What happens when the trustee becomes insolvent?
How trading trusts and insolvency law co-exists is always topical.
A liquidator’s or a bankruptcy trustee’s rights and restrictions can be complex. Trading trusts aren’t new and its appeal to business owners are to distance the risks of trading a business from the personal risk: as a vehicle for asset protection.
Legally, a trading trust has a trustee that trades for the trusts’ beneficiaries (not trading under their own right). However, the trustee is the legal owner of the trust assets and therefore liable for the debts that it incurs (as trustee).
Elements of a trust
Trusts need three basic elements to exist:
- A trustee—who holds the legal title to the assets and is primarily responsible for the debts.
- Property—to be held ‘on trust’ for the beneficiaries.
- Beneficiaries—who benefit from the assets being held.
A trust deed directs and appoints the powers for a nominated trustee under the relevant Trust Act (state-based).
Right of indemnity
When a trustee trades a trust, it generally incurs costs, expenses, and liabilities in their name. To protect the trustee from personal liability, they generally have recourse to pay trust debts from trust’s assets pursuant to a ‘right of indemnity’ under statute.
The right of indemnity is integral to how trust assets are handled in insolvency. That right of indemnity is supported by a lien over the trust’s assets and a right to enforce that lien to recover monies. The indemnity is an asset of a trustee (often the only asset). How much is recoverable under the lien is limited to the value of trust assets or the debts incurred as trustee—whichever is less.
The insolvency of the trustee
What happens when a corporate trustee is subject to an insolvency administration? The possibilities depend on the status of the trustee, as follows:
- New trustee was appointed (pre-emptively).
- The insolvent trustee remains trustee of the trust.
- The insolvent trustee is automatically removed.
New Trustee was appointed
If the parties to the trust foresee the trustee’s potential insolvency before a formal appointment (voluntary appointment or court appointment), they may elect to appoint a new trustee. Meanwhile, any liquidator appointed to the previous trustee (insolvent) is then appointed to a shell company (with the right of indemnity being the only asset).
The new trustee would be directed to payout the indemnity value (previous trustee’s debts). Given the assets would now be in the new trustee’s possession, the lien backing the indemnity would probably have little benefit.
If the new trustee fails to payout the value of the indemnity, the previous trustee could sue the trust (the new trustee) and seek court assistance to have trust assets realised to pay any debts.
The insolvent trustee remains trustee of the trust
While uncommon, the trustee of a trust is sometimes not automatically removed upon an insolvency appointment—i.e. there is no Ipso Facto clause in the trust deed—and remain as trustee. In this case, the trustee retains all the same rights to sell assets to pay the trust’s debts.
However, the same mechanisms for changing trustees are still available under the deed and its relevant Trust Act and the insolvent trustee can be removed after the appointment with or without a new trustee being appointed.
The insolvent trustee is automatically removed
Many trust deeds have an ‘Ipso Facto’ clause that automatically terminate the trustee’s appointment under certain circumstances (commonly an insolvency appointment). So, at the time of an insolvency appointment: the trustee’s appointment ends.
Between when the Ipso Facto clause is activated and the new trustee is appointed (if one is ever appointed), the insolvent trustee remains as the trustee of a ‘bare trust’. This trustee has most of the obligations, but with less rights and possibly no right to realise assets. This is where the differences in the various states Trust Acts may create different rights for the liquidator.
One line of thought appears to be that, although the indemnity and lien still exist, a liquidator must apply to court to be appointed as receiver of the trust assets to deal with those assets. This becomes impractical where there are trust assets with minimal value.
If the trustee and the beneficiaries agree, a new trustee can be appointed, whether by the liquidator or an associated entity of the directors. The benefit being that trust assets can be dealt with, without obtaining a court order. As follows under the ‘new trustee appointed’ scenario, the new trustee can be directed to payout the indemnity value (previous trustee’s debts).
This article is just the tip of the iceberg in the matters of insolvent trading trusts and insolvency law. Particularly, as the inconsistent decisions of the courts over the years has made the administration of insolvent trustee companies more complicated. We explore some of these in next month’s ‘Worrells – On The Pulse’.