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Trustee's Indemnities - more than reasonable security?
Written by Richard Pirie and David Dorgan
Introduction
When a trustee resigns, retires or is removed from office it is under a statutory obligation by Article 34 of the Trusts (Jersey) Law 1984 (as amended) ("the Trusts Law") to surrender the trust property. On doing so the trustee is simultaneously released from liability to any beneficiary, trustee or person interested under the trust except for liability arising from any breach of trust to which it was a party or in respect of actions to recover trust property in its possession or its proceeds. However at the same time the trustee is entitled to require to be provided with "reasonable security" for liabilities before surrendering trust property. It is the manner in which this entitlement has been satisfied and the lack of any provision in the Trusts Law where a trustee which distributes part of the trust fund but remains a trustee of the remainder, which have created a complex problem for which there is no immediately obvious solution.
Personal Liability of Trustees
Because trusts do not have separate legal personality a trustee remains personally liable for third party contractual, tortious or taxation liabilities incurred or arising during its office as trustee. Whilst in office a trustee has possession or control of the trust property and can therefore utilise it to directly discharge properly incurred liabilities. However after leaving office the trustee no longer possesses or controls the trust property and yet will remain personally liable for such liabilities. One of the greatest fears of a retired trustee is being assessed for an unforeseen tax liability arising from its trusteeship and then finding that it is not possible to have that liability discharged from the trust fund.
Due to the onerous nature of a trustee’s duties, a professional trustee expects not only to be remunerated but also protected in respect of any personal liability to third parties, including those arising whilst in office but which do not come to light until after transfer of the trusteeship. These concerns were only partly dealt with by what is now Article 34(2) of the Trusts Law, which provides that "..A trustee who resigns, retires or is removed may require to be provided with reasonable security for liabilities whether existing, future, contingent or otherwise before surrendering trust property".
However, and very unfortunately, Article 34(2) is silent upon whether a trustee who distributes or transfers trust property to beneficiaries or to other trustees but remains as trustee of the remainder of the trust fund can require to be provided with reasonable security for third party liabilities. Under English case law Lord Roskill said in Roome v Edwards [1981] that "Persons, whether professional men or not, who accept appointment as trustees…are clearly at risk…and have only themselves to blame if they accept the obligations of trustees without ensuring that they are sufficiently and effectively protected whether by their beneficiaries or otherwise for fiscal or other liabilities which fall on them personally..".
It is therefore up to a trustee to protect itself in respect of third party liabilities arising from its trusteeship, and Article 34(2) gives it the statutory right to do so by entitling it to require "reasonable security" before transferring the trust property. It is in exercise of that right that the practice has developed of including a contractual indemnity within an Instrument of Appointment and Retirement of Trustees by virtue of which a retiring trustee preserves the right to have liabilities arising from its trusteeship discharged out of the trust property notwithstanding the transfer of possession and control of it to its successor.
As the term "reasonable security" remains undefined by statute and there has been no judicial interpretation, a retiring trustee invariably insists on continuance of the maximum protection permitted by the Trusts Law by requiring an indemnity for all liabilities except for breach of trust to which it was party and in respect of actions against it to recover trust property or the proceeds of it.
Why have chains of indemnity come about?
Almost without exception the indemnity required is unlimited in any way and is thus for the full value of the trust fund for an infinite period. Such provision is claimed to be "reasonable security" on the basis that a retiring trustee should be in no worse position in respect of protection against personal liability for third party liabilities arising from its trusteeship than if it had remained as trustee.
However the practice has gone a stage further by seeking to attach the right to protection to trust property after distribution by successor trustees to beneficiaries, and it is this which causes the greatest problem - and often the greatest expense - on a change of trusteeship. This was initially achieved by the retiring trustee insisting on a blanket provision in the Instrument of Appointment of Retirement under which the new trustee undertook that it would not make any distribution to a beneficiary unless it first procured from that beneficiary an indemnity limited to the value of the distribution.
Over time some qualification has developed to enable distributions to be made up to a certain amount or a certain percentage of the trust fund without any indemnity being required from the beneficiary because beneficiaries have not always been willing to give indemnities and/or because the cost of putting them in place was disproportionate to the amount being distributed.
Initially the indemnity was required to be given to the trustee making the distribution, but this resulted in chains of indemnities through successive trustees and the need to take them into account on every change of trusteeship. There also developed a school of thought that an incoming trustee should not agree, as a condition of its appointment, to fetter its discretion by making its ability to distribute to beneficiaries conditional upon the them giving indemnities. However at the same time it was still generally considered reasonable for the retiring trustee to maintain the protection of the trust property.
In an effort to balance those conflicting interests and also to try to avoid the creation of chains of indemnities the practice developed of providing in the Instrument of Retirement and Appointment that the trustee did not have to procure an indemnity from the beneficiary as a condition of being able to make the distribution, but that if it did not do so then it would remain liable to the extent of the distribution. However the latter option would place the distributing trustee in a potentially exposed position because it was maintaining an indemnity to its predecessor to the extent of the value of assets which it would no longer have possession or control of. Furthermore in practice the problem has been encountered of a former trustee to whom the beneficiary of a proposed distribution is willing to provide an indemnity refusing to accept or be party to it without legal advice, refusing to seek that advice unless it is indemnified for the cost of it, and neither the distributing trustee or the beneficiary of the proposed distribution being willing to do so because they consider it unnecessary for the former trustee to seek advice to implement something which it insisted on when it transferred the trusteeship. Therefore this effort to avoid chains of indemnity has not been entirely successful.
What is "reasonable security?"
The principal reason why the indemnities commonly used may in some cases go far beyond what amounts to "reasonable security" is because there is invariably no risk assessment made by the retiring or distributing trustee of what third party liabilities there may be, in terms of nature, amount or time. It may well be the case that there is no risk at all of third party liability, but the retiring trustee nevertheless insists on an unlimited indemnity because it has not addressed its mind to the issue. Even where there is some potential liability, the absence of any limit or qualification to the extent of the indemnity will in many cases lead to a trustee receiving a degree of security which is much more than anyone would consider "reasonable" – for example, security over a trust fund of £10million for an indefinite period when the worst case on a full risk assessment is that there will be a tax liability of no more than £50,000 and which will become prescribed after 6 years.
The fundamental principle of a trust is that it is set up for the benefit of the beneficiaries and not the trustee. Furthermore it is contemplated from the outset by all concerned (including the original trustee and its successors) that the trust fund will ultimately be paid out to the beneficiaries and the trust will cease to exist. The vast majority of powers to pay or appoint income or capital to beneficiaries do not contain any provision which specifically entitle the trustee to make distributions conditional upon the beneficiary providing an indemnity for the amount of the distribution. Most powers provide that the power to pay or appoint is on such terms as the trustee may in its absolute discretion think fit, but such powers are fiduciary and the indemnity often required to be given by a beneficiary on a distribution is for the benefit of the trustee, not the beneficiary. On that basis it could be argued that trustees are not entitled to require a beneficiary to provide any indemnity as a condition of a distribution.
However there is an equally legitimate argument which reaches the opposite conclusion. The courts have accepted that as a matter of principle it is in the best interests of beneficiaries to have trusts properly managed by those who have the requisite skill and knowledge to do so, and have applied that principle to vary trusts to enable trustees to be paid in order to secure their services where the trust instrument contained no or insufficient or defective charging provisions. As stated above, due to the onerous nature of trusteeship, a professional trustees expects not only to be remunerated but also protected in respect of any personal liability whilst in office and thereafter. It can therefore also be argued that if a party is not adequately protected against personal liability for third party claims arising from its trusteeship it will not take on the trusteeship in the first place. On that basis, by virtue of the same principle which applies to remuneration of trustees, it is in the best interests of beneficiaries for trustees to be protected against third party liabilities.
It is perhaps not surprising that these indemnities, even with de minimus provisions, are subject to continuing criticism by trustees and beneficiaries alike. From a successor trustee’s perspective it is easy for a busy trust administrator to overlook the existence of a covenant given on that trustee’s appointment, resulting in neglect of the trustee’s obligation to procure a direct indemnity from the recipient of a distribution. Furthermore, if there have been many changes of trusteeship, each with an open-ended indemnity to be carried forward, a chain of indemnities may have been created between the original trustee and the current trustee because of the doctrine of privity of contract. In such cases the administration of any distribution may become complicated and time-consuming, and therefore costly, particularly if there are regular capital payments which are not within any de minimus provisions that may exist.
From a beneficiary’s perspective, it may seem unreasonable that a benefit can only be received if he agrees to expose himself to potential personal liability for something he had nothing do with and may very well not understand – indeed the imposition of any condition is likely to be contrary to his understanding of the purpose of the trust because he did not expect any condition or restriction on his freedom to deal with any benefit received as he sees fit.
For both trustee and beneficiaries the process of negotiating indemnities leads to higher costs of administration which depletes the trust property intended for other purposes and also often causes unnecessary delays to distributions and to the transfer of effective management of the trust to new trustees.
Is there an effective solution?
Two options have been put forward for consideration in draft Amendment No. 5 to the Trusts Law, either of which might provide an improvement to the current unsatisfactory situation, but neither of which provide a complete practical solution.
The first option under consideration is the creation of an equitable lien which attaches to the trust property for the benefit of the trustee for the time being and all former trustees, whilst the second is to permit a former trustee to vicariously benefit from a contractual indemnity to which it is not a party. In both cases statutory intervention will be required because Jersey law does not possess the developed principles and judicial judgements to support either option from its customary law. It is therefore prudent and instructive to consider the position under English law (from which the trust was imported into Jersey law) when evaluating these options.
Under English Law a trustee’s equitable lien confers a charge upon the trust property which exists independently of possession and control of it and until all claims are satisfied. This means the lien will take priority over the interests of the beneficiaries. It will also survive the trustee’s loss of office and dispossession of the trust property. However because it is equitable it will of course have no effect against a bona fide purchaser for value without notice of it. Practically speaking if a third party liability arises against a former trustee its equitable lien will not only attach to or charge all property comprised in the trust fund from time to time, but will also continue to attach to trust property after distribution to a beneficiary.
It is to be anticipated that for such an arrangement to be effective and thus acceptable to trustees as an alternative to a contractual right, the enabling statute will require to provide that the lien will continue to exist unless expressly released, rather than requiring it to be expressly preserved. However this would mean that distributed trust property comprised of tangible or real assets would never be free of the lien unless and until it passed into the hands of a bona fide purchaser for value without notice.
From a trustee’s point of view an equitable lien might well be worthless if either (a) the present trustee or the beneficiary to whom trust property has been distributed no longer has any traceable trust property because it has been dissipated (e.g. for tax planning reasons all capital has been paid out and only accrued income since the transfer of trusteeship remains); or (b) the trust property is in or has been moved to a jurisdiction which does not recognise equity or trusts; or (c) because title to trust property has been passed to a bona fide purchaser for value without notice.
Because the proposed equitable lien has those risks for a trustee it can be argued that it will not provide "reasonable security". Furthermore it does not solve the problem of a beneficiary wishing to receive a distribution unconditionally and unencumbered.
The second option under consideration proposes protection of a former trustee by giving it the benefit of contractual terms to which it is not a party, namely those imposed upon any subsequent transfer of trusteeship or distribution of trust property. This would be a significant exception to the general rule that only the parties to a contract have rights or duties under it, although it must be noted that England brought into force the Contracts (Rights of Third Parties) Act 1999 which put onto a statutory basis the common law concept of vicarious immunity developed by the House of Lords over the twentieth century in the context of shipping law. This approach would remove the need for a former trustee to be party to a subsequent transaction in order to benefit from any indemnity on the transfer of the trust or given by a beneficiary on a distribution of trust property.
In some ways the third party rights option might be preferable to an equitable lien as it maintains a contractual relationship of some description because contract law is recognised in civil law countries and because the beneficiary remains contractually liable, it avoids the issue of a bona fide purchaser for value without notice. For this reason trustees may see it as potentially more solid protection and, if so, are more likely to accept it as "reasonable security". However it still does not achieve a position whereby a former trustee is as protected as if it retained the trust fund, and, if that degree of protection is to be maintained, it does not enable the beneficiary of a distribution receives trust property unconditionally, so again it is only a partial solution to the problem.
There may be a third option. What a trustee requires is to be protected against a risk, namely the risk of third party liability arising from its trusteeship. It should surely be possible to insure against that risk. The lack of any cases of enforcement of indemnities suggest the risk is not high. If protection of the trustee can be achieved there will be no need for indemnities to be given, either on a change of trusteeship or on distributions. All regulated Jersey trustees are required to carry significant professional indemnity insurance as a condition of their licence so perhaps this could be dealt with on a global basis as additional cover. Alternatively insurance could be taken out on the transfer of trusteeship. As Article 34 (2) entitles the outgoing trustee to require "reasonable security" it must surely follow that this is to be provided at the expense of the trust, and therefore the premium for such insurance is a proper expense of the trust.
Conclusion
There is no decided case on the enforcement of any such indemnity, for which possible explanations are either (i) that the system is working very well and beneficiaries are willing to accept the requirement to give indemnities as a condition of distributions to them; or (ii) that any indemnities are unnecessary in the first place. What is not in dispute is that there is a serious issue which requires to be resolved as a matter of some urgency because at present a great deal of time and expense is incurred dealing with indemnities in these circumstances and this has an adverse effect on Jersey’s position in an increasingly competitive market. This is a problem that must be resolved without delay to avoid damage to Jersey’s competitive position, and insurance may be the solution to it.
Should you have any queries and wish to have a confidential conversation with regard to any concern then please do not hesitate to contact call.
Advocate Richard Pirie – 01534 601755 Email
David Dorgan – 01534 601757 Email
Carl O’Shea - 01534 601750 Email
THIS ARTICLE IS FOR INFORMATION PURPOSES ONLY AND NOT BY WAY OF LEGAL ADVICE. PROFESSIONAL LEGAL ADVICE SHOULD BE SOUGHT BEFORE ANY ACTION IS TAKEN.