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The Jersey Law Review - February 2004

SHAMS, PIERCING VEILS, REMEDIAL CONSTRUCTIVE TRUSTS AND TRACING

David Hayton

1       The Jersey case, Grupo Torras SA and another v Sheikh Fahad al Sabah and others,[1] the latest instalment in the litigation concerning the Sheikh’s Esteem settlement,[2] (hereinafter referred to as Esteem), and the English case, Shalson v Russo,[3] usefully clarify the law relating to shams and to attempts to pierce the so-called “veil” of a trust in similar fashion to the veil of a company.  Esteem also considers the concept of remedial constructive trusts, while Shalson sheds light on the difficulties arising where a plaintiff seeks to take advantage of the tracing process to establish a proprietary claim.

Shams

2       Esteem convincingly establishes that where a settlor transfers assets to a trustee (other than expressly for the settlor as sole beneficiary) the trust will only be a sham if the settlor and the trustee have a common intention that it is to be a sham.  A trustee’s duties as trustee of an express trust (to manage the trust property in accordance with its terms and the duties imposed by law) only arise when he knows of the trust[4] and agrees to be trustee, not disclaiming any trust property vested in him without his knowledge.[5] His duties then are to hold the trust property on the express terms for the designated beneficiaries unless he has agreed with the settlor that such property is to be treated as the settlor’s for the trustee to deal with as directed by the settlor.  For there to be a sham, both settlor and trustee must subjectively intend that their trust instrument is not to create the legal rights and obligations which it gives the appearance of creating, thereby creating a false impression to others.[6]

3       There is no sham if only the settlor has a subjective intention to create a sham but, due for example to linguistic difficulties in the dealings between the foreign settlor and the trustee, the trustee reasonably believes that it is to be trustee of a true trust.  However, the settlor will have a right to set aside the trust for mistake[7] if, for example after two years in which the trustee has acceded to all the settlor’s requests because independently considering it proper for the trustee so to accede, the trustee refuses a request and makes it clear that it believes itself to be trustee of a true trust.

4       The basic maxim can be said to be “once a true trust of property, always a true trust”, so that if the trustee of a true trust commences to act as if it were a sham trust, always doing as directed by the settlor it will be liable as trustee to restore the trust assets (wrongly distributed at the settlor’s direction) to the trust fund to the extent they cannot be traced and recovered.  Nevertheless, even where there is a true trust it is perfectly possible for the trustee and the settlor to agree that in respect of a particular asset then being transferred by the settlor to the trustee to be held apparently on the terms of the true trust established years earlier, such asset is actually to be held to the order of the settlor, a new trust of such asset arising[8] which is a sham trust of that asset.[9]

5       In Shalson Rimer J[10] respectfully regarded Esteem as correct in principle and as squarely in line with the guidance given by the English Court of Appeal in Snook v London and West Riding Investments Ltd[11] and Hitch v Stone.[12] Somewhat elliptically, however, Rimer J went on to state -

“But unless that intention [the settlor’s ‘unspoken intention that the assets are in fact to be treated as his own and that the trustee will accede to his every request on demand’] is from the outset shared by the trustee (or later becomes so shared ) I fail to see how the settlement can be regarded as a sham”. [13] 

6       The clause “or later becomes so shared” is difficult to understand as contravening “once a true trust of property always a true trust” and not dealing with the special case where a particular subsequent transaction creates a new separate sham trust of the asset transferred by the settlor to the trustee under a new deal. It is submitted, however, that such clause cannot bear the meaning it has at its face value, especially when, if it did, it would contradict the approach of Rimer J[14] to attempts to pierce the veil of a trust.

Attempts to pierce the veil of a trust

7       It is well established[15] that a court can pierce a corporate veil by treating the assets, rights or liabilities or activities of a company as those of its controlling shareholder, whether to impose liability upon the company for its controller’s action or to impose a liability of the company upon its controller where the company’s action has operated to mask or conceal action which in substance is the act of the controller.[16]  The new question was whether it is possible to pierce the veil of a trust so as to attribute its assets to its settlor when his trust is not a sham trust under which he remains absolute beneficial owner of the trust assets, but he still exerts a great deal of influence over the trustee so that it is very likely indeed that the trustee will accede to his requests as in Esteem.

8       A resoundingly negative answer was given in Esteem and Shalson.  If the settlor does actually control the trust, so that the trustee always does as directed as originally agreed with the settlor, then the trust is a sham trust.  However, if the trustee is trustee of a true trust, having the duty to exercise its own independent judgment in respect of investments and distributions of capital or income, it does not matter that the settlor’s wishes greatly influence it so that it is very likely indeed that it will accede to those wishes (especially if, in the trust instrument, he is specified to be “the primary beneficiary” whose interests when requesting a distribution of capital or income are to be considered without reference to the interests of any other beneficiaries).[17]  Evidence (not being pretences set up by the trustee and the settlor) that the trustee refused requests or required reversal of some transactions purportedly effected by the settlor on behalf of the trust (e.g. due to his control over a bank with which trust money is deposited as in Shalson) will refute any sham allegations.[18] 

9       If, after running a true trust for a while, the trustee in breach of trust does do as directed by the settlor as if the trust had been a sham trust, this does not enable the court to ignore the terms of the trust and permit the transfer of the beneficial interests in the trust fund from the beneficiaries to the settlor.[19]  The court must enforce the obligations which the trustee owes to the beneficiaries pursuant to the trust instrument.[20]  The nature of a true trust of property cannot be changed just because the trustee wrongfully permits the settlor to have de facto control of such property.  Between sham and true trust there is no half-way house of “quasi-sham” where the veil of the true trust can be pierced so that the trust assets can be regarded as beneficially owned by the settlor.[21]

10     Where a beneficiary, whether or not also the settlor, is very likely indeed to have money distributed to him or her if requesting it under a proper consideration by the trustee, this is a matter to be taken seriously into account by a divorce court having to consider what assets are available to a divorcing spouse,[22] but this is a completely different context, not involving the court depriving someone of a proprietary interest by giving such interest to another person under some alleged inherent power.

Remedial constructive trusts

11     If a court has a discretionary inherent power to impose a remedial constructive trust over A’s property so as to create a proprietary interest in favour of B, then it is exercising a power to alter or vary existing proprietary rights, rather than the well-established power to declare what rights have existed under an institutional constructive trust as a result of the happening of some earlier circumstances.  As Tipping J stated in Fortex Group Ltd v MacIntosh[23] -

“An institutional constructive trust arises upon the happening of the events which bring it into being.  Its existence is not dependant on any order of the court.  Such order simply recognises that it came into being at the earlier time and provides for its implementation in whatever way is appropriate.  A remedial constructive trust depends for its very existence on the order of the court, such order being creative rather than simply confirmatory.”

12     Canadian courts developed this concept based on unjust enrichment principles, first deciding whether the defendant was liable for wrongful conduct and then deciding what remedy was appropriate.[24]  Subsequently, the Australian courts used the concept based on unconscionability,[25] while recently a New Zealand court[26] has used the concept as available to remedy unjust enrichment or unconscionability.  In England it had been thought that there might be scope for a remedial constructive trust concept to arise via the imposition of an equitable proprietary estoppel interest as from the date of the court order.[27]  However, it now seems that such interests, certainly in respect of the acquisition of homes,[28] have been equated with interests under institutional constructive trusts so that they both arise at the time of the plaintiff’s detrimental reliance on the defendant’s conduct.[29]

13     It is already clear in England[30] that if the defendant is insolvent (when proprietary remedies are of crucial importance) there can be no scope whatsoever for imposing a remedial constructive trust flouting the position as to priorities established under statutory insolvency law.  Even outside the insolvency context how can the court re-order existing proprietary rights (with potentially adverse impact on incidental third party proprietary rights affecting such property, whether legal or equitable)[31] without statutory authority as in the Variation of Trusts Act 1958 or the Matrimonial Causes Act 1973?[32] In any event, if the defendant is solvent monetary compensation should suffice. It thus seems most unlikely that the English courts will establish an inherent jurisdiction to vary existing proprietary rights as recognised in Shalson.[33]

14     In Esteem the Royal Court[34] for similar reasons was inclined to find that the Jersey courts had no jurisdiction to impose a remedial constructive trust, although it examined the facts to hold that even if there had been such jurisdiction there was no basis of unjust enrichment (or of unconscionability)[35] to justify it.

Tracing

15     Of course, the greater the possibility of finding there to be an institutional constructive trust over property via the tracing process the less any alleged need for developing the concept of a remedial constructive trust.

16     Historically, the tracing rules were developed in the context of trusts to vindicate the equitable proprietary interests of beneficiaries in the trust fund comprising the original trust assets and the property representing them from time to time as a result of the trustee’s rightful management of the trust (so that the assets are held under an express trust). The tracing rules enabled the trust fund by way of a constructive trust to extend to property wrongfully representing trust assets as a result of the trustee’s wrongful conduct in purporting to acquire assets for himself with trust money or to make gifts to relatives and friends who were not beneficiaries under his trust.  Subsequently, the tracing rules were made available against a defendant owing fiduciary obligations to the plaintiff even where the plaintiff had a legal interest rather than an equitable interest.[36]

17     Professor Birks in his important essay The Necessity of a Unitary Law of Tracing,[37] expressly endorsed by Lord Steyn[38]and by Lord Millett[39](with whose speech Lord Hoffmann[40] agreed except on one point) in Foskett v McKeown, has made it clear that, in truth, tracing is a process of identifying assets which belongs to the realm of evidence and tells us nothing about what rights, personal[41] or proprietary, legal[42] or equitable,[43] the plaintiff can assert in respect of the traced assets.  There is a unified regime for tracing so that the flexible sophisticated equitable rules also apply where the plaintiff’s claim has a legal, as opposed to an equitable, proprietary base.[44]   However, tracing must be clearly separated from the business of asserting proprietary rights or personal claims in relation to assets successfully traced, being regarded as substitutes for the plaintiff’s initial assets.

18     The tracing process merely concerns assets so that shares can be traced into the proceeds of sale thereof which can be traced into a flat.  The separate issue then arises as to whether the plaintiff’s initial proprietary interest and the circumstances surrounding its disposal are sufficient for the plaintiff to establish a legal or equitable proprietary right in successfully traced assets or merely a personal claim against the defendant owning such assets.

19     Thus in Bracken Partners Ltd v Gutteridge[45]Peter Leaver QC, sitting as a Deputy High Court Judge, concluded in the light of Foskett v McKeown that there is now only one set of tracing rules and there is no longer any necessity for there to be a pre-existing fiduciary relationship for tracing to be permitted.  Nonetheless, he found a trust had arisen so his remarks, like those of their Lordships in Foskett, were obiter dicta.

20     However, Rimer J in Shalson concluded that because Foskett concerned only obiter dicta “it cannot be said that Foskett has swept away the long-recognised difference between common law and equitable tracing”,[46] in particular “the need to identify a fiduciary relationship as a precondition to tracing into a mixed fund”,[47] but he found[48] there was “a fiduciary relationship sufficient to invoke equity’s tracing ability,” so his remarks were obiter dicta.

21     In my very firm view, although Foskett concerned only obiter dicta, the strong opinions of Lords Steyn and Millett, strongly supported by impressive academic publications, should be taken to have swept away any differences between the common law and equitable tracing rules so that the equitable tracing rules are the tracing rules, but, of course, without prejudice to the separate establishment of the appropriate remedy in respect of the successfully traced assets which will depend upon the nature of the plaintiff’s claim.  Any first instance judge should therefore proceed on the basis that there is one unitary set of tracing rules and should have no fear of being reversed on appeal on this issue.

22     The more significant and sometimes more complex issue is, having traced particular assets in the hands of the defendant, whether the plaintiff should have a personal or proprietary claim and whether such claim should extend to any windfall secondary profits represented by the traced assets.[49]  Where the plaintiff is a beneficiary under an express trust the position is clear.[50] Such beneficiary's equitable interest automatically becomes an equitable interest in the successfully traced assets, so vindicating the original equitable proprietary interest and also forcing any defendant trustee (and persons deriving title under him) to disgorge any windfall profit.  However, if the defendant is an innocent volunteer consideration needs to be given as to whether or not he should be allowed to retain the profit, particularly if he would have used his own money to buy the traced asset if he had known the actual money he used was tainted with the plaintiff's interest.

23     In Shalson the plaintiff was defrauded by Russo of US$ 7.5 million which he sought to trace into a valuable luxury motor yacht and a chose in action.  Rimer J held that the fraudulent misrepresentations did not lead to the loaned money being held on any constructive or resulting trust for the plaintiff:[51] the full legal beneficial ownership passed as intended by the plaintiff although the contract was voidable.[52]  The plaintiff, however, by his legal action had impliedly rescinded the contract, thereby revesting the equitable title to the money in himself, at least to the extent necessary to support an equitable tracing claim, following Banque Belge v Hambrouck,[53] El Ajou v Dollar Land Holdings[54] and Bank Tejerat v HKSB Corp (C1) Ltd.[55]

24     Rimer J, nonetheless, pointed out[56] that until rescission the property is validly vested in the fraudster so that if it is disposed of to a bona fide purchaser without notice of the equity to rescind, that purchaser will acquire a good title unimpeachable after rescission.  Similarly, if a fraudulent corporation were to go into compulsory liquidation before any rescission its assets would cease to be beneficially part of its property and would become subject to the statutory scheme for creditors whose rights would almost certainly not be capable of being affected by any rescission.  Rimer J was thus able to explain that Lord Mustill's insistence in Re Goldcorp Exchange[57] that purchasers of gold due to fraudulent misrepresentations would only have personal claims was because the purchase price when paid over became subject to a floating charge which crystallised before rescission.

25     Rimer J, as a first instance judge, naturally followed authority rather than considering the underlying rationale for conferring proprietary rights on victims of a fraudster if they rescind in time.  The justification could well be that the victim believes himself to be entering into a genuine commercial transaction while the fraudster knows matters are a confidence-trick or sham.  He has conned his victim into making an unintended gift, so the victim should not be regarded as an ordinary trade creditor.[58] 

26     In applying the tracing rules Rimer J was asked to consolidate various current and deposit accounts with the same Swiss bank so as to prevent money paid into particular overdrawn accounts becoming untraceable.  He refused, following Box v Barclays Bank,[59] pointing out[60] that it is not possible to trace into net assets,[61] only into identified assets.  He did, however, accept that "proof of a connection between the acquisition of a particular asset with money from an overdrawn account and misappropriation from a trust fund enabling the borrowing for the acquisition to be repaid might enable the beneficiary to trace into an asset".[62]  No such proof, however, was provided.

27     Evidence had been provided on the basis of the (ultimately disallowed) consolidation of current and deposit accounts with the plaintiff conducting a "cherry-picking" exercise exploiting Re Hallett's Estate[63] or Re Oatway[64] as appropriate, the defendant wrongdoer responsible[65] for the missing of moneys thereby not being able to disprove the plaintiff's assertions.  Thus, sometimes the plaintiff relied on the presumption of honesty to assert that the defendant used his own money first (so that it was dissipated), and sometimes asserting that the plaintiff's money was used first (so as to acquire a valuable asset).  Rimer J accepted[66] that this would have been correct if the accounts could have been consolidated, but held that the tracing process failed.

Conclusion

28     These two cases have plumbed the core of the sham trust and attempts to pierce the so-called "veil" of a trust so as to clarify the law once and for all.  It seems unlikely that attempts to develop a remedial constructive trust will lead anywhere.  However, much case law development is likely on the extent to which, after the tracing exercise has been carried out, there should be a proprietary remedy against the traced assets and whether it should extend beyond the value-input from the plaintiff's property to windfall profits. It seems to have been assumed that there should be such an extension for a plaintiff who is not a beneficiary under a trust but merely a tricked commercial operator with a mere equity to rescind who has made a timely rescission against his fraudster. Query whether a court on policy grounds should merely allow an equitable lien, so that the plaintiff receives no further preference against the fraudster’s general creditors.

David Hayton is Professor of Law, King’s College, London University, Barrister of 5 Stone Building, Lincoln’s Inn and Deputy Chair of the Trust Law Committee (England & Wales) since its inception in 1994.He sat as Recorder 1984-2000 and as Acting Justice, Supreme Court of The Bahamas in 2000 and 2001.

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