"Reserved powers trusts" can, under Cayman Islands law, be of practical assistance in ensuring that a trust instrument reflects the reality of the arrangement, thereby lessening the risk of a "sham" challenge
In the offshore world, the discretionary trust has traditionally been regarded as a leading device for estate-planning, offering as it does such flexibility and the ability for a settlor to set out his intended dispositive plan in an accompanying private letter of wishes, rather than in the trust instrument itself.
Trust companies are used to marketing and administering fully-discretionary trust structures, and to maintaining the important distinction between "a direction from the client" and "a request from the settlor". But at the same time they are faced with an increasing tide of trust litigation, as settlors from the early days of offshore planning are starting to die or lose capacity and as society in general becomes more litigious.
There is also a trend towards settlors becoming more and more insistent that they should be permitted to retain a degree of control over their trust’s investments. This is particularly the case with entrepreneurs having personal experience of high risk investments, and settlors wishing to settle the shares in companies which operate family businesses. If such settlors are effectively to direct the trust investments, a fully-discretionary trust may not be appropriate.
From the trustees’ perspective, there may be a risk of a claim that they failed to exercise any independent judgement in exercising their powers1. There is also likely to be a dilemma as to whether they should comply with the settlor’s requests to make risky investments (for which they may be called to account by the beneficiaries) or refuse requests and perhaps see the trusteeship moved elsewhere.
From the settlor’s perspective, the effectiveness of the structure may be undermined because the trust may be laid open to a risk of a "sham" claim. There are essentially two broad types of "sham":
- what may be termed a "formal sham", where the dispositions under the document do not create a trust at all, but some other form of relationship such as an agency or nomineeship; and
- a "substantive sham", where the settlor and the trustees have effectively agreed between themselves an arrangement different to that set out in the trust instrument.2
It is the latter which is likely to be in issue where the trust is fully-discretionary but with the settlor retaining a degree of indirect control or influence over its administration.
A particularly unsatisfactory aspect of a claim of this type is that it is based on an assertion of ownership. If the claim is successful there is, in whole or in part, no trust at all, and the trustees therefore have no right to the property. This in turn means that the trustees may not, unless a pre-emptive costs order has been obtained, have any right to remuneration or expenses, including the legal costs of defending the claim, and that any rights of indemnity and exculpation under the document may not apply.
There is therefore good reason to look for an alternative approach to the structuring of the trust in these circumstances, to reflect more clearly the reality of how it is to be administered.
One possible solution is for the trustees to relinquish the investment function, in respect of all or part of the trust fund. This approach is likely to appeal, provided they can at the same time ensure that they escape liability for investments that turn out badly. In the past, "special companies" provisions have sometimes been used for this, but this approach has its limitations. First, in the current age of money laundering concerns, provisions in the trust deed to the effect that the trustees are under a positive duty to leave the conduct of the business of an underlying company to its directors and not in any way to interfere or inquire into its activities are unlikely to be acceptable, especially for institutional trustees. Secondly, it is arguable that the trustees may in any event retain a residual responsibility to oversee the performance of a company in which they hold a controlling interest, particularly if they are on notice of any irregularity in its management by its directors.
A more satisfactory solution may be a "reserved powers trust". This is not a legal term of art, but describes a trust under which the settlor reserves powers or interests to himself or to a third party, such as a protector. In the Cayman Islands, the Trusts (Amendment) (Immediate Effect and Reserved Powers) Law3 is helpful in this regard. The Law introduced provisions, now found in ss 13 to 15 of the Trusts Law (1998 Revision)4, which confirm that the reservation or grant by the settlor of a trust of certain powers shall not invalidate the trust. These provisions largely confirm the position under the common law, but add certainty. They are of particular assistance in connection with the reservation of investment powers.
Settlor Direction Of Investments
There are broadly two possible approaches to the structuring of a power for the settlor to direct investments:
(1) Reservation Of Power To Direct Investments
The trust deed may include a power for the settlor to give investment directions to the trustees. The following issues are likely to arise:
- Under this approach, can the trustees be relieved of their usual investment duties? The judgement of Millett L.J. in the English case Armitage v Nurse5 suggests they can, and that this would not be inconsistent with the concept of a trust:
"I accept … that there is an irreducible core of obligations owed by the trustees to the beneficiaries and enforceable by them which is fundamental to the concept of the trust … But I do not accept the further submission that these core obligations include the duties of skill and care, prudence and diligence. The duty of the trustees to perform the trusts honestly and in good faith for the benefit of the beneficiaries is the minimum necessary to give substance to the trusts, but in my opinion it is sufficient."
However, whether or not a clause reserving to the settlor a power to give investment directions to the trustees will actually be effective in relieving trustees of investment duties in a particular case will be a matter of construction.
- Are there limits to the scope of the investment directions the settlor can give the trustees? The trustees may be concerned about whether or not the settlor may direct them to make an investment which they could not themselves make. This should not be an issue if (as is common under trusts governed by Cayman Islands law) the trust instrument confers on the trustees all the investment powers of an absolute beneficial owner. A more difficult aspect is whether the settlor may direct the trustees to purchase assets from himself, or sell assets to himself, and if so, on what terms (the issue of "self-dealing"). This will depend to a large extent on whether the powers have been reserved to the settlor in a non-fiduciary capacity. There are two separate issues here:
- Can investment powers be reserved in a non-fiduciary capacity?
- Should the reserved investment powers be drafted as fiduciary or not?
Given that a settlor can reserve to himself, or confer on another person, a general power of appointment, it seems clear that he should be able to reserve in a non-fiduciary capacity a power to direct the acquisition or disposal of investments. In strict terms, such a non-fiduciary power would be described as a "quasi-dispositive power", meaning a power which at first sight appears administrative in nature but which on closer examination is actually a type of dispositive power because it can be exercised so as to confer a benefit from the trust fund. For example, a power for the settlor to direct the trustees to make a loan to himself interest-free would be a quasi-dispositive power, as would a power for the settlor to direct the trustees to purchase assets from himself (or to sell assets to himself).
The duties which attach to quasi-dispositive powers are closer to those attaching to dispositive powers than typical trustee administrative powers; however, quasi-dispositive powers are not subject to the requirement attaching to administrative powers that they must be exercised bona fide in the best interests of the beneficiaries as a whole. It seems clear from the judgements in the House of Lords in the leading English case, Lord Vestey’s Executors v IRC6, that a power of investment can be reserved free of fiduciary duties. In the judgement of Lord Simonds:
"… Nothing short of the most direct and express words would, I think, justify a construction which would enable those who exercised the power of direction [of investments] to disregard the interests of the beneficiaries …"
But it is also clear that if the settlor’s intention is that the power to direct investments need not be exercised in the best interests of the beneficiaries, that must be made absolutely clear in the drafting.
The potential advantage in drafting the power as fiduciary is that the risk of the arrangement being viewed as a mere agency is reduced. But the potential difficulty, so far as trustees may be concerned, is that they may be under a duty to refuse to implement a direction if they are aware that the settlor is exercising the power in his own interests and in disregard of the interests of the other beneficiaries. It may perhaps be preferable for the power to be drafted as non-fiduciary, but with a provision to prevent self-dealing by the settlor; possibly it may include a requirement that it must be exercised in good faith, although in many cases that may be implied in any event.
- The list in s14 of the Trusts Law (1998 Revision) of powers which may be reserved does not specifically refer to the reservation of an investment power. Sub-section (1)(e) refers to "a power to give binding direction to the trustee in connection with the purchase, holding or sale of the trust property". This should be sufficiently wide to cover the reservation of most types of investment power (depending on the way in which such powers are drafted), but in any event the list in s14 does not purport to be comprehensive and it is generally thought that even without the 1998 Amendment Law the reservation of investment powers would not ordinarily invalidate a trust under Cayman Islands law.
- Is it possible the trustees may have a right or a duty not to follow some directions? Apart from the considerations referred to above, as to whether or not the power is drafted as fiduciary, another issue to consider is the position of the trustees where they receive a direction to carry out an act which might otherwise, had they initiated it, constitute a breach of trust. Section 15 of the Trusts Law (1998 Revision) assists the trustees in this regard:
"A trustee who has acted in compliance with, or as a result of an otherwise valid exercise of, any of the powers referred to in section 14(1) shall not be acting in breach of trust"
The implication of this is that the trustees can be directed to carry out a transaction which, if they had initiated it, might be a breach of trust (by reason of the trustees being subject to a standard of care not applicable to the settlor).
If the direction is ostensibly valid i.e. it appears to be within the scope of the power, the trustees should not be under any obligation to second-guess whether or not it is appropriate and to refuse to follow it. A possible exception to this may be where the settlor appears to be acting irrationally, for example by reason of drugs or mental illness.
It should also be noted that, under Cayman Islands law, trustees in doubt as to the propriety of a direction may under s48 of the Trusts Law (1998 Revision) apply to the Court for an opinion, advice or direction as to how to proceed.
(2) Reservation of Power To Effect Investments
An alternative approach may be for the trust instrument to vest in the settlor a power to effect investments, for so long as he is alive and not under any incapacity, leaving the trustees with no investment powers during that period. Is this possible? Unit trusts are commonly established by deed between a trustee (who is essentially an administrative custodian) and an investment manager (who handles the investments). As a matter of general principle, a similar approach should be possible under Cayman Islands law for a private trust, with the investment function effectively "carved out" to the settlor until his death or incapacity.
The particular advantage of this approach is that, if properly structured, it can enable the settlor to deal directly with the broker in effecting investment transactions. By reserving an investment power to the settlor, the risk of the settlor being deemed the agent of the trustee in respect of investment directions to the broker is reduced. The manner in which the trust is actually administered, as regards investments, is also likely to resemble much more closely the terms set out in the trust instrument, thereby reducing the risk of the trust being challenged as a substantive sham.
The considerations set out above as to whether the reserved investment powers should be drafted as fiduciary or not will equally apply where a power to effect investments (as compared with a power to direct the trustees) is reserved to the settlor, so the drafting should ideally include a prohibition on self-dealing.
Thought also has to be given to the risk of co-trusteeship and to tax issues. Under the unit trust structure outlined above, there is a risk that the investment manager could be deemed a co-trustee.
There is a similar risk as regards the reservation of investment powers under a private trust. Depending on the jurisdiction concerned, the person holding the powers could be deemed a co-trustee for particular purposes such as liability or tax, which could also affect the tax residence of the trust. It is therefore essential that tax advice is obtained in all relevant jurisdictions. A possible solution in some cases may be for the investment powers to be vested in a committee, with the settlor appointed as a minority member.
The Reservation Of Other Powers
The Cayman Islands statutory provisions also assist as regards the reservation of other powers:
- Section 14(1)(b) confirms that a general or special power of appointment may be reserved over income or capital, but careful thought must be given to the other terms of the trust before reserving a power of appointment over both. (See the caveat below about the risk that an otherwise valid trust may be viewed instead as a will.)
- The question of whether or not the settlor should reserve a power of revocation will depend largely on the applicable tax considerations. The inclusion of this power may cause the trust assets to be viewed for tax purposes as remaining within the settlor’s control. Institutional trustees may wish the power to be limited so that a partial revocation cannot be made without their consent.
- A power of amendment is frequently included in a trust drafted under Cayman Islands law, to add flexibility for the trust to be adapted in the light of future circumstances. If tax considerations dictate that the power should not be reserved to the settlor, another possibility to consider is whether the power could be vested in the trustees but made subject to the consent of the settlor.
- Powers to appoint, add or remove trustees, protectors or beneficiaries are commonplace in trusts governed by Cayman Islands law. Such powers should be regarded as non-fiduciary.
Whilst a carefully-structured reservation of powers can assist in reducing the possibility of a successful sham claim, there are some potential pitfalls:
- Where the powers and beneficial interests reserved are substantial, in particular where a power of revocation is included, there is a risk that what would otherwise be a valid trust may be viewed instead as a will7. This argument has been seen in various judicial decisions in Canada, and has recently been recognised by the Privy Council in Baird v Baird8. However, the argument should only apply where the settlor is, under the terms of the document, effectively the absolute owner of the trust property during his lifetime. The inclusion, as a minimum, of a discretionary power for the trustees to pay or apply capital for the benefit of the settlor during incapacity should be sufficient to make it clear that document is intended to take effect before the settlor’s death, and is not intended to be dependent on his death for its "vigour and effect"9.
- As already mentioned, tax considerations in particular cases may of course dictate that certain powers should not be reserved to the settlor. In some cases, it may be appropriate to consider leaving the investment powers vested in the trustees, but with a power for the settlor to give binding directions from time to time.
- The Cayman Islands statutory provisions go as far as is possible at the present time in reducing the possibility of a successful challenge of "formal sham" but this does not assist as regards a challenge of "substantive sham". It is therefore important not to lose sight of two fundamentals of trust planning:
(i)The trust assets must be properly transferred under the control of the trustee. The fact that investment powers may be reserved to the settlor does not mean that this requirement applies any less stringently.
(ii)In the administration of the trust, the proper formalities must be observed at all times. It must be clear that the settlor does not continue to treat the assets as his own. The trust must be, and be seen to be, administered as a trust.
As mentioned above, the risk of a substantive sham challenge may also be lessened by including a provision to prevent self-dealing by the settlor. This clearly assists in showing that the assets have ceased to be within the settlor’s personal ownership.
- Care must be taken that the powers reserved under a trust are not, when taken together, so substantial that (even bearing in mind s14 of the Trusts Law) there may not be a trust at all. It is difficult to know exactly where to draw the line, but there is clearly little merit in creating a trust which carries a high risk of attack.
Under Cayman Islands law, the "reserved powers" provisions are helpful in confirming that investment and other powers may be reserved to the settlor or a third party, without jeopardising the integrity of the trust. A number of institutional trustees in the Cayman Islands10 have recognised the potential advantages of structuring trusts, in appropriate cases, as "reserved powers trusts" rather than as fully-discretionary trusts. Reflecting the reality of the intended arrangement in this way, rather than having a settlor exercise indirect control or influence over the trust administration, must clearly assist in lessening the risk of a "sham" challenge.
This article first appeared in Trusts & Trustees, and is reproduced with permission.
1See for example the English case Turner v Turner  Ch 100, where appointments by the trustees were held void, on the basis that the trustees failed to exercise any independent judgement
2The principles are well laid out in the English case Snook v London and West Riding Investments Limited  2 QB 786
3The 1998 Amendment Law applies to trusts created after 11 May 1998, and may also be extended to existing trusts, by a deed executed by the trustees.
4A similar provision is found in section 3 of the Trustee Act 1998 of the Bahamas
5 Ch 241
6 1 All ER 1108
7The document may well be invalid through non-compliance with the requisite formalities for execution of a will
8 2 AC 548
9This is the test for a testamentary document established in Cock v Cooke (1866) LR 1 P&D at p.243
10In Jersey, there is a similar trend towards institutional trustees offering "reserved powers" trusts, under Jersey law
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.