appeal decision
The Court of Appeal held that the lower Courts had erred in finding that the trust was illusory. The concept of an illusory trust was unambiguously rejected.
Relying on authority and commentary from other jurisdictions, the Court held that the distinction between a sham and illusory trust could not be supported.13 The question in both cases is, notwithstanding the existence of a trust deed, did the settlor genuinely intend to create a valid, enforceable trust?
The Court pointed out that, in order to find that no sham trust exists, a court is required to examine all the relevant evidence and conclude that the settlor intended to create valid trust. In such circumstances it is not appropriate for a trust to be invalidated simply because the trustee has wide power of control over trust property.
The Court found that an illusory trust was inconsistent with the fact that the terms of the VRPT did not erode Mr Clayton's core obligations as trustee to act honesty and in good faith:14
The powers of Mr Clayton as trustee under the [trust] to deal with the trust property for his own benefit and without regard to the interests of the other beneficiaries did not mean that he owed no obligations at all to those beneficiaries or that they had no rights enforceable against him as trustee.
The Court was also concerned to recognise rights of beneficiaries in this context. It noted that where the conditions have been met to establish a trust (and there is no sham) uptake of control by someone other than an authorised person ought not to extinguish the rights of beneficiaries under a trust.15 In such cases beneficiaries have remedies available which they may choose to pursue.
The Court concluded that in the absence of a finding of a sham or the existence of a statutory power to set aside a trust (as in the case of a tax avoidance arrangement), the courts have no power to set aside an otherwise valid trust.
In our view the Court of Appeal's decision regarding illusory trusts is to be commended.
The issue of whether the illusory trust has utility as an equitable concept goes well beyond trusts concerned with relationship property issues. It is not uncommon for trusts to contain a clause which allows a settlor beneficiary to exercise powers in his or her favour. If the High Court decision had been upheld, such trusts may have required provisions preventing "self-benefit" in order to avoid the risk of a court concluding that they were illusory.
Prior to the Hotchin and the High Court decision, many considered it settled law that a settlor was accorded a large degree of freedom provided the irreducible core of a trust is present. The powers afforded to Mr Clayton do not dissipate his core obligations to the VRPT's beneficiaries.
The powers held were fiduciary powers, and consequently had to be exercised honestly, in good faith, and in the best interests of the beneficiaries as a whole. The trustee would be subject to acting for proper purposes and not committing a fraud on any power.
There may be injustices within the relationship property context which require remedying through reform to the Property (Relationship) Act 1976. That is a matter for Parliament.
The Court of Appeal's decision is to be commended for correcting the development of an "off-shoot" in trust law, which could have undermined established trust law principles, and resulted in uncertainty for settlors and beneficiaries beyond the relationship property context.
1Clayton v Clayton  NZCA 30
(the "Court of Appeal decision").
2Hamish Fletcher Rotorua sawmill magnate's $28 million divorce wrangle: Ruling 'redraws the landscape' (The NZ Herald website, 6 March 2015).
3I intend to discuss the more controversial aspect of the judgment, relating to a settlor's power of appointment, in a separate article.
4The Court of Appeal decision at , citing MAC v MAC FC Rotorua FAM-2007-063-652, 2 December 2011 (the "Family Court judgment") at .
5The Court of Appeal decision at [26(a)].
6The Court of Appeal decision at [26(c)].
7Clayton v Clayton  NZHC 301,  3 NZLR 235 (the "High Court decision").
8Armitage v Nurse  Ch 241 (CA).
9The Court of Appeal decision at  and the High Court decision at -.
10 NZHC 323.
11Ibid at .
12The Court of Appeal decision at  and the High Court decision at 
13The Court of Appeal decision at  - .
14The Court of Appeal decision at .
15The Court of Appeal decision at .
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.