Hong Kong as a Trust Hub: Can a Settlor Maintain Control and Avoid an Illusory or Sham Trust?

Hong Kong continues to grow in strength as a trust hub attracting settlors who desire a modern trust law in a settled and mature legal system. Many settlors seek the assurance of a trust but at the same time desire to retain a degree of control over their settled assets. This is true whether for settlors of Hong Kong trusts or of offshore trusts administered from Hong Kong. The transfer of assets into a trust should be a true divestiture of those assets. This article examines whether a settlor can alienate assets whilst retaining control over the destiny of those assets. Can the settlor have his cake and eat it?

This important point was the subject of a recent English High Court decision: JSC Mezhdunarodniy Promyshlenniy Bank v Sergei Pugachev and others [2017] EWHC 2426 (Birss J) (‘The Pugachev case’). The decision is a timely reminder that there are limits on the kind and degree of control that can be imposed by a settlor. Too much of the wrong kind can jeopardize the trust.

The Pugachev Case

Sergei Pugachev, a Russian oligarch, founded the Mezhprom Bank (‘the Bank’) in 1992. The Bank had subsequently become insolvent with a shortfall of US$2.2 billion in assets. The Bank’s liquidator claimed US$1 billion against Pugachev and others. The underlying claim was the allegation that Pugachev had misappropriated very large sums of money from the Bank.

What Pugachev had done was to establish five trusts comprising real estate in Chelsea, St. Barths and Switzerland. The defendants included a descendant of Leo Tolstoy, Alexandra Tolstoy, with whom Pugachev had children. The family circumstances lent a sad glamour to the case. The terms of the trusts were materially the same and the main elements were as follows:

a) each trust was a discretionary trust;

b) the Protector of each trust was the Settlor but, upon his death or if he came “under a disability”, one of his adult sons from a previous marriage would assume the role of Protector; and

c) the discretionary beneficiaries were the Settlor himself, and certain named beneficiaries ie the children of the Settlor from his relationship with Alexandra Tolstoy.

The Grounds for Challenge

The liquidator had two arguments to challenge the trusts. It argued that, properly construed, the trusts were not effective in divesting Pugachev of his beneficial ownership to the settled assets. As such, the trusts were illusory. Alternatively, the claimant argued that the trusts were sham trusts that had no effect. In either case, what the claimant was saying was that the supposedly settled assets were not in fact held on trust and thus not beyond the reach of the claimant. The claimant was successful on both grounds. We will discuss the illusory trust argument first.

The Illusory Trust Argument

Each trust was a discretionary trust

What was significant is that the trusts were discretionary. The court pointed out that a simple trust is helpful in concealing legal ownership of assets because public records will show the trustee as the owner. But it is helpful only up to a point because a settlor (who is also a beneficiary) might be compelled in court proceedings to admit to beneficial ownership. A discretionary trust is helpful because a trustee has the discretion whether or not to advance property to a beneficiary. Because there is no certainty, the settlor has no proprietary interest and in court or other proceedings can say hand on heart that he has no interest in the settled assets. This means that an unscrupulous person can use a discretionary trust to try to shield assets from creditors.

The Protector of each trust was the Settlor

The fact that a Protector is also the Settlor is not unusual. The court commented that the expression “Protector” was not a term of art and that the role of a Protector is to provide a check on the trustees. In this case, however, the Protector was conferred both strong negative control rights as well as significant positive control rights. So much so that they lent weight to the conclusion that the Settlor had not divested of the settled assets.

Negative control of the Protector

The terms of the trusts provided that the consent of the Protector was required for: (a) declaring any person to cease being a discretionary beneficiary; (b) the appointment of further discretionary beneficiaries; (c) the distribution of income and/or capital (including any distribution to a beneficiary to the exclusion of all other discretionary beneficiaries); (d) the investment of trust funds; (e) any variation of the trust deeds; and (f) releasing and revoking any power conferred on the trustees. So (a) and (b) permitted the Protector to define who could benefit, (c) allowed the Protector to determine who could receive money and when, (d) gave the Protector the right to decide how funds were to be invested, and (e) and (f) entrenched the powers of the Protector. This bundle of control rights effectively gave the Protector a high degree of negative control.

Positive control of the Protector

The terms of the trusts also conferred positive control rights on the Protector. So the Protector has the power to remove trustees with or without cause and to appoint additional trustees. In effect, if the trustees do not make a distribution to the Protector-Settlor or to a beneficiary he chooses, the Protector can remove the trustees and appoint more compliant ones. In essence, this was not a discretionary trust at all. The Settlor retains effective control.

Are powers personal to the Protector or fiduciary in nature?

The court also considered whether the Protector’s powers were purely personal and could be exercised for selfish purposes or if they were fiduciary in nature. To be clear, in the case of the former, it was not a question of lawfulness or dishonesty - the question was whether the Protector could act lawfully on selfish grounds. If so, it was not a misuse of power. The court held that the Protector could exercise those rights freely for his own benefit. They were not fiduciary in nature but personal powers conferred on the Protector giving him the ability to act in his own best interests in an unconstrained or even selfish manner. He did not need to consider the interests of other discretionary beneficiaries as a class.

In what circumstances would the Protector be “Under a Disability”?

Where the Protector is “Under a Disability” then he automatically and immediately ceases to be the Protector. In addition to what would typically be understood to be a disability, the definition of “Under a Disability” also included imprisonment, involuntary detention, physical and mental duress, and “coercion by operation of law”. Essentially, if the Protector does not want to do something but is compelled to do it under duress or coercion, the person ceases to be the Protector. The court held that if the Protector’s powers were limited to acting for the discretionary beneficiaries as a class (excluding himself), then there would be no need for this evolved form of definition of “Under a Disability”. But, as drafted, the Protector would cease to have effective complete control the moment he is compelled to do something he does not want to do such as handing over assets to a creditor. The Settlor was attempting to make the trusts “judgment proof”. All these indicia supported the argument that there was no true alienation of the assets.

The Settlor also being a beneficiary and other overlapping roles

The decided cases show that a court is entitled to look at the powers and duties of the Protector as a whole to work out what is in substance the reality. In Re AO Revocable Trust [2010] 13 ITELR 260, the settlor was the sole trustee with the power to absolve himself of any breaches of trust and the power to revoke the trust at any time. This “concatenation of rights and powers” coupled with the fact the settlor was the sole trustee rendered the trust illusory.

In the Pugachev case, the court held that the “true effect of the trust” was that Pugachev had not divested his assets and retained beneficial ownership of them. The flaw was the extensive nature of the Protector’s powers combined with the fact that he was also the Settlor and also one of the named beneficiaries. If the facts had been different, eg if the Protector was a third party, or the Settlor was also not a beneficiary (ie a mere watchdog), or if less powers had been conferred on the Protector, or if the Protector did not have the right to remove trustees without cause, or if there was a purpose to the trust, then the outcome could have been different.

The Sham Argument

Strictly speaking, there is no such thing as a sham trust. It is the acts or documents that purport to set up a trust that are the sham. In Snook v London and West Riding Investment [1967] 2QB 786, Lord Diplock said (at 802) that the parties “must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating.” It is an open point whether there needs to be a “common intention” between all the parties (compare Midland Bank v Wyatt [1995] 1 FLR 696 and Shalson v Russo [2003] EWHC 1637). However, in this decision, after going through the evidence, the court held that “the whole scheme always was in truth that the settlor would exercise covert control of the trustee and both settlor and trustee always intended that that would be so … the word sham accurately describes the trust deed.” The scheme was set up to facilitate a pretence about ownership or rather its absence of ownership. The supposedly settled assets were therefore not held in trust and available to meet the claims of the Bank’s liquidator.

Take Away Points

Settlors and their advisers should note that ultimately there must be a genuine alienation of the assets. A factual matrix designed to give some control or oversight back to the Settlor or the Protector may be acceptable but all the indicia must be looked at collectively and individually as a court is entitled to work out what is really going on (those being the words used). A single factor such as the Settlor not being a beneficiary goes a long way and can almost be a knock-out point but everything needs to be looked at as a whole.

Advisers and trustees need to be cautious in not being too accommodating of a settlor’s wishes where there is an aggressive scheme in terms of retention of control. Advisers and trustees need to have independent thought and action to avoid a finding that their intention has been fused with that of the settlor. That can lead to a finding of a sham.

In the case of a sham, there was never a trust so the position is irretrievable. In the case of an illusory trust, there is a trust but a bare trust. If behaviour is modified and/or the terms of the trust can be changed, the position is not immutable and what is an illusory trust can become a genuine trust.

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