Forget the label, what is the true effect of your trust deeds?

It is common for settlors to try retaining a degree of control over their settled assets.  After all, it is only human nature wanting to keep an eye on your wealth.

However, in order to enjoy the benefits of a trust, the trust needs to withhold scrutiny. In this article, we shall look at the recent landmark case of Mr. Pugachev to understand more of the Court’s considerations. 

Prior to Mr. Pugachev’s case, in Clayton v Clayton [2016], the New Zealand Supreme Court asserted that a finding of the trust as a sham or to be illusory would both invalidate a trust. Following that, the English High Court in JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev [2017] held that an analysis of the true effect of the trust deeds is needed in order to determine whether the trust is illusory or, in more general terms, succeeds in divesting the beneficial ownership of the assets from the settlor.

Background of the Pugachev case

The case centers on Mr. Sergei Pugachev, a Russian entrepreneur and the founder of MezhProm Bank (the “Bank”) which was once a leading private bank in Russia but collapsed following the financial crisis and finally declared bankrupt in 2010.

From 2011-2013, Mr. Pugachev set up five discretionary New Zealand trusts (the “Trusts”). Although the Trusts were not identical, they shared the features below:

  • Settlor: Mr. Pugachev
  • Trustee: New Zealand private trust company of which Mr. Patterson and his wife were directors
  • Protector: Mr. Pugachev
  • Beneficiaries: Mr. Pugachev, his wife and their children
  • All trust deeds were drafted by Mr. Patterson and the Trusts were governed by New Zealand law

In 2014, proceedings were brought against Mr. Pugachev in London to enforce the judgement given in Moscow where Mr. Pugachev allegedly embezzled the Bank leading to its downfall. The English Court has since issued numerous orders and in this latest judgment, the claimants alleged that Mr. Pugachev has retained beneficial ownership of the assets in the Trusts and sought orders requiring the assets be vested in them or the Court appointed receiver.

The Court granted the said orders by reason of the following:

  1. Mr. Pugachev has retained the beneficial ownership of the assets as it is the “True Effect of the Trust”; and
  2. Even if it is not the “True Effect of the Trust” and hence Mr. Pugachev did not retain the beneficial ownership of the asset, the trust is a sham and is equally invalid.

The True Effect of the Trust

The Court held that when analyzing the True Effect of the Trust, it is entitled to construe the trust instruments as a whole and involves considerations such as who exercises the power and to whom the benefit of the power is given to and whether the individual is taking up several roles within the Trust. The relevant analysis is explained in detail below.

When answering the question of whether Mr. Pugachev has retained beneficial ownership of the Trust, the Court needs to make a finding whether Mr. Pugachev’s extensive power given to him as the protector of the Trust is “fiduciary” or “personal” in nature. The power is “fiduciary” if the power must be exercised in the interest of the beneficiaries as a whole and “personal” if he can exercise the power for his own selfish interest. Mr. Pugachev might be regarded to have divested himself successfully of the beneficial ownership of the trust assets if the power is found to be “fiduciary”.

Mr. Pugachev’s wide-ranging power which includes vetoing any distribution made by the trustee to the beneficiaries and removing the trustees as he wishes can be “fiduciary” if Mr. Pugachev is not one of the class of discretionary beneficiaries and he is only performing a “watchdog” role. However, that is not the case and Mr. Pugachev can theoretically use this power to force the trustee to make distribution for his sole benefit as a beneficiary and remove the trustees that did not follow his instructions. Thus, the power attached to Mr. Pugachev’s role as the protector is not “fiduciary” and the True Effect of the Trust is for Mr. Pugachev to retain beneficial ownership of the assets.

The Trust is a sham

As mentioned above, even if that is not the True Effect of the Trust, the Court is prepared to declare the trust as a sham and will make the orders regardless.

A trust might be declared as a sham if the parties to the trust deeds have a common intention of creating a false impression of the rights and obligations as appeared in the trust documents. In this case, based on the extensive power given to Mr. Pugachev as a protector, the Court held that Mr. Pugachev’s intention of the Trusts “was not to cede control of his assets to someone else” and this intention is shared with all other individuals within the Trusts, especially the trustees who took instructions from Mr. Pugachev from time to time.

Notes to take when setting up a trust

Bearing in mind that a trust is only valid and can withstand attack from creditors only if, when viewed objectively, the trust constituted a true divestiture of the assets, it is still possible and common to devise mechanism to retain certain control over the assets. However, after taking the lesson from Mr. Pugachev, the following should be kept in mind when doing so: – 

  1. All the power, oversight and control given to any individual within the trust must be viewed individually and collectively within the trust;
  2. No excessive control over the trust should be reserved to the settlor or granted to the protector;
  3. Transfer assets to offshore location which is different from the settlor’s place of residence and its place of business;
  4. The protector should ideally not be a beneficiary of the trust;
  5. The trustees have to be truly independent; and
  6. All individuals should carry out the terms as stated in the trust deeds.

OLN provides a full range of probate-and-estate-planning-related services. If you have any questions regarding the above or any other private asset management issues, please contact one of the members of our Probate and Estate Planning team.  

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.