What claims can a bankruptcy trustee make against family trusts?
During the course of bankruptcy administrations, one of the most frequently encountered asset protection structures are discretionary family trusts. It’s a reasonably secure protection strategy in the event of bankruptcy because trust assets held by the bankrupt do not form part of the bankrupt’s divisible assets and are not available for the benefit of creditors (section 116(2)(a) of the Bankruptcy Act 1966. And if the bankrupt was a beneficiary of the family trust, it will not make any distributions to the bankrupt as those distributions would likely become divisible assets or assessable income during the bankruptcy period.
However, a bankruptcy trustee has several powers and options to ‘attack’ a typical family trust or otherwise recover funds, which commonly include:
- Existing debts;
- Voidable transactions; and
- Orders in relation to controlled entities.
Our initial investigations always involve obtaining the family trust’s financial records, which we can obtain pursuant to section 77A of the Bankruptcy Act if the trust meets the definition of an associated entity. We review the records to establish if any outstanding debts or loans are owed to the bankrupt by the trust. This may include unpaid outstanding employee entitlements if the family trust operated a business.
Those financial records also assist in our investigations into the other potential claims discussed below.
Commonly, the family trust assets comprise of assets or funds transferred from the bankrupt prior to the bankruptcy date. These include transfers of real property (often the family home shortly prior to commencement of a risky business endeavour), large cash payments, redirection of part of the bankrupt’s ordinary wages or assignments of loans and debts to the trust.
If the bankrupt did not receive a commensurate benefit from such transactions, it may give rise to a potential ‘undervalued transaction’ or ‘transfer to defeat creditors’ claim against the family trust. Primarily, the transaction must mean the bankrupt received less than fair value for the transfer of the assets and the transaction occurred within the relevant timeframes. If argued that those transfers were to repay an existing liability owed to the family trust, this could also potentially give rise to a preferential payment claim.
Our website factsheet details the elements and process for commencing such claims, click here.
Orders in relation to controlled entities
Division 4A of the Bankruptcy Act is sometimes colloquially referred to as the “trust busting” provisions. Its purpose is to enable recoveries where bankrupts have historically diverted personal assets or income to an entity that they control, such as a family trust. It seeks to make available, for the benefit of creditors, the accumulation of assets in a trust or other structure that resulted from the bankrupt’s efforts and exertions. Broadly, depending on specific circumstances, the elements to establish a Division 4A claim will generally include the following:
- The bankrupt supplied personal services to the controlled entity without commensurate remuneration for those services and/or provided financial contributions to the controlled entity.
- The controlled entity acquired property, and/or their net wealth increased from those services or financial contributions.
- The bankrupt derived a benefit from the property when the bankrupt controlled the entity.
- The controlled entity still has an interest in the asset.
The Bankruptcy Act sets out the particular combination of elements that apply to establish a claim depending on the specific circumstances. If a valid claim exists, the courts can make orders to vest the interest in the asset in the bankruptcy trustee or for the controlled entity to pay a specified amount to the bankruptcy trustee.
The above examples are some of the more common investigations and recovery actions against family trusts; however, often other potential claims are available depending on the administration’s specific circumstances.
It should also be noted that quite often, bankrupts hold the power to replace and appoint a new trustee. Throughout the years, we have been requested on many occasions to exercise that power to appoint a “friendly” trustee to distribute discretionary trust assets. The courts have held that the general power of appointment is not property that vests in a bankruptcy trustee pursuant to section 58 or 116 of the Bankruptcy Act (Re Burton: Wiley v Burton (1994) 126 ARL 557) and accordingly, that option is not available.