Distribution of trust assets in a personal insolvency: Same, but different? - Insolvency/Bankruptcy

This week's TGIF considers the case of Lane (Trustee), in the matter of Lee (Bankrupt) v Commissioner of Taxation [2017] FCA 953, where the Federal Court considered whether the claims of 'non trust' creditors in a bankruptcy are to be treated differently than like creditors in a corporate insolvency.

BACKGROUND

Mr Lee was the sole trustee of a family trust. The family trust owned and operated a Subway franchise business and employed a small number of staff. The business was struggling and was ultimately sold. Within a few days of the sale, Mr Lee was bankrupted. The net proceeds from the sale of the business were received by Mr Lee's trustee in bankruptcy.

In the course of the administration of the bankrupt estate, Mr Lee's trustee in bankruptcy recovered an unfair preference payment from the ATO. The ATO contended that the business sale proceeds were available to all creditors, not just the creditors of the family trust.

Mr Lee's trustee in bankruptcy sought directions from the Court as to the proper application of the business sale proceeds.

THE COURT'S GUIDING PRINCIPLES

Derrington J considered the application and noted the considerable confusion in this area of the law as evidenced by numerous inconsistent authorities and commentaries. His Honour summarised the guiding principles that he considered should be applied, which included:

A trustee has a right to indemnification from the assets of the trust for debts incurred in operating the trust.
The right of indemnity is comprised of two discrete parts. A right of recoupment (being the right to recoup money from the trust assets in respect of liabilities which the trustee has previously discharged from their own funds) and a right of exoneration (being a right to discharge trust liabilities directly from the assets of the trust).
On the insolvency of the trustee, all existing trust creditors are equally entitled to be subrogated to the trustee's right of exoneration and lien, but not the right of recoupment.
Both the right of recoupment and right of exoneration will form part of the personal property of the insolvent trustee which will pass to the bankruptcy trustee (in the case of personal insolvency) as "property of the bankrupt divisible amongst creditors". Neither can be characterised as trust property (nor can the supporting equitable lien).
The exercise of the right of recoupment by a trustee in bankruptcy will result in trust funds being transferred beneficially to the estate of the bankrupt which are then available to meet the claims of both trust and non trust creditors.
The exercise of the right of exoneration by a trustee in bankruptcy is more limited, but will result in the transfer of trust funds directly to the trust creditors in payment of their debts.

COURT'S DECISION

Ultimately, the Court determined that the proceeds of the business sale were subject to Mr Lee's right of exoneration and were available to trust creditors to the exclusion of non-trust creditors, including the ATO.

Importantly, Derrington J disagreed with the assessment of the Supreme Court of Victoria in Re Amerind Pty Ltd (In liq) [2017] VSC 127 ( see our thoughts on this case here) (which is currently subject to appeal) that the right of indemnity itself was 'trust property' and not a personal asset of the trustee. In reconciling Re Amerind and other conflicting authorities, Derrington J noted that the only use to which the right of exoneration can be put by is to discharge liabilities owing to trust creditors, but that non-trust creditors will in turn benefit by having the claims on the non-trust property reduced.

COMMENT

While this decision does set out some helpful guiding principles that may be applied by insolvency practitioners when dealing with the distribution of trust assets, real uncertainty remains.

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.