The lien’s share

Background

In the case of Equity Trust (Jersey) Ltd v Halabi (in his capacity as Executor of the Estate of the late Madam Intisar Nouri) (Jersey); ITG Ltd and others v Fort Trustees Ltd and another (Guernsey), the Judicial Committee of the Privy Council (the Privy Council) was faced with two appeals from Guernsey and Jersey, respectively. The applicable law in both appeals was the law of Jersey, which the Privy Council held to be the same in all relevant respects as English and Welsh law.^[2] As a result of this, the Privy Council assessed the issues in the appeals by using the principles established under English law as a starting point.

Under s.26(2) of the Trusts (Jersey) Law 1984 (the Law), trustees have a right to be indemnified out of the trust assets for their proper expenditure. Although a trustee’s right of indemnity is well established in English law and forms part of Jersey law by way of s.26(2) of the Law, the contentious aspect in these appeals arose from the context of ‘insolvency’. Specifically, what happens if the assets of the relevant trust/s are inadequate to fully cover the legitimate expenses and liabilities incurred by the trustees and former trustees?

In both cases, there was a contest between successive trustees as to their respective entitlement to be indemnified out of the available trust assets. This gave rise to an argument as to what is the correct method under Jersey law of dealing with trust liabilities in such circumstances and, in particular, whether the trustee who is first in time enjoys priority for its claim over those of subsequent trustees and their creditors.

Much of the argument on this issue centred on the nature (and existence) of what English authorities commonly refer to as the trustee’s lien. The respondents in both appeals asserted that this lien establishes a form of proprietary interest for the trustee in the trust assets, which takes precedence over the interests of beneficiaries and any subsequent trustees.

The appellants’ main argument, on the other hand, was that a former trustee possesses no inherent proprietary or security interest in the trust assets, except in cases where it has specifically negotiated and obtained such security interest to safeguard its position concerning future or outstanding liabilities before transferring the assets to a successor trustee. Any existing indemnity rights must be pursued against the current trustee and will be treated equally alongside other relevant claims for indemnity and reimbursement.

In the Jersey case, there was also an additional point for the Privy Council to consider. This was whether a trustee is entitled to recover the costs of proving its claim under the indemnity.

Jersey

The Royal Court of Jersey held that successive trustees and the creditors claiming through them by way of subrogation ranked pari passu (equally) in their claims on the trust assets and that a trustee is not entitled to the costs of proving its claim under the indemnity.

The Jersey Court of Appeal reversed this decision, holding that a former trustee’s right of indemnity ranked ahead of those of successor trustees on a first-in-time basis and that a trustee’s costs of proving its claim were recoverable under the indemnity.

Guernsey

The Royal Court of Guernsey held that the claims of a former trustee and its trust creditors had priority over those of successor trustees and that trustee claims had priority over creditors claiming through them as subrogated to their lien. The Guernsey Court of Appeal upheld this decision.

The Privy Council's approach

The Privy Council identified four principal issues that had to be determined to reach a conclusion on these issues, namely:

• Does the right of indemnity confer on the trustee a proprietary interest in the trust assets?
• Does the proprietary interest of a trustee survive the transfer of the trust assets to a successor trustee?
• Does a former trustee’s proprietary interest in the trust assets take priority over the equivalent interests of successor trustees?
• Does a trustee’s indemnity/lien extend to the costs of proving its claim against the trust if the trust is ‘insolvent’, in the sense that trustees’ claims to indemnity exceed the value of the trust fund?

The Privy Council’s findings are explored in more detail below.

The Privy Council's findings

Legal effect of the right of indemnity

The first question that the Privy Council looked at was whether a right of indemnity conferred on a trustee a proprietary interest in the trust assets. It unanimously held that the right of indemnity confers on a trustee a proprietary (rather than merely possessory) interest in the trust assets.

In reaching this conclusion, the Privy Council noted that, although the mention of an equitable lien or charge held by the trustee over the trust assets captures much of the essential nature of the trustee’s right of indemnity, it can divert attention from the fundamental character of that right.

The trustee’s right is to payment from the trust fund, and this right is enforceable through a court order for payment from the fund, essentially an order for specific performance. The Privy Council also noted that it is the consequence of that right to equitable enforcement of the indemnity out of the trust property that the trustee has a proprietary interest in the trust property.

Therefore, the trustee’s right, enforceable in equity, is nothing more and nothing less than the right to have the trust property applied to indemnify the trustee against properly incurred liabilities.

The effect of a transfer of assets on a proprietary interest

After reviewing the legal impact of an indemnity, the Privy Council examined the survival of a trustee’s proprietary interest following the transfer of trust assets to a new trustee. It unanimously held that the proprietary interest of a trustee survives the transfer of the trust assets to a successor trustee.

The Privy Council remarked that it is usually an essential feature of an equitable interest that it survives transfer of legal ownership. Given that the indemnity establishes in equity a proprietary interest in the trust assets, it would be very unusual if this interest automatically ceased to exist when the trustee relinquished legal ownership and/or physical possession of the trust property. This analysis is supported by numerous Australian authorities and various leading textbooks.^[3]

Ranking of trustees’ interests

Next, the Privy Council examined whether the proprietary interest of a former trustee in the trust assets takes precedence over the equivalent interests of successor trustees. The Privy Council was split 4:3 in respect of this question. The majority held that the successive trustees’ interest in the trust assets ranks pari passu where those assets are insufficient to meet all the claims on them made by or through the trustees pursuant to their indemnities.

Majority decision

The reasoning of the majority (Lord Briggs, with whom Lord Reed and Lady Rose agree and Lady Arden agrees in part) can be summarised as follows:

• This was a novel question.
• The trustees’ lien, being distinct from other types of equitable interest, cannot be subjected to an existing priority rule by analogy. Instead, it necessitates the development of a meticulously crafted rule specific to its nature and characteristics.
• Equity has a flexible and pragmatic approach to the task of devising an appropriate solution where none has been identified before.
• Considerations of justice, fairness, equity and common sense strongly militate in favour of the recognition between trustees of a pari passu general rule for enforcement between them of their liens over an inadequate trust fund. Some of these considerations include:
  • If the lien of the initial appointed trustee were to prevail, it could lead to peculiar and unjust outcomes among successive trustees, dependent solely on the exact timing of their appointment and retirement.
  • A trust should be regarded as a form of ‘continuing institution or scheme’. Viewed in this way, the insufficiency of the fund to meet all the trustees’ lien-based claims in full should be considered as a common misfortune for which a pari passu sharing of the residue is the ‘fairest, or least worst, general rule’.
  • When considering the standpoint of the trust creditors, it would appear even more unjust and impractical for their priority to be contingent on the specific dates of appointment of the trustees with whom they coincidentally engaged to provide services for the use and advantage of the trust.

Concurring decision

Lady Arden, in a concurring judgment, agreed that pari passu is the appropriate rule of priority but (in part) for different reasons, including:

• granting priority to a former trustee is inconsistent with equitable principle;
• there is no logical purpose in establishing a priority date for expenses by reference to the appointment dates of trustees or at all; and
• applying the first-in-time maxim will needlessly postpone creditor payments (while the priority position is sorted out), create disruptions in trust administration and undermine the practicality of the trust concept.

Dissenting view

The reasoning behind the dissenting view (Lord Richards and Sir Nicholas Patten, with whom Lord Stephens agrees) can be summarised as follows:

• The interest of each trustee arises to protect the personal position of that trustee against the liabilities it has incurred and for which it is liable. It does not exist to protect trust creditors by way of subrogation to the trustee’s right. Any benefit to trust creditors is both limited and indirect.
• Embracing the pari passu approach would lead to outgoing trustees demanding increased security to protect against potential future liabilities and the potential insufficiency of the fund, thereby complicating the trust administration process.
• If the first-in-time approach is adopted, the priority of the outgoing trustee’s proprietary interest will minimise disputes regarding the required level of ‘reasonable security’. The first-in-time approach not only aligns with principle but also offers a logical framework with commercial and administrative benefits.
• The trustee’s right is an equitable right, enforceable by an order of the court requiring the trust fund to be so applied.
• The general rule as to the priority of equitable interests is determined by the order of their creation.
• There is no sufficient reason for developing and applying a different principle to the equitable interests of trustees in respect of their rights of indemnity.

Extent of the trustees’ indemnity/lien

The next question that the Privy Council looked at was whether a trustee’s indemnity/lien extended to the costs of proving its claim against the trust where the trust is ‘insolvent’ (i.e., where trustees’ claims to indemnity exceed the value of the trust fund). The Privy Council unanimously held that a trustee’s indemnity extends to the costs of proving the trustee’s claim against the trust assets.

The Privy Council noted that it was well established that a trustee’s right of indemnity extends to costs incurred in proceedings brought by or against a trustee in its capacity as trustee, provided only that there is no misconduct on the part of the trustee. It also held that there is no justification for asserting that this principle does not apply to the costs incurred in proceedings initiated by a trustee to establish their right to indemnity for specific liabilities. Similarly, there is no basis for claiming that this principle does not extend to costs incurred after the replacement of a trustee.

Conclusion

Is the decision of the majority, namely, that the successive trustees’ interest in the trust assets ranks pari passu, correct? In the authors’ view, it is. This is because the decision, at its core, reflects a fair approach and one that promotes certainty and good trust administration.

A key aspect of this relates to the issue of novation. On a change of trustee, it is common for the obligations of the former trustee to be novated to the successor trustee. Thus, by a deed of novation, the creditor will accept the new trustee as debtor in place of the former trustee and will discharge the former trustee from the obligation. This reflects that it will be the successor trustee who has possession of the trust property, whereas the former trustee will no longer hold trust assets and will depend upon its right of indemnity to meet any obligation to the creditor. However, will creditors be as willing in future to agree to novation?

As was made clear by the Privy Council in Investec Trust (Guernsey) Ltd and Ors v Glenalla Properties Ltd,^[4] a creditor can only have access to the trust property via the trustee’s right of indemnity. If the current trustee’s right of indemnity ranks behind that of a former trustee, a creditor who has agreed to novation may be prejudiced if there are insufficient trust assets to pay all creditors. They will now claim through the successor trustee and will therefore rank behind any creditors claiming through the former trustee. If, however, they had refused to agree to novation, they would have continued to be able to claim through the former trustee’s right of indemnity and had priority over all creditors claiming through the successor trustee. Of course, this will only matter in the event of an insolvency arising, but one can foresee the possibility of a cautious creditor wishing to stay with the former trustee rather than agree to novation to the successor trustee. If this were to become widespread, it would inhibit necessary changes in trusteeships to the detriment of those with an interest in the trusts. Ultimately, this could result in trusts being viewed as a less attractive mechanism through which to hold assets.

Another key aspect of why the pari passu approach is appropriate is because it promotes certainty. On a first-in-time approach, a successor trustee will face considerable uncertainty in administering the trust assets. Although the successor trustee will know that any claim through the former trustee will take priority over creditors claiming through them, they will not necessarily be aware of the full extent of the creditors claiming through the former trustee when the successor trustee takes office. The successor trustee will, therefore, have to administer the trust assets in the knowledge that even liabilities that they have incurred in the administration of the trust may end up being irrecoverable if one or more creditors claiming through the former trustee have, by virtue of their priority, ‘scooped the pot’ and exhausted all the assets of the trust in the event of its becoming insolvent. The practical implications of this uncertainty for the trust industry are unlikely to be positive and, again, have wider implications on the desirability of using trusts in the longer term.

It could, of course, be said that it is a successor trustee’s choice whether to assume the role. Before they do so, they could exercise due diligence on the state of the trust and the potential liabilities to which it might find itself subject and consider the potential for the trust to become ‘insolvent’. However, these measures have their natural limits and potential successor trustees may question the extent to which they can realistically mitigate this risk through due diligence.

An Australian perspective

Since the Privy Council’s decision, the Australian Federal Court’s decision in Fotios (Bankrupt) v Helios Corporation Pty Ltd (No 3) has been handed down.^[5] This decision has received attention because the Federal Court has endorsed the first-in-time approach and, while acknowledging the Privy Council’s findings, concluded that it was not bound by those findings in circumstances where the existing state of the law of Australia was a first-in-time approach. The Federal Court noted at para.11 of the judgment that:

‘It is not for this Court acting at first instance to form the view that it would be appropriate to introduce some new rule of equity as part of Australian law to deal with the particular case of priorities between successive trustees, even with the support of such high authority as Equity Trust (Jersey) v Halabi.’

However, the Federal Court was also at pains to make clear that the first-in-time approach was not an ‘absolute rule’ and that equity will depart from affording priority to the prior equity where there is inequality in merit or if the subsequent trustee takes office without any knowledge of the possibility of a prior equity that may affect the position. However, on the facts of the case, those exceptions did not apply and, on the state of the existing law, the first-in-time approach was applicable.

Though the decision is of undoubted interest, practitioners outside of Australia may be reasonably cautious about relying upon such a first-instance decision. However, what is consistent about the approach of both the Privy Council and the Federal Court is that neither the pari passu approach nor first-in-time approach appear to operate as a general rule. There are exceptions, which are highlighted below.

As matters stand, the Privy Council judgment serves as a much-needed elucidation of the ranking of claims by ex-trustees and creditors making claims through them by way of subrogation in an ‘insolvent’ trust in a Jersey-law context. It adopts, in the authors’ view, the correct approach to priorities and, despite the fact that this judgment focused on the Jersey-law position, it has important implications for current and former trustees of trusts in the common-law world.

However, the judgment has given rise to several unresolved questions:

• When the trust’s assets are insufficient to fully satisfy all the liens, how will the enforcement of pari passu priority be carried out? If a liquidator has been appointed over the insolvent trust in question, then it would seem likely that they would approach matters in the same way as they would in respect of a pari passu apportionment for unsecured creditors in a liquidation of a company. If no liquidator has been appointed and the trustee is, in effect, tasked with distributing the assets as a liquidator would, then the expectation would seem to be that it would approach matters in the same way. However, many trustees may reasonably wish to seek the court’s directions on such matters.
• Is it possible for the general rule of pari passu priority to be overridden by explicit provisions in the applicable trust document? It is reasonable to assume that it would be possible, but this is yet to be tested.
• Briggs L alluded to the potential existence of exceptional circumstances where strictly adhering to the pari passu rule of priority could lead to clear inequity, necessitating a departure from the rule. What specific circumstances would fall under this category? Given the underlying equitable underpinnings of the principle, it might be the case that if a trustee has engaged in inequitable behaviour (fraud, deceit, unconscionability or bad faith) then that could lead to a departure from the rule (at least as regards to that trustee). However, whether that would qualify as the necessary exceptional circumstances is not entirely clear. As noted by the Australian Federal Court in Fotios, it would seem possible that equity will depart from any general rule where the result would lead to an unfairness in outcome. Therefore, if there are circumstances in which a successor trustee should be given priority, then this would also appear to serve as an exception. Much will turn on the facts of each case and how the courts subsequently consider these issues.

For the time being, all outgoing trustees need to be cognisant of the aforementioned principles arising from the case and must make sure that they take the necessary steps to protect their interests.