Australia: Part 1: Trusts and insolvency—is it different in bankruptcy?

A personal taste to the ongoing trust complexities.

As many readers are aware, there has been no shortage of cases in recent years dealing with a scenario where a corporate trustee of a trust goes into liquidation. Judges have drawn on various authorities to provide guidance on key principles surrounding the liquidator exercising the company's right of indemnity and supporting lien, and the interactions with the Corporations Act 2001 (most notably, whether the priority provisions apply). Despite the number of cases, uncertainty remains and currently, no firm overriding authority on a final position.

At Worrells, while we are avidly watching the judgements that are continually handed down in the corporate sphere, we are involved in a trust matter that adds another layer of complexity to the 'trusts and insolvency' issue. We are the bankruptcy trustees of an estate where the bankrupt is trustee of a trust. We recently sought directions from the Federal Court of Australia on various matters surrounding the bankruptcy's administration and how to deal with the trust assets in Lane (Trustee), in the matter of Lee (Bankrupt) v Deputy Commissioner of Taxation [2017] FCA 953.

The matter involves a bankrupt who was sole trustee of discretionary family trust that owned and operated a Subway franchise business and employed several staff. Prior to our appointment, the trust sold the Subway business resulting in substantial sale proceeds. It must be noted that the bankrupt remained as trustee of the trust after our appointment as bankruptcy trustees. This is because there was no ipso-facto clause removing the bankrupt as trustee due to the bankruptcy.

From the outset, it was apparent that we were dealing with both Subway business assets, being the sale proceeds (trust assets), and the bankrupt's personal assets (non-trust assets). We also found the Subway business had outstanding debts (trust creditors) and separately, the bankrupt's personal debts (e.g. personal credit cards, loans, and tax debt) (non-trust creditors) that exceeded the value of trust and non-trust assets. Compounding the complexity, was an unfair preference claim, comprising of payments partially made using the bankrupt's own funds and trust funds, but the debt only related to a trust debt. The lack of precedence involving a bankrupt trustee of a trust and administrations dealing with both trust and non-trust assets and creditors led us to seek directions from the Federal Court of Australia.

A 111-page judgment was handed down by Justice Derrington, referring to the large number of directions that we sought, and the uncertain state of the law in relation to the matters. His Honour provided much-needed guidance on some key principles around a bankrupt trustee's right of indemnity out of trust assets, which is summarised as follows:

  1. A trustee has the right of indemnity from trust assets in respect of trust debts.
  2. The right of indemnity from trust assets falls into two distinct parts, being the right of recoupment (right to reimbursement from trust assets for trust debts discharged by the trustees using personal funds) and right of exoneration (right to discharge trust debts from trust assets).
  3. The trustee has an equitable lien supporting the right of indemnity. Upon the trustee's insolvency, trust creditors are subrogated to the trustee's right of exoneration and supporting lien.
  4. The right of recoupment and right of exoneration is the insolvent trustee's personal property, which passes to the bankruptcy trustee as 'property of the bankrupt divisible amongst creditors'.
  5. The right of recoupment results in the trust funds being transferred beneficially to the bankrupt estate, available to meet claims of both trust and non-trust creditors, under the priority provisions of the Bankruptcy Act 1966.
  6. The right of exoneration is much more limited. It does not result funds being beneficial received by the bankrupt estate, merely a right to use trust funds to discharge trust debts to the exclusion of non-trust creditors.
  7. As all trust creditors have equal rights of subrogation to the right of exoneration and supporting lien; payments out of this right are to occur pari passu ).

Some interesting observations can be made from His Honour's guidance above.

Firstly, how the right of indemnity exercised by a bankruptcy trustee compares to that of a liquidator. The bankrupt estate runs alongside the bankrupt's ongoing personal duties and obligations as trustee of the trust. This differs from a liquidated company that remained as trustee of the trust that would be fully controlled by the liquidator as company officer. In this administration, as the trustee is bankrupt, the only recourse is for trust creditors to claim in the bankrupt estate. His Honour explains that the right of indemnity that arises is 'property of the bankrupt' and that it is this right of indemnity that vests in the bankruptcy trustees.

Secondly, His Honour's interpretation of sections 58 and 116 and their interaction with section 108 and 109 of the Bankruptcy Act. His Honour states that while a bankruptcy trustee can take possession of all 'property of the bankrupt', only 'proceeds' from this realisation process are payable under the priority provisions. His Honour expresses that although the right of exoneration is 'property of the bankrupt', this right is not capable of being realised to produce 'proceeds' under section 108 and 109. What is interesting is that the Corporations Act's priority provisions do not refer to 'proceeds', however, His Honour does address that the right of exoneration itself is incapable of being realised. Furthermore, His Honour noted that a right of exoneration provides a very narrow right for the sole purpose of discharging trust debts.

A growing list of authorities confirms that the priorities outlined in sections 108 and 109 of the Bankruptcy Act and section 556 of the Corporations Act for distribution of trust assets do not apply, and this is the first case we know of that involves a bankrupt trustee and the Bankruptcy Act. Its effect has a significant impact on employees of trading trusts, particularly the Commonwealth where it has paid employee entitlements under the Fair Entitlements Guarantee (FEG) regime and seeks to recover these advances as a priority. This point of contention is currently being considered in two matters, being Re Amerind Pty Ltd (Receivers and Managers Appointed) (In Liq) VSC 127 of 2017 and Killarnee Civil and Concrete Contractors Pty Ltd (In Liq) WAD 181 of 2016, where the Commonwealth is involved and undoubtedly, seeking that the priority provisions should apply.

The proceeding in our matter is ongoing with considerations on how to allocate the unfair preference monies, and how to distribute the trust assets in view of the orders that the statutory priorities do not apply.

In our next article on this administration we will cover what orders were made in respect of the distribution of the trust and non-trust assets, the 'hotch-pot' principle, and the judgment details regarding our remuneration and costs and therefore how those will be paid from the asset pools.

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