Just when you thought the transaction was going to be straightforward, you are told that one of the borrowers is a manager of a unit trust governed by the laws of an offshore jurisdiction. The manager says the trustee need not be a party to the transaction and insists that liability should be limited to trust property (to which it does not have title). With completion just days away, where do you start?
Promoters of investment funds often consider common law unit trusts to be attractive structures due to the flexibility they provide. The terms of a trust and the trustee's powers are not constrained by corporate law requirements including those relating to maintenance of capital and distributable profits. Trusts may be tailored to effectively achieve the objectives of the promoter and the investors.
The aim of this article is to highlight some fundamental considerations for lenders when lending to trustees or managers of common law unit trusts. Many of the principles also apply when a lender is considering loaning funds to trustees of family trusts (whether discretionary trusts or otherwise), charitable trusts and non-charitable purpose trusts.
Important considerations (among many) for those lending to trustees and managers of unit trusts include the:
- legal nature of a unit trust;
- the role, powers and duties of the trustee and the manager respectively;
- the relationship between the trustee and the manager; and
- the lender's recourse to the trust fund in the event of default by the trustee or manager.
What is a trust?
The common law unit trusts referred to in this article should be distinguished from companies which may be established as collective investment vehicles (such as real estate investment trusts in the UK and elsewhere) which may on occasion be referred to as trusts but often are not actually structured as common law trusts.
The Hague Convention on the Law Applicable to Trusts and their Recognition concluded on 1 July 1985 provides:
"... the term "trust" refers to the legal relationship created ... by a person, the settlor, when assets have been placed under the control of a trustee for the benefit of a beneficiary or for a specified purpose.
A trust has the following characteristics
- the assets constitute a separate fund and are not a part of the trustee's own estate;
- title to the trust assets stands in the name of the trustee or in the name of another person on behalf of the trustee;
- the trustee has the power and the duty, in respect of which he is accountable, to manage, employ or dispose of the assets in accordance with the terms of the trust and the special duties imposed upon him by law ..."
Many common law jurisdictions have adopted or reflected this definition in their trusts statutes. The definition reflects the fundamental principle that a common law trust does not have separate legal personality. It is a legal fiction to suggest that a lender loans funds to, or takes security from, a trust. One cannot contract with a trust. One must contract with a trustee, the trustee and the manager, but contracting with the manager alone may be inadvisable for reasons outlined below.
SO, WHAT THEN IS A UNIT TRUST?
A unit trust may be described as a contract between the trustee, the manager and unitholders which provides for the creation of a trust. The manager is generally a party to the trust instrument or is granted powers which are set out in the trust instrument and/or investment management agreement. The unit holders ordinarily agree to be bound by the terms of the trust instrument and prospectus when they subscribe for units, thereby becoming parties to the contract.
The unit trust differs from most family trusts where a settlor gifts funds to a trustee to hold for the benefit of beneficiaries in accordance with the terms of the trust. The beneficiaries of family trusts are generally volunteers. They have not transferred funds to the trustee to hold pursuant to the terms of the trust and have not entered into a subscription or other agreement with the trustee or manager. In contrast, unit holders are typically investors who have transferred funds to the trustee in return for a promise that the unit holder's investment will be pooled with those of other unitholders, the manager will invest the funds (and be entitled to fees set out in the prospectus) and the trustee will make distributions to unit holders in accordance with the trust instrument and prospectus.
For these reasons, a unit trust cannot be analysed by reference to trust concepts alone but involves consideration of contract and trust concepts which co-exist in the one entity. The application of trust concepts cannot be ignored by lenders when lending to, or taking security from, trustees or managers of unit trusts.
INDEMNIFICATION OF TRUSTEES AND MANAGERS OUT OF THE TRUST FUND
The trustee may be authorised to discharge its, or the manager's, liability to a lender from the trust fund. However, on occasion, the trustee or the manager may not be entitled to such indemnification. This may occur when the trustee or the manager has:
- not acted within its powers when incurring the liability for which it seeks indemnification; or
- ostensibly acted within its powers but the liability was otherwise incurred as a result of a breach of its duties for which it is not entitled to indemnification pursuant to the terms of the trust.
It may be difficult for a lender to access information to definitively determine whether or not the trustee or manager is entitled to indemnification out of the trust fund in respect of a particular transaction.
The trustee and the manager are often corporate entities. The lender may obtain legal opinions consisting of, firstly, corporate opinions regarding the trustee and the manager respectively confirming:
- they have been properly incorporated and are in good standing;
- they are not in liquidation or otherwise struck off or dissolved from the relevant corporate register;
- they have authority under their corporate governing documents (ie memorandum of association, bye-laws, articles of association etc) to act as trustee or manager and enter into the transactions contemplated; and ––
- the directors or others signing the transaction documents on their behalf have been properly authorised to do so.
A second opinion, focusing on the trust, may be obtained in respect of the powers of the trustee and the manager under the terms of the trust and the prospectus. The purpose of this opinion is to provide the lender comfort that the trustee and the manager are acting within their powers and, ostensibly, not breaching the terms of the trust by entering the transaction.
In addition, the lender may require inclusion of representations from the trustee and the manager in the transaction documents, the breach of which may result in the trustee and the manager being personally liable for the inaccuracy of those representations. However, this highlights that the lender's primary recourse is against its counterparties (ie the trustee –and the manager if it is party to the transaction documents) and not the trust fund and accordingly, a proper assessment of the credit risk should include consideration of whether the trustee and the manager may discharge the liability if they are, for whatever reason, unable to be indemnified out of the trust fund. This suggests that it is often preferable for a lender to:
- contract with institutional trustees and managers, or licensed trustees and managers that have sufficient resources to personally discharge the liability if required; and/or ––
- take security over trust assets.
CONTRACTING WITH THE MANAGER ALONE
It is not uncommon for the unit trust instrument to provide the manager with extensive powers. The manager ordinarily owes fiduciary duties to the unit holders which may be enforced by the unitholders or the trustee.
By comparison, it is not unusual in respect of family trusts in a number of jurisdictions, for powers to be reserved to the settlor or granted to another person such as a protector or a beneficiary if not appointed as a trustee. It is suggested that the manager of a unit trust is often in an analogous position to such power holders in relation to how its powers may be implemented.
A poorly drafted trust instrument may provide that the manager's powers, including the powers to borrow and grant security over the trust fund, may be exercised by the manager at the exclusion of the trustee or on behalf of the trust. However, a power that authorises a person other than the trustee to deal with the trust fund can only be implemented by the trustee who either directly or through its delegate has title and control over the trust assets. Accordingly, consideration needs to be given as to how the manager exercises its powers to borrow or grant security in respect of the trust fund. The manager may provide a direction to the trustee to enter into the transaction documents. This is often what is intended but, as indicated above, may not be expressed. It may be that the trust instrument expressly authorises the manager, as the trustee's delegate, to bind the trustee to transactions which fall within a specified criteria.
If the lender enters into the contract with the manager alone, the lender would have contractual rights against the manager subject to any applicable limited recourse provisions. However, the manager would ordinarily be required to enforce its indemnity against the trustee in order to have recourse to the trust property. This involves a second and (perhaps undesirable) step for a lender. In order to recover or take security from the trust fund, it is preferable for the lender to contract with the person with title and control over the trust assets to execute the transaction documents so that, upon default, the lender can enforce its rights directly.
The trustee may be unable to give effect to an indemnity in the trust deed in favour of the manager if the manager entered into the transaction in breach of its duties.
Accordingly, in order to maximise its recourse to the trust fund, the lender should ideally contract with the:
- trustee, who has ultimate title and control over the trust assets; and
- manager, to confirm that it has properly exercised it power to direct the trustee to borrow or grant security over the trust assets.
WHAT IF THE TRUSTEE HAS NOT BEEN PROPERLY APPOINTED?
In some cases, the lender may find itself considering entering into a loan or security transaction with a trustee in circumstances where the trust has existed for many years. It may be that the trustee has not been properly appointed. In those circumstances, the lender may nevertheless have rights to recover from the counterparty (a de-facto trustee) who has represented that it has authority to grant the lender recourse to the trust fund in the event of default of the de-facto trustee's obligations under the loan or security contract. If the de-facto trustee has entered into the transaction in good faith, and honestly believed that it had been properly appointed, a court may grant the de-facto trustee an indemnity to enable it to discharge its obligations from the trust fund. Accordingly, it is prudent for a lender to obtain an opinion in relation to whether the trustee (and the manager) were properly appointed before entering into loan or security arrangements with them.
WHAT IF THE TRUSTEE SUBSEQUENTLY RETIRES OR IS REMOVED?
A lender may enter into a loan agreement with a trustee who subsequently:
- ceases acting as trustee; and
- transfers the trust fund to its successor trustee.
In these circumstances, the outgoing trustee may be wise to retain an appropriate level of security from the trust fund in order to discharge the liability before transferring the entire trust fund to its successor. Generally, however, it may often be difficult for an outgoing trustee to transfer title to trust property which has been granted as security without first obtaining the consent of the secured party.
In the absence of security, the lender's first recourse is against the borrowers (ie the outgoing or former trustee and the manager) both who would ordinarily seek to enforce an indemnity against the successor trustee for discharge out of the trust fund. What if the successor trustee is located in another far away jurisdiction? The lender may find itself in the difficult position of having to compel its counterparty (who may have limited funds) to enforce its indemnity against a successor trustee in another jurisdiction in order to recover from the trust fund. Accordingly, it may be prudent to include in the transaction documents a requirement for the relevant counterparty to notify the lender when it becomes aware that it may retire or be removed as trustee or manager. This will assist arrangements to be made to novate the loan contract (if otherwise appropriate) so that the successor trustee will assume the obligations of the former trustee.
LIMITED RECOURSE PROVISIONS
There are many advantages to taking security. These may include providing the lender with title to the secured assets or having the secured party recorded on title as a person to whom the relevant registry requires evidence of consent before recognising a transfer.
However, what of the unsecured lender who has loaned funds to the trustee without imposing any restrictions on the trustee's dealings (including distributions) with the trust fund? Trustees and managers often seek to limit their personal liability by including provisions in the transaction documents which limit their liability to the trust fund in the trustees' possession from time to time. In addition, trust statutes in certain jurisdictions, such as Guernsey and Jersey, purport to limit the liability of the trustee to the trust fund if the counterparty is made aware that it is contracting with a trustee. This is a statutory limited recourse provision. However, if the contract is governed by laws other than Jersey or Guernsey or the trustee borrower's property is not situated in those jurisdictions, the trustee may nevertheless have difficulty limiting its liability if relying exclusively on those statutory provisions.
Lenders providing unsecured loans should be mindful that, following the trustee and manager's agreement with a lender, it is possible that the trustee may subsequently make distributions which it is either compelled, or has the discretion, to make in accordance with the trust instrument. There is a risk that, following such distributions, the trust fund held by the trustee may be insufficient to discharge the trustee's and manager's liability to the lender. The lender may wish to consider including certain provisions in the transaction documents to provide that the trustee and the manager shall:
- have joint and several personal liability to the lender which is not limited to the trust fund;
- require consent from the lender before entering into any subsequent material borrowing arrangements or making discretionary distributions;
- notify the lender of material mandatory distributions;
- be required to discharge the liability to the lender if the trust fund falls to a certain value; and
- procure appropriate indemnities in favour of the lender from the recipients of discretionary distributions.
There may be occasions where taking security over trust assets is undesirable yet the lender has the confidence to make an unsecured loan to the trustee and the manager because they:
- are institutions with financial resources to discharge obligations from their own assets; or
- have undertaken to obtain the consent of the lender should the trustee wish or be required to distribute assets of the trust fund which in aggregate exceed the value of a specified proportion of the trust fund.
Obtaining security is generally preferable to pursuing unsecured personal claims against trustees or managers, particularly if the trustee or manager is thinly capitalised, as may be the case with private trust companies and managers formed as special purpose companies.
The trustee of the unit trust may consider establishing a wholly owned special purpose company to make investments and enter loan or security transactions. This may simplify the arrangements, particularly if lenders may be unfamiliar with issues arising when contracting with trustees.
However, the risks that lenders face when lending to, or taking security from, a trustee or manager of a unit trust may be managed and minimised if the lender has an understanding of the legal nature of unit trusts and the roles of and relationships between, and resources of, the trustee and managers.
Article first published in JIBFL November Issue
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.