Australia: Part 2: Trusts and insolvency—is it different in bankruptcy?

The 'hotch-pot' causes a stir and a twist

Plenty of lively discourse ensued from November's article Part 1!

This article shared insight into a bankruptcy where we sought directions from the Federal Court of Australia involving trust and non-trust assets being distributed to trust and non-trust creditors. The strained and counterproductive relationship of insolvency with trust law continues to enliven interesting discussion on an insolvent trustee's rights to trust assets and its subsequent impacts on creditors.

In Part 1, I summarised Justice Derrington's key principles, outlined in his judgment, in Lee (Bankrupt) v Deputy Commissioner of Taxation [2017] FCA 953. These included a bankruptcy's impact on the right of indemnity, the differences between a company in liquidation and an individual in bankruptcy where they are trustees of a trust, and the impact on the property of the trust.

In this article, Part 2, I give some guidance on some key principles on the right of indemnity in a bankruptcy scenario, in particular how trust and non-trust assets should be distributed.

Justice Derrington's orders said:

  1. Trust assets are subject to the trustee's right of exoneration out of trust assets and must be distributed to trust creditors—at the exclusion of non-trust creditors.
  2. Trust assets are distributed first and prior to a bankruptcy dividend.
  3. That the priority provisions of section 108 and 109 Bankruptcy Act 1966 do not apply to the trust assets' distribution and are to be paid pari passu (equal basis).
  4. In the bankruptcy's dividend to all creditors, the trust creditors must bring into "hotchpot" the amount that they received from the trust assets.
  5. The principles in Re United Distributing, and Berkeley Appelgate justify payment to the bankruptcy trustees of amounts relating to performing work necessary to exercise the right of exoneration.

The reasoning behind point one above, at the exclusion of non-trust creditors, is premised on the right of exoneration's limited application of the right of exoneration and that the trustee's insolvency does not alter these limited rights.

It was no great surprise that the distribution of the trust assets should occur first prior to the distribution of the non-trust assets. It seems only reasonable that debts incurred from trust activities are paid from trust assets first, prior to those trust creditors participating in any distribution from the non-trust assets in the bankrupt estate. In obiter dictum (i.e. a judge's passing comment), Justice Derrington commented trust creditors being akin to secured creditors, where the amount remaining owing to trust creditors is the total amount of their debt less the value of subrogated right of indemnity. In this context, His Honour commented that it would be unusual to allow a trust creditor to claim for the full amount in the bankrupt estate without exhausting its higher rights. If that was to occur, His Honour states that a 'right of recoupment' could arise for the bankrupt estate for the amounts paid to trust creditors from the personal asset pool. This would lead to further funds becoming available in the bankrupt estate, and a further right of recoupment arising, over and over. His Honour comments that it is unlikely legislature would have intended such an 'absurd' result.

The "hotchpot" principle is something that we had never heard of until our solicitor brought it to our intention; subsequently forming part of our submissions, and ultimately considered by Justice Derrington. Having brief references in legal literature, little authority had applied the principle in an insolvency context. The "hotchpot" principle in our context is the deferral of the trust creditors' right to participate in the bankrupt estate dividend until the non-trust creditors received the same rate of dividend that the trust creditors received from the initial trust distribution (through the right of exoneration). The principle has been used in cross-border insolvencies where a creditor has obtained a benefit from distribution of property in one jurisdiction, should not participate in a subsequent distribution in another jurisdiction without bringing into 'hotchpot' the amount they received from the first distribution. The real point of contention was whether the trust creditors had benefited from a 'common fund' which His Honour decided was the case. His Honour went on to say that section 108 of the Bankruptcy Act 1966 further supports the use of the 'hotchpot' principle where the legislative direction was for all debts in the bankruptcy to be paid proportionately, and unless otherwise provided for, equally.

Justice Derrington's route to justify the basis of our costs, expenses, and remuneration involved a dissection of several cases, all of which considered the principles of Re United Distributing and Berkeley Appelgate. A common message that resonates from these cases is that an insolvency practitioner should be paid for all reasonable and necessary steps taken to enable trust creditors to benefit from the subrogated right of exoneration, and that the payment should come out of the pool (created or preserved by the insolvency practitioner) in priority. Specifically, in our case, the justification was that if we had not undertaken the work, then trust creditors would be forced to apply to court to have a receiver appointed to enforce their rights. The circumstances required us to complete work that the receiver would have otherwise completed and as such, His Honour stated we were entitled to charge on the funds created to preserve our entitlement as against the trust creditors.

These were comforting words from the Federal Court, which gives insolvency practitioners reassurance on the ability to be paid for the work conducted to create and/or preserve trust assets for the trust creditor's benefit.

The ongoing proceedings in our matter has taken some interesting turns with the Commissioner of Taxation's application seeking leave to appeal the decision being stood over until the decision in Killarnee Civil & Concrete Pty Ltd (In Liq) (WAD 181/2016) comes down. We are now waiting for a decision to be handed down in respect of the treatment of the ATO preference funds. With a few balls in the air, uncertainty remains as to how they will fall in place; but, we will be sure to share developments with readers in Part 3, in early 2018.

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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