Friday, July 3rd, 2009

Trusts and Creditors

Trusts — getting it right from the start.

There is nothing like a good recession to test the strength of an estate plan, particularly where assets are transferred to a family trust to put them out of harm’s way.

A recent Supreme Court Decision and an amendment to the law relating to prejudicial dispositions put the spotlight on the integrity of asset transfers which may have the effect of defeating creditors.

If you intend to set up a trust or if you have been asked to be a trustee, read this first.

A practical example.

The Supreme Court decision is Regal Castings Ltd v Lightbody SC 72/2007.

Mr. Lightbody was a jeweller. He was a director of a company which carried on the business.  Most of his supplies came from Regal Castings to which his company owed a considerable amount of money.

Mr. Lightbody had guaranteed that debt.

Mr. and Mrs Lightbody set up a family trust to which they transferred their jointly owned home.  The trust signed an acknowledgement of debt and Mr. and Mrs Lightbody released that debt by gifting.

At the time of the transfer, Regal Castings and Mr. Lightbody had agreed that Mr. Lightbody’s company would repay the debt to Regal Castings by monthly instalments.

Mr. Lightbody’s company made substantial inroads into the debt.  However, he was subsequently declared bankrupt with a balance still payable to Regal Castings.

Regal Castings then tried to recover the remaining debt from the family trust on the basis that Mr. Lightbody had transferred his share in the home to the trust with the intention of defrauding creditors and in particular Regal Castings.

Intention to defraud

The old legislation allowed the Court to set aside transactions undertaken “with intent to defraud creditors”.  Mr. Lightbody said he had no intention of defrauding anybody.

Regal Castings was unaware of the transfer of the home to the trust at the time that it occurred.

The Supreme Court said that it was not necessary to go so far as to prove an intention to cause loss to a creditor nor was it necessary to show that the debtor acted dishonestly.

The Court took the view that Mr. Lightbody must have known that by disposing of the property, he would hinder, delay or defeat a Regal Castings’ recourse to Mr. Lightbody’s share of the home and, as a result, there was a significantly enhanced risk of Regal Castings not recovering the amount owing.  Once this knowledge was imputed to Mr. Lightbody, the Court concluded that he must have intended that consequence. This was enough to satisfy the test of “intention to defraud”.

No need to prove insolvency

It was not necessary to show that the debtor was insolvent at the time of the transfer.  It was enough to show that even though a debtor may be able to pay debts when and as they fall due at the time, there was a high level of probability that this situation would not continue.

Mr. Lightbody’s company had agreed to make monthly instalments and, indeed, made those instalments for quite some time.  However, its financial position was precarious and it was relying on the goodwill of Regal Castings to provide working capital.

In the circumstances, the Supreme Court appeared to have little difficulty in finding for Regal Castings and directing the trustee to transfer one half share of the property to the official assignee.

Property Law Act 2007.

The new legislation clarifies the law.

Firstly, it does away with the term “intent to defraud”. Most people establishing a family trust in order to protect their assets do not see themselves as fraudulent.  They see the protection of, for example, the family home as a sensible precaution.

Mr. Lightbody, for example, did not think he was defrauding Regal Castings when he transferred his house to the trust.  He was probably quite confident that he could continue trading and pay off the debt over a period of time.

Had the new legislation been in place at the time he established his trust, his advisers may well have investigated circumstances more thoroughly.

Section 344 succinctly sets out the purpose of the new legislation.  That purpose is to:

enable a Court to order that property acquired or received under or through certain prejudicial dispositions made by a debtor (or its value) being restored for the benefit of creditors…”

A disposition prejudices a creditor if it hinders delays or defeats the creditor’s right of recourse against property belonging to the debtor.

A matter of timing.

The timing of any estate plan is critical.  The new provisions apply where a prejudicial distribution is made where:

  • a debtor is insolvent at the time of the disposition or becomes insolvent as a result of the disposition or
  • the debtor is engaged or is about to engage in a business or transaction for which the remaining assets of the debtor are unreasonably small having regard to the nature of the business or the transaction or
  • the debtor intends to incur or believes or reasonably should believe that the debtor will incur debts beyond the debtor’s ability to pay.

There cannot be much room to argue over dispositions which occur when a debtor is insolvent or which will render a debtor insolvent.

Nor can there be much room to argue about dispositions that take place at the same time that a debtor is about to incur liabilities beyond the debtor’s means to pay.  It is probable that both of those instances would have been caught by the old legislation.

The second limb — transactions where a debtor is about to engage in a business or a transaction for which the remaining assets are unreasonably small — involves careful consideration.

Many trusts are established at the same time that a Settlor commences business.  In order to avoid problems in the future, it would be very helpful if a Settlor could produce a cash flow, independently reviewed, establishing that the Settlor is unlikely to need recourse to other assets in the foreseeable future.

What can the Court do?

If a disposition is caught by the section the Court can:

  • vest the property in the official assignee in the case of a bankrupt;
  • vest the property in the debtor if the debtor is a company in liquidation;
  • vest the property in a trustee for creditors;
  • vest the property in the debtor so that a creditor can have recourse to that property;
  • order that the person who received the property pay compensation.

Who should take notice?

Obviously, anybody establishing a trust should do so before there are any clouds of financial uncertainty or risk on the horizon.

When establishing a trust, make sure that you have a statement of assets and liabilities and, if you are about to embark on any business venture, prepare a cash flow, identify any areas of risk and identify any assumptions such as market demand.  Build in a contingency allowance.

If you are a trustee, you may be liable to transfer property received from a Settlor or pay compensation.

The Court may decline to make an order against a trustee or any other person who receives property if that person acted in good faith and without knowledge that the disposition was caught by the Act.  This is not an absolute defence.

The Court can still make an order if a trustee acted innocently.  Trustees, particularly independent trustees, must therefore make a proper enquiry before receiving assets.

Creditors, faced with a plea of poverty from debtors, should not overlook the possibility that dispositions to a trust can be set aside.

Advisers — lawyers, accountants etc — should advise clients of the practical implications of the section before making any transfers to a trust.