New Book - Constructive and Resulting Trusts - and - the law of insolvency and the law of trusts

Hart Publishing have published a new book which touches on our area. Whilst not strictly insolvency related the new text, which is entitled: "Constructive and Resulting Trusts." (edited by Professor Charles Mitchell), is particularly important as it highlights an area which constitutes what Professor Finch (see: Finch, V. Is Pari Passu Passe [2000] Insolvency Lawyer, 5(Oct), 194-210) has called a 'true exception' to the so called fundamental or cardinal principle of pari passu distribution, namely, the law of trusts. Let us now consider some issues around insolvency and the law of trusts.

Professor Sir Roy Goode QC (pictured) has noted that the Enterprise Act 2002 (EA 2002) has resulted in a, “shift in the balance of power from secured creditors to general creditors.”[1] This shift in balance highlights for consideration an area of law that has long impacted on the law of insolvency, arguable from the inception of the bankruptcy jurisdiction in 1543.[2] The area is of course the law of trusts. Consideration of what constitutes property[3] for the purpose of the collectivised interests of creditors is perhaps one of the most important tasks for the officeholder administering an insolvent estate.[4] The subsequent method by which the value raised is distributed is perhaps the second most important.[5] As Professor Mokal has shown it must now be considered that pari passu is not a fundamental principle of insolvency law, but more like a convenient default principle.[6] The discussion of the place of trusts in the law of insolvency (or rather outside the law of insolvency!) can therefore be based on the premise that creditors are treated in a ranked order of priority in terms of distribution. The establishment of a trust helps a given ‘creditor’ escape this ranking. Whether they can be considered a true creditor in light of their beneficiary position will be discussed below.

One learned commentator has observed that the establishment of a trust helps the creditor escape “the fate destined to be experienced by the other ordinary, unsecured creditors.”[7] The effect of escaping priority ranking or pari passu treatment is the same for the beneficiary of any trust, namely that they avoid participating in a pool of assets alongside other creditors in whatever form of participation is being used. If it is accepted that the use of a trust is a true exception to pari passu principles of distribution,[8] other examples can also be given, such as set-off[9] and romalpa clauses[10] which aid one creditor in their attempts to circumvent the distribution mechanisms, or indeed the effect of the insolvency laws in their totality. This is because the property against which the creditors are seeking to claim, in the context of trusts and romalpa clauses, never formed part of the insolvent estate. Set-off of course does fall within the insolvency laws but operates automatically causing value to be removed before collectivised interests take hold. The property in the trusts and romalpa sense is therefore, not available to the officeholder for realisation and subsequent distribution according to collectivised interests and any given distribution mechanism, but can be sought by the trust ‘creditor’ alone to satisfy their claims as beneficiaries (or owners in the case of romalpa clauses).

With the diminution in protection provided by security as a result of the Enterprise Act 2002 reforms[11] on administrative receivership and by extension fixed and floating charges[12] practical use as security mechanisms[13] and the subsequent shift in balance between secured and unsecured creditors as highlighted by Professor Goode above, alternative mechanisms must be explored that could help what have hitherto been secured creditors. Space does not allow within this blog entry a full discussion of the merits of secured credit,[14] but it is recognised that, “the world in which we live and the creation of wealth depend upon a system founded on credit…”[15] As a consequence it must be recognised that credit providers must be encouraged to proffer their wares with appropriate protection. The qualities of security and its benefit to commerce, namely, low monitoring costs, aggressive unsecured creditor behaviour, must surely still be prevalent in a post EA 2002 world. If security for credit extension is meritous,[17] but it effects have been diminished, what alternatives exist that credit providers can seek redress to?

Professors Stevens and Finch, amongst others, have begun the search by highlighting the possible use of trusts in the context of post administration funding protection for creditors who advance new monies in a rescue environment.[18] The impact of equity and trusts on insolvent situations is of course long standing and has again risen to the fore recently with the case of Re Farepak Food and Gifts Ltd (in administration).[19] The law of insolvency can trace its early modern beginnings to the equitable jurisdiction of the Court of Chancery.[20] The law of equity and trusts is of course a core staple of any qualifying undergraduate law degree[22] and the impact of the jurisdiction is by no means foreign to commercial law[23] or insolvency practitioners generally.[24] Indeed, the office holding position of a trustee in bankruptcy is by its designation and nature integral to the good management of third party trust monies and their being administered and distributed in a fiduciary manner.[25] The beginnings of the trust as an idea, namely a transaction where S (the settlor) transfers property to T (the trustee) with a direction that the property should be applied for the benefit of B (the beneficiary) can be traced to the activities of the King’s Chancellor in the fourteenth century, although there has been some academic debate regarding the origin of the jurisdiction. These divergent views can be illustrated by reference to some recent pronouncements and some of a rather older vintage. The first explanation for the genesis of the equitable jurisdiction and the trust can according to Professor Wood be seen in Roman law.[26] Furthermore he observes that that the development on the jurisdiction can be traced in English law to the conquest and the adoption of Norman principles into English common law.[27] The second main school of thought regarding the genesis of the trust can perhaps best be expressed by reference to Professor Maitland. During the course of his equity lectures in the University of Cambridge, delivered some 110 years before Professor Wood’s pronouncement, Professor Maitland observed when tracing the history of the uses, “I don’t believe there is anything Roman about it.”[28] These principles came to the fore perhaps most forcibly during the sixteenth and seventeenth centuries and reached their zenith of perfection in the 19th century. [29]

For a trust to exist there must be three qualities in place that any lender must establish, these are known as the three certainties.[30] First, there must be certainty of intention to create a trust by virtue of the words used in the relevant instrument.[31] Second, there must be certainty of subject matter[32] and third there must be certainty of objects.[33].

For a trust to arise there must be certainty of intention that the settlor intended and showed by their words or actions that they intended to transfer property from themselves (S) to the trustee (T) for the benefit of the beneficiary (B). As Scarman, LJ observed in Paul v. Constance, “…there must be a clear declaration of trust and that means there must be clear evidence from what is said or done of an intention to create a trust.”[34] S’s words must show that they intend for T to be obliged to apply the property for the benefit of B. The language which is used must be obligatory in nature, i.e. not precatory.[35] The area of certainty of intention in an insolvency context is best illustrated by Re Kayford[36], a case which involved a mail order company that was in liquidation.

For a trust to be valid there must also be certainty of subject matter. This certainty has two subsets. First, there must be certainty in relation to the trust property. [37] Second, there must be certainty if there is more than one beneficiary as to which beneficiary is going to receive what proportion of the trust property. The area of certainty of subject matter in an insolvency context is best illustrated by Re London Wine Shipping Co[38], a case which involved a company that was in receivership.

The final condition that must be extant for a trust to arise is that there must be certainty of objects, which means certainty of who the beneficiaries are. The words that define the beneficiaries must be certain in terms of their linguistic content.[39]

Through long usage the commercial world is familiar with the trust instrument. This “appendix to the law of property”[40] had its first widespread deployment within England.[41] Perhaps the most obvious example of the trust and equitable principles playing a part in the commercial sphere relates to companies. The interface has occurred on a number of fronts, namely, in the development of early joint stock companies,[42] within the sphere of directors fiduciary duties[43] and directors holding profit on trust for the benefit of a company pursuant to a constructive trust following the breach of those fiduciary duties.[44] But the interface between these two areas of law must be left for another time. Trusts then can be used in an insolvency context in a number of ways. Professor Finch has observed that the protection of the ill informed pre- paying consumer is one method.[45]

Trusts can arise in a number of different circumstances,[46] but for the purposes of this blog entry the most important species of trust to consider is the resulting trust. This is also sometimes referred to as the implied trust. The resulting trust was further sub-categorised by Megarry, J in Re Vandervell (No.2) Ltd[47] when he observed that a resulting trust could be: (1) a presumed resulting trust, or; (2) and automatic resulting trust. Megarry, J’s classification has however been disapproved by the House of Lords in the West Deutsche opinion.

Professor Fletcher has noted that, “Not surprisingly, the validity of formation of an alleged trust under which a favoured sub-group would escape the fate otherwise in store for them according to the pari passu principle is seldom uncontested by those for whom the self same trust has detrimental effects.”[52] This quote gives rise to a number of extremely important questions and also raises the question why have trusts not been used before as methods of quasi-security devices? Is it because the fixed and floating charge security protection, that has been so greatly eroded by the Enterprise Act 2002, has negated the need to seek further or alternative security devices? The debate will go on!!

[1] Goode, RM. Legal Problems of Credit and Security. 3rd Edition. Sweet & Maxwell Ltd, 2003, at page v. See also: Goode, RM. Is the law to favourable to secured creditors (1983-84) 8 Can Bus Rev 53. A shift of this nature has been noted previously in other jurisdictions, see: White, J. The recent erosion of the secured creditor’s rights through cases, rules and statutory changes in bankruptcy law (1983) 53 Miss LJ 389.

[2] See the first English bankruptcy statute: Act Against Such Persons As Do Make Bankrupts 1543, 34 & 35 Hen VIII, c.4. Professor David Graham Q.C. has posited that the widely held view that this statute received Royal assent in 1542 is erroneous. He observed, “'The statement in paragraph 35 of the Cork Report that the Act was passed in 1542 (and repeated elsewhere) must now be regarded as erroneous’. See: Graham, D. The formative years of English Insolvency Law – 1543 to 1603 (1995) Phoenix, December 1995, Issue 21, pages 23 to 25. For this contention he has relied on the arguments of Professor Elton. See: Elton, G. Reform and Renewal: Thomas Cromwell and the Common Weal. Cambridge, 1973. at page 149. See also the historical citations on the history of English insolvency in: Tribe, J. Book Review of: ‘Personal Insolvency Law, Regulation and Policy’ by Professor David Milman [2006] IL&P, 22(3), 115-116.

[3] As defined by s.436 Insolvency Act 1986 (IA 86).

[4] As defined by s.123 IA86. This is a convenient point to note that this article takes as its subject matter corporate insolvency, as opposed to personal insolvency.

[5] This discussion is for another article. See for example: Mokal, R.J. Priority as Pathology: the Pari Passu Myth [2001] CLJ 580.

[7] Fletcher, IF. The Law of Insolvency. 3rd Edition. Sweet & Maxwell Ltd. London, 2002, at paragraph 26-019.

[8] See also: Finch, V. Is pari passu passé? [2000] Insolvency L, 5, 194.

[9] See further: Derham SR. The Law of Set Off. 3rd Edition. Oxford University Press, Oxford, 2003.

[10] See further: Tribe, J. The morality of Romalpa clauses in corporate insolvency: a case for reform [2001] Insolvency Law & Practice (IL&P), vol.17, no.5, pp 166-175.

[11] On the Enterprise Act 2002 generally see: Davies, S (Ed). Insolvency and the Enterprise Act 2002. Jordans Publishing Ltd, Bristol, 2003. See also: Frisby, S. In search of a rescue regime: the Enterprise Act 2002 [2004] M.L.R, 67(2), 247-272.

[12] On the floating charge see further: Mokal, RJ. The Floating Charge – An Elegy, in Worthington, S (Ed). Commercial Law and Commercial Practice. Hart, Oxford, 2003, pages 479-509.

[13] On security in the post EA 2002 world see: Stevens, R. Security after the Enterprise Act, in J Getzler, J and Payne, J (Ed.) Company Charges: Spectrum and Beyond (Oxford University Press, 2006), 15.

[14] In this regard see: Farrar, J. Floating charges and priorities (1974) 38 Conv (NS) 315; Allan, D. & Drobnig, U. Secured Credit in commercial Insolvencies: A comparative Analysis (1980) 44 Rabel’s Zeitschrift 615; Goode, R.M. The Secured Creditor and Insolvency under English law (1980) 44 Rabel’s Zeitschrift 673; Bebchuk, L.A. & Fried, J.M. The uneasy case for Priority of Secured Claims in Bankruptcy (1996) 105 Yale LJ 857.

[15] Insolvency Law and Practice, Report of the Review Committee. Cmnd 8558. HMSO, London, 1982, at paragraph 198. Hereafter referred to as the Cork Report. See further: Cork, K. Cork on Cork. Macmillan, London, 1988, at Chapter 10. Hereafter referred to as Cork on Cork.

[16] See further: Finch, V. Corporate Insolvency Law: Perspectives and Principles. Cambridge University Press, Cambridge, 2002, at pages 452 to 464. See also: Finch, V. Security, Insolvency and Risk: Who Pays the Price? [1999] MLR vol.62, no.5 page 633.

[17] On this debate see further: Mokal, RJ. The Search for Someone to Save: A Defensive Case for the Priority of Secured Lending (2002) 22(4) OJLS 687-728.

[18] Stevens, R. Insolvency, in Swadling, S (Ed). The Quistclose Trust: Critical Essays. Hart, Oxford, 2004, at Chapter 8. See: Finch Corporate Insolvency at page 479. On alternative funding mechanisms in a rescue environment see, McCormack, G. Super-priority new financing and corporate rescue [2007] J.B.L, Oct, 701-732.

[19] [2006] EWHC 3272. Hereafter referred to as Farepak.

[20] On the development of that court see: Parkes, J. A History of the Court of Chancery; with practical remarks on the recent commission, report, and evidence, and on the means of improving the administration of Justice in the English Courts of Equity. London, 1828. See also: Ritchie, J (Ed). Reports of Cases decided by Francis Bacon in the High Court of Chancery (1617-1621), Oxford, 1932, which includes a number of judgments on insolvency issues. See further: Tribe, J & Graham, D. Bacon in Debt - The Insolvency Judgments of Francis, Lord Verulam [2006] IL&P, vol.22(1), 11-16.

[21] Wood, PR. Law and Practice of International Finance, University Edition. Sweet & Maxwell, London, 2008, at paragraph 19-01. Hereafter referred to as Wood Finance.

[24] See for example: Tribe, JP. Trust assets held under a CVA: do they survive the termination of the CVA through liquidation? (2002) Insolv.L, August(5), pp. 186-189.

[25] On the trustee in bankruptcy see: Fletcher, I.F. The Law of Insolvency. 3rd Edition. Sweet & Maxwell Ltd. London, 2002, and; Morgan, S and Tribe, J. Personal Insolvency: A User's Guide. Jordans Publishing Ltd. 2010 (In Press)

[26] Wood Finance at paragraph 19-04.

[27] Ibid. Author’s italicised emphasis.

[28] Maitland.

[29] See for example: Jane Tyrrell’s Case (1557); The Earl of Oxford’s Case (1615). On this case see: Knafla, LA. Law and Politics in Jacobean England: The Tracts of Lord Chancellor Ellesmere. Cambridge University Press, 1977.

[30] per Scarman, LJ in Paul v. Constance [1977] 1 WLR 527, at page 530, paragraph B. On the three certainties see: Oakley, AJ. Parker and Mellows: The Modern Law of Trusts. 9th Edition, Thomson Sweet & Maxwell, London, 2008, at paragraphs 3-002 to 3-075. See also: Martin, JE. Hanbury and Martin: Modern Equity. 17th ed, Sweet and Maxwell, 2005.

[31] On certainty of intention generally see for example: Jones v. Lock (1865) 1 Ch App 25; Lambe v. Eames (1871) 6 Ch App 597 CA; Comiskey v. Bowring-Hanbury [1905] AC 84, HL; Paul v. Constance [1977] 1 WLR.

[32] On certainty of subject matter see: Mussoorie Bank Ltd v. Raynor (1882) 7 App Cas 321 PC; Re Golay [1965] 1 WLR 969; Re Goldcorp Corporation [1995] 1 AC 74; Hunter v. Moss

[33] On certainty of objects see: IRC v. Broadway Cottages Trust [1955] Ch.20; McPhail v. Doulton [1971] AC 424 HL; Re Baden’s Deed Trusts (No.2) [1973] Ch.9; Re Barlow’s Will Trusts [1979] 1 WLR 278.

[34] per Scarman, LJ in Paul v. Constance [1977] 1 WLR 527, at page 531, paragraph G.

[35] See for example: Re Adams and the Kensington Vestry (1884) 27 Ch D 394, CA, where the language used (“in full confidence”) was deemed to not be sufficiently obligatory.

[36] [1975] 1 WLR 279.

[37] In Palmer v. Simmonds (1854) 2 Drew 221, the phrase ‘the bulk of my estate’ was held to be void for lack of certainty.

[38] [1986] PCC 121.

[39] See further: Re Tuck’s Settlement [1978] Ch. 49.

[40] Maitland.

[41] Wood Finance at paragraph 19-02.

[42] See for example: Cooke, CA. Corporation, Trust and Company. An essay in legal history. Manchester University Press, Manchester, 1950. See also: Runciman, D & Ryan, M (Eds). Maitland: state, trust and corporation. Cambridge University Press, Cambridge, 2003.

[43] It could of course be argued that the no conflict/no profit rule for directors takes as its start point the trusts case of Keech v. Sanford (1726) 25 ER 223. For the modern tests see: Companies Act 2006, s.175. On the pre-codification case law see: Cooks v. Deeks [1916] 1 AC 554; Re Smith & Fawcett [1942] Ch.304, CA; Hogg v. Cramphorn Ltd [1967] Ch 254; Howard Smith v. Ampol Petroleum Ltd [1974] AC 821; Industrial Development Consultants v. Cooley [1972] 1 WLR 443; Island Export Finance v. Umuna [1986] BCLC 460. See further: Sealy, LS. Fiduciary Relationships [1962] CLJ 69; Sealy, LS. Some Principles of Fiduciary Obligation [1963] CLJ 119; Sealy, LS. The Director as Trustee [1967] CLJ 83.

[44] e.g. Regal (Hastings) Ltd v. Gulliver [1967] 2 AC 134.

[45] Finch, V. Corporate Insolvency Law: Perspectives and Principles. Cambridge University Press, Cambridge, 2002.

[46] e.g. express trusts, implied trusts, constructive trusts, charitable trusts, purpose trusts.

[49] [1970] AC 567. Hereafter referred to as Quistclose.

[50] Bridge, M. The Quistclose Trust in a World of Secured Transactions (1992) OJLS 33. See also: Bridge, M. Form, Substance and Innovation in Personal Property Security Law [1992] JBL 1; Uph, ?. Equitable Proprietary Rights in Insolvency: The Ebbing tide? [1996] JBL 482; Belcher, A & Belgan, ?. Jumping the Queue [1997] JBL 1.

[51] On bankruptcy law and practice during this 100 year period see: Lester, VM. Victorian Insolvency. Clarendon Press, 1995. See also the relevant practitioners’ texts of the period, a sample of which is given here: Montagu, B & Ayrton, S. The Law and Practice in Bankruptcy. 3 volumes. London, 1834-9; MacMahon, H. The Insolvent Act of 1875, including full notes to each section, tariff of costs, index, and list of cases. 1875; Williams, Roland Lomax Bowdler Vaughan. The Law and practice in bankruptcy: comprising the bankruptcy acts, 1883 to 1890; the bankruptcy rules and forms, 1886, 1890; the debtors acts, 1869, 1878, the Bankruptcy (discharge and closure) act, 1887, the Deeds of Arrangment Act, 1887, and the rules and forms thereunder. 7th Edition. Stevens and Sons. London. 1898; Roper, A. Ringwood’s Principles of Bankruptcy. 13th Edition. Sweet & Maxwell Ltd, London. 1920.

[52] Fletcher, I.F. The Law of Insolvency. 3rd Edition. Sweet & Maxwell Ltd. London, 2002, at paragraph 26-021.

Picture Credit: