Trusts: A Realistic Alternative to Security?

Trusts: A Realistic Alternative to Security? This article, written by restructuring & insolvency senior associate Rebecca Walker, first featured in the April 2014 edition of Butterworths Journal of International Banking and Financial Law. This article considers ways in which trusts can be used in transactions with a debtor so as to exclude assets from the debtor s estate on insolvency. Key points Trusts can be a legitimate quasi-security device Care needs to be taken when drafting documents to ensure the formalities for establishing a trust are satisfied Courts will strike down attempts to use a trust as a disguise for a secured loan Issues surrounding establishing trusts shortly before the insolvency of the debtor need to be carefully navigated It is helpful if trust assets are and remain segregated INTRODUCTION It is a fundamental principle of insolvency law that the debts of an insolvent company rank equally with one another. There are, however, a number of exceptions to this. If a debtor grants security, those secured creditors achieve priority status, so that, broadly speaking, any insolvency practitioner subsequently appointed in respect of the debtor is obliged to apply realisations resulting from the sale of its assets in discharging the secured debt ahead of any unsecured debt. However, the law permits a number of deductions from secured realisations see the waterfall of payments in Fig. 1. As a result, the best way for a creditor to protect its position is to ensure that the assets it wishes to use as collateral for its lending do not form part of the debtor s 1

insolvent estate and thus confine the role of the insolvency practitioner to handing those assets over to the creditor. This article focusses on trusts created by corporate debtors. References to the term insolvency means a collective insolvency process, such as administration or liquidation, where the administrator or liquidator is appointed over all of the assets of the debtor. Fig. 1: Waterfall of payments on insolvency Creditors in order of priority Fixed charge holders Deductions permitted to be made from sums owed to that creditor Costs of realising the fixed charge asset Expenses of the insolvency process, including the professional fees of the insolvency practitioner and expenses incurred during the insolvency process Preferential creditors (e.g. certain debts owed to employees) Floating charge holders Costs of realising the floating charge assets The prescribed part, i.e. a fund calculated as a percentage of the floating charge realisations (up to a maximum of 600,000) which is set aside for unsecured creditors Unsecured creditors Shareholders 2

SECURITY V. QUASI SECURITY When a debtor grants security, it grants to the creditor a right in an asset that the debtor owns or in which the debtor has an interest. The analysis is the same whether the security granted is by way of fixed or floating charge. On the insolvency of the debtor, the charged asset continues to belong to the debtor and therefore falls under the control of the insolvency practitioner, who will deal with the asset and apply any sale proceeds in the order of priority set out in Fig. 1. However, the legal analysis is different with, for example, reservation of title terms. Here, the title to the asset being purchased remains with the seller until the buyer pays the purchase price in full. The buyer has a right to possess the asset until such time as the title transfers (or not) under the agreement. It is akin to security, in that the seller is protecting itself against the risk of insolvency of the buyer, but is not strictly security at all. Should the buyer enter insolvency, the insolvency practitioner is not entitled to sell the asset as it does not belong to the buyer and must instead invite the seller to identify and collect its assets. (In fact, the reality is somewhat different as possession of assets subject to reservation of title terms is often transferred to a third party on the sale of the business of the insolvent company.) Factoring or invoice discounting arrangements are similarly considered to be quasisecurity devices if drafted as a sale and purchase of receivables. The company assigns its receivables to the factor/invoice discounter absolutely, such that the company retains no proprietary interest in those receivables. Should the company fail, then those receivables and any cash received in respect of the receivables fall outside the company s insolvent estate and are not available for its creditors. Clearly it is only assets beneficially owned by a debtor that are capable of forming part of its insolvent estate. It follows that assets held by a debtor on trust for third parties are never available for distribution to its creditors. This is regardless of whether the trust is express or implied, resulting or constructive or is imposed by statute. Trusts, therefore, can afford useful protection and importantly do not need to be registered at Companies House. 3

So in what circumstances can a creditor protect its position by stipulating that certain assets of the debtor are to be held on trust for it? This article will first consider common applications of trusts before examining reasons why a trust might fail. COMMON USES OF TRUSTS Subordination trusts. Used in situations involving multiple lenders, wording is inserted into an intercreditor deed whereby the junior lender agrees to turn over to the senior lender any sums that it receives from the borrower until the senior debt has been paid in full. Pending turnover to the senior lender, the junior lender declares itself trustee of such sums. It is designed to protect the agreed priority of debts on the insolvency of the borrower, although it does also protect the senior lender on the insolvency of the junior lender. Purpose trusts (also known as Quistclose trusts). Named after the House of Lords decision in Barclays Bank Ltd v Quistclose Investments Ltd [1970] A.C. 567, Quistclose trusts protect money that has been advanced to a borrower for a specific purpose. In Quistclose, money advanced solely for the purpose of paying a dividend to shareholders was held on resulting trust for the lender, where the payment of that dividend was frustrated by the borrower entering voluntary liquidation. A trust will similarly arise where a lender advances money for the sole purpose of acquiring an asset, provided that the borrower is not free to use the money as it wishes (see Cooper v PRG Powerhouse Ltd [2008] EWHC 498 (Ch)). Other types of purpose trusts. Purpose trusts are also used in offshore securitisation structures. Distinct from Quistclose trusts, a trust can be established with the purpose of entering into securitisation transactions through an underlying SPV. Security trusts. Here, the debtor grants security over its assets to a security trustee, who then holds that security interest on trust for the lenders. This is used in syndicated lending transactions and secured bond issues, as it simplifies the perfection and enforcement of that security. In addition, it makes it easier to trade in the underlying debt, as neither the security 4

documents nor the registration of the security will need to be amended on a transfer of all or part of the debt to a new lender. A transfer simply involves the change in the identity of the beneficiaries under the trust and thus the priority of the security is unaffected. Trusts used in bond issues. A trustee is often interposed between the issuer of bonds and the bondholders. The trustee acts on behalf of the bondholders and holds any money paid out under the terms of the bonds for the bondholders. The trust structure simplifies matters for the issuer as it only has to deal with one party rather than multiple bondholders. It also benefits the bondholders where secured bonds are issued, as in that situation is it generally coupled with a security trust. Twilight trusts. Twilight trusts are used by failing retail companies. A retailer s business will often involve accepting customer deposits, for example, for the purchase of furniture, before then manufacturing and delivering the items ordered. Yet accepting those deposits (and using the cash to support other aspects of the retailer s business) at a time when the directors knew that the retailer was in financial difficulty could expose the directors to wrongful trading and other misfeasance actions should the retailer eventually fail. It is therefore becoming more commonplace for the directors to pay those deposits into a separate trust account known as a twilight trust and only to draw down on those accounts once the retailer fulfils the customer s order. POTENTIAL PITFALLS OF TRUSTS Certain requirements need to be fulfilled to properly establish an express trust (see Fig. 2). However, there are additional factors that must be considered for a trust mechanism to successfully withstand the insolvency of the debtor trustee (see below). 5

Fig. 2: Requirements for establishing a trust Express trusts (such as security trusts and subordination trusts) should be established by deed. Clear language must be used to evidence the parties intention to establish a trust. Although no technical language is required, the words on trust for will help. The trust property must be identifiable. So with cash, for example, there should really be an obligation on the debtor to place this in a separate account. This will not only help in terms of identifying the trust property, but will also assist in demonstrating a clear intention that the money was impressed with a trust and not at the free disposal of the recipient. It must be clear who the beneficiaries under the trust are. A clear mechanism (such as a deed of accession) must be used in security trusts, where the beneficiaries under the trust naturally change from time to time, so that it is clear at what point the purchaser of the underlying debt becomes a beneficiary under the security trust. Does the trust go too far? It is imperative, for a trust to survive the insolvency of the trustee, that the trust is not considered to be a dressed-up equitable charge. Reservation of title terms, for example, can be challenged where parties agree that on failure by the buyer to pay the purchase price: the seller can repossess the supplied assets despite the fact that they have been incorporated through a manufacturing process into another product; and/or the buyer is obliged to pay the proceeds of sale of any supplied assets into a separate account to be held for the benefit of the seller until such time as the purchase price is fully paid. 6

In both cases, the courts have held that such terms are to be regarded as an equitable charge over the manufactured product and/or the funds standing to the credit of the account, which, absent registration at Companies House, is void on the insolvency of the debtor (Compaq Computer Ltd v Abercorn Group Ltd [1991] BCC 484). An equitable charge involves charging an asset as security for an obligation, on the basis that the encumbrance will be released once that obligation has been discharged. The reason for treating these extended reservation of title terms as equitable charges is that, in each case, the asset held for the seller could exceed the value of the outstanding purchase price, such that the seller might have to account to the buyer for the excess. In essence, therefore, the seller s beneficial interest in the manufactured product or the proceeds of sale is determinable on the payment of the outstanding purchase price, making the commercial agreement in substance a security arrangement. Trusts have similar limitations. In Re ILG Travel Ltd [1996] B.C.C. 21, it was held that the substantive agreement between the parties was to confer security for payment of outstanding indebtedness, despite an express clause in the agreement that monies should be held on trust. Subordination trusts, in particular, have to be carefully constructed. The following should assist: Include wording to ensure that the amount that the junior lender is obliged to hold on trust and turn over to the senior lender is limited to the amount of the outstanding senior debt. In Re SSSL Realisations (2002) Ltd (in liquidation) [2006] EWCA Civ 7, this was held to be sufficient to negate the creation of a charge. Alternatively, consider using a security trust, under which the trustee holds sums received from the borrower on trust for the senior lender until the senior debt is discharged in full and then on trust for the junior lender. The trustee cannot be said to be creating a charge as it does not beneficially own any property; equally the senior lender will be incapable of receiving more than is required to discharge the senior debt. 7

When was the trust created? A trust created in the six month period before the trustee enters an insolvency process (or in the two year period in the case of beneficiaries that are in other ways connected to the trustee, for example by having common directors) are at risk of challenge as a preference by an insolvency practitioner. Pursuant to section 239 of the Insolvency Act 1986, a company gives a preference where: it puts a creditor (whether secured or unsecured) in a better position than that creditor would have otherwise been in on an insolvent liquidation of that company; and the company was influenced by a desire to put that creditor in a better position. Any declaration of trust shortly before the debtor enters insolvency is therefore at risk, although the insolvency practitioner would still need to evidence that the debtor was influenced by a desire to prefer the creditor. This is difficult in practice, as the insolvency practitioner would need to show that the company or, in practical terms, the directors positively wished to put the creditor in a better position on its insolvency (which is more than, say, agreeing to put the creditor in a better position in order to secure continued funding). Desire to prefer is, however, presumed where the debtor and creditor are connected parties. Twilight trusts are most at risk of being challenged on these grounds. Customer deposits in respect of placed orders would normally rank as unsecured debts of the retailer. Placing those deposits into segregated accounts clearly improves those customers positions on the retailer s insolvency. However, the true motivation of the retailer in segregating customer deposits is unlikely to be to improve those customers positions on its insolvency, rather to allow the retailer to continue to trade through difficult conditions while limiting the personal liability of its directors. 8

What was the conduct of the debtor following the creation of a trust? As highlighted in Fig. 2, it is important that trust assets are, and remain, identifiable. This will usually involve the trust assets having to be segregated from the trustee s own assets. So does there need to be an express obligation to keep the trust assets separate? And will the failure to segregate the trust assets result in the trust failing? The courts take a holistic approach to these issues and consider all the circumstances surrounding the parties relationship. There will be situations where it is impractical to separate trust assets, particularly cash. If the parties contemplate the mixing of monies at the outset, this will not automatically result in the trust being defeated. It may be possible to identify trust monies through e.g. accounting records. However, there must be some other clear evidence of the parties intention to create a trust for a trust to be inferred in these circumstances. Where there is an obligation on the trustee to segregate trust monies, and the trustee fails to do so, this too is not in itself fatal to the existence of a trust and the beneficiary may be able to trace into the mixed account, provided the account is not overdrawn. These issues were discussed in Re Lehman Brothers International (Europe) Limited (In Administration) [2010] EWCA Civ 917. Here, LBIE was permitted to use client funds and to mix client funds with its own funds, provided that LBIE then segregated client funds at the close of each business day. At the point at which LBIE entered administration, client funds remained unsegregated. The Court of Appeal held that client funds were, and remained, subject to the statutory trust imposed by Chapter 7 of the Client Assets Sourcebook (CASS 7) made under section 139 of the Financial Services and Markets Act 2000 and that trust came into existence at the point of payment into LBIE s account and not only at the point of segregation. CONCLUSION Trust mechanisms are increasingly being used to protect against the insolvency risk of counterparties. Importantly, courts appear to be respecting how parties are choosing to structure their arrangements. This is evidenced by the success of simple reservation of title terms and factoring/invoice discounting arrangements. It remains to be seen, however, whether more creative trust arrangements will become 9

commonplace. Parties inevitably wish to have some clarity at the outset that the structure of their transaction will withstand insolvency. The prospect of a trust arrangement being re-categorised as an equitable charge, which would be void for non-registration, may be enough to put some risk-averse clients off the structure completely. Equally, the prudent approach of registering trust arrangements may simply not prove desirable or practical. Rebecca Walker is a Senior Associate in the Restructuring & Insolvency department of Stevens & Bolton LLP. Rebecca can be contacted at Rebecca.Walker@stevens-bolton.com 10