The ground-breaking English High Court decision JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev  has potentially introduced the concept of an "illusory trust", a rather different concept from the commonly-known concept of "sham trust" which concerns the common subjective intentions of the settlor and trustee to mislead third parties by giving a false impression that legal rights and obligations were created in accordance with the trust deeds.
This case concerns Mr Pugachev, founder of Mezhprom Bank, once Russia's leading private bank, which collapsed in 2010. Russian creditors asserted that Mr Pugachev had misappropriated funding during the global financial crisis in 2007 and 2008 and settled the funds in five irrevocable discretionary trusts governed by New Zealand law. Pursuant to the terms of the trusts, Mr Pugachev and his minor children were included as beneficiaries, Mr Pugachev was the Protector and his adult son was the successor Protector. Extensive powers were conferred on the Protector including powers to veto the distribution of income and capital, investment of the trust fund, removal of beneficiaries, variation of the trust instruction, etc. The Protector also had positive powers such as power to add beneficiaries and to remove trustees with or without cause.
Extensive powers of Protector
The English High Court determined that the powers of the Protector were extensive and personal in nature (rather than fiduciary), which allowed Mr. Pugachev to exercise them freely for his own benefit without the need to consider the interests of other beneficiaries. Given such extensive powers it would be difficult to see how the trustee could act without Mr Pugachev's consent on any matter affecting the trusts in any significant way. This led to a finding that the effects of the deeds were to allow Mr Pugachev to retain ownership of the assets and on the terms of the trusts Mr Pugachev had not properly divested himself of beneficial ownership of the assets when settling the assets – effectively the trusts amounted to bare trusts of assets held by the trustees for Mr Pugachev, which could therefore be used to satisfy claims by Mr Pugachev's creditors. On the other hand, if the construction of the trust deeds was that the Protector's powers were fiduciary in nature, then there would have been a difference between the trust deeds (which on their face indicated the Settlor had divested his control) and Mr Pugachev's intention (which was to keep such control) by the evidence shown, and hence the trusts would be regarded as a sham and should not be given effect to.
Offshore trust legislation
Although many of the offshore trust statutes provide that trusts with certain reserved powers (e.g. s14 of the Trusts Law in the Cayman Islands, s2(4) of the Trusts (Special Provisions) Act of Bermuda, s86 of the Trustee Act of the BVI, Article 9A of Trusts (Jersey) Law) will not invalidate the trust, and contain "firewall" provisions which confer exclusive jurisdiction on the relevant offshore court over most of the matters concerning trusts of such offshore jurisdiction (e.g. ss90-93 of the Trusts Law in the Cayman Islands, s11 of the Trusts (Special Provisions) Act of Bermuda, s83A of the Trustee Act of the BVI, Article 9 of Trusts (Jersey) Law), the trust may not necessarily be immune from a claim in another jurisdiction where the trust assets are located. Also, an English Court decision may have persuasive value in offshore jurisdictions.
Lessons from Pugachev
Many Asian families, while having an understanding on the benefits of setting up trusts for succession planning, asset consolidation, asset protection and for other purposes, are generally not willing to give up too much control to the trustees over the assets placed into the trust. The following issues should therefore be considered by both the settlor and the trustee when creating and administering a trust:
- There should be a balance between the extent of powers and functions given to a settlor, a protector and a trustee of a trust. A trust instrument should avoid conferring excessive retention of powers to either the settlor and/or protector. Powers reserved to a settlor could be exercised by the trustee in bankruptcy.
- Where possible, the protector should be a third party not a beneficiary of the trust. Otherwise the power conferred to such protector should be less extensive, if any.
- Where possible, the trust should be irrevocable to minimise the risk of being revoked by the settlor's future creditors.
- Trustees should remain active in administering the trusts under their management, be independent and act in the best interests of the beneficiaries as a whole.
- All the parties of the trust should act in accordance with what is set out in the trust deed to minimise the risk of finding the arrangement a sham.
- Prior to setting up the trust, the settlor should consider transferring all the intended trust property to a company incorporated or registered in the same offshore jurisdiction as the trust. They should consider the issue of shares to the settlor, and subsequently the settlor settling such shares into the trust, so that the property being transferred under the disposition will be within the jurisdiction of the court of the offshore jurisdiction.
- Trust assets should be kept as much as possible outside the jurisdiction in which there may be significant risk of attack (e.g. settlor's residence or where settlor carries on business).
The above considerations are likely to reduce the risks of exposure of the assets of an offshore trust to claims from creditors, though they are not by all means exhaustive – care must be taken to analyse and arrive at the best possible solution depending on the specific facts and purposes of each proposed trust arrangement.
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.