Challenging the validity of the trust - the attack
A properly drafted and administered trust is an effective asset protection vehicle. However, if there is any question over the validity of the trust, it can expose the entire structure. If the trust is found to be invalid, the trust assets will revert to the settlor’s personal ownership. And if that settlor is the divorcing spouse, the opposing spouse will have a direct line to those assets.
Challenging validity of the trust - the defence
How do you ensure that a trust is validly created? This isn’t just a question of getting the technical details right when drafting and executing the trust. Of course, that will be critical, as will other issues, such as whether the settlor spouse in fact had the capacity and authority to settle the trust assets. This may not be the case if, for example, they have mental capacity issues or are subject to a matrimonial property regime which requires their spouse’s consent.
The real concern here, is the question of the settlor’s intentions when creating the trust. Is it clear from the terms of the trust, and the ways in which the trust is administered in practice, that the settlor genuinely intended to create a trust? Has the settlor surrendered sufficient control of the assets to the trustees? Ultimately, retaining too much control will render the structure vulnerable. The settlor must be encouraged by those advising him or her to respect the integrity of the structure and the independent discretions of the trustees.
At present, the legal burden on a spouse seeking to argue that a trust is a “sham” is an onerous one, and not easily discharged (see Roberts J’s very helpful summary on the issue in the recent English case of ND v SD & Ors
). A common intention on the part of the settlor and the trustees (or at least reckless indifference on part of the trustees) is required, and this can be difficult to make out on the evidence. However, real care should be taken to avoid this risk. If a settlor’s level of control undermines and ultimately extinguishes the powers and duties of the trustees, it could be found that the trust is not held on the express terms set out in the settlement deed, but constitutes a nomineeship or bare trust arrangement. Again, the trust assets will be considered personal assets of the settlor and the protection of the trust will be lost.
Nuptial settlements and the risk of variation - the attack
If the Family Court considers a trust to constitute a “nuptial settlement”, this will allow the Court to open up its armoury under the matrimonial legislation and make an order to vary the trust in favour of the financially weaker spouse. From a trust perspective, this is intervention by the Family Court at its most invasive. So, what can be done to prevent it?
Nuptial settlements and the risk of variation - the first defence
First of all, the court has to be satisfied that there is a “nuptial settlement”, i.e. that there is a connection between the settlement and the marriage in question. The term is not defined in the legislation and judicial debate continues over what it is intended to capture. As covered in our last blog
, the leading modern case on the meaning of nuptial settlements, Brooks v Brooks
, a BLP (Paisner & Co) case in which we acted for the successful wife, provides a useful starting point. In that case, the House of Lords (as it then was) treated a private pension fund as a nuptial, and therefore variable, settlement. Lord Nicholls suggested a nuptial settlement would be one which makes: "some form of continuing provision for both or either of the parties to a marriage, with or without provision for their children". Clearly, trusts made in contemplation of the marriage will fall squarely within the net, as will trusts holding the couple’s matrimonial home. However, the courts have also demonstrated a willingness to find “nuptiality” where a trust only makes provision for one of the parties in the marriage.
Ultimately, all cases are fact-sensitive. The court will look at the reality of the situation and assess the quality of the connection between the trust and the marriage. This assessment will be informed by factors such as the identity of the settlor and the beneficiaries, the time at which the trust was established and the intentions expressed in any letter of wishes. With this in mind, there are obvious steps to take when drafting a trust to reduce, if not avoid entirely, indications of nuptiality. These include:
- thinking carefully about the wording of letters of wishes and the impact that this could have one day in a divorce court;
- ensuring that the trust has a broad class of beneficiaries, as this makes it more difficult to link the trust to any particular marriage; and
- ensuring that this broad class of potential beneficiaries does not include any spouse or prospective spouse, but includes future generations of the family.
Nuptial settlements and the risk of variation - the second defence
Even if nuptiality cannot be avoided, a well-advised settlor will consider taking advantage of a secondary line of defence against an attacking spouse: the protection afforded by the so-called “firewall” legislation of certain offshore jurisdictions. In essence, this legislation (found in Cayman, Bahamas, Bermuda, BVI, Isle of Man, Jersey and Guernsey) ensures that any issues arising in relation to the trust must be determined in accordance with that jurisdiction’s law. Any foreign judgment which is inconsistent with that law will not be recognised.
In practice, this means that even if the Family Court makes an order to vary a trust governed by the laws of one of these jurisdictions, the trustees are under no obligation to comply with such an order. In fact, in certain circumstances the offshore Court will go so far as to direct the trustees that they must not comply with such an order (see for example the Cayman case of RBS Coutts Cayman Ltd v W
Trust assets as a financial resource - the attack
When a spouse makes a claim over trust assets, the simplest line of attack and most common approach is to allege that those trust assets are a resource available to the other spouse. This direct line of attack is the most complex to guard against, as the issues of recognition and enforceability that occur with variation orders do not arise. The court can simply make an order directly against the beneficiary spouse on the basis that the corresponding trustees will likely come to his or her assistance in order to prevent contempt of court or bankruptcy. Accordingly, this form of ‘judicious encouragement’ has become a common feature in divorce cases involving offshore trusts otherwise guarded by firewall legislation.
The key questions are:
- when will a court find that trust assets constitute a financial resource?; and
- what can be done to protect family wealth from falling into this net?
- In answer to the first question, the court will assess the reality of the situation by applying the ‘likelihood test’:
- what is the likelihood of the trust fund, either by way of income or capital, being made available to the beneficiary spouse?; and
- if the beneficiary spouse were to ask the trustees for an advance, would they oblige?
The test looks not just at the terms of the trust instrument, but any guidance in letters of wishes and, most critically, whether there has been a pattern of distributions to or for the benefit of the beneficiary spouse. If the evidence suggests the trust funds would indeed be made available to the beneficiary spouse upon request, those assets will be taken into account by the court when deciding what financial award should be made.
Trust assets as a financial resource - the defence
First and foremost, the underlying purpose of the trust will be critical and should be made clear in the drafting of the trust instrument itself, as well as in any letters of wishes. If the trust is dynastic in nature and intended to benefit a wide class of future generations, this should be made crystal clear.
Again, the question of the relationship between the trustees and the spouse will be critical. The trustees must be seen to be exercising their discretions free from any controlling influence on the part of the beneficiary spouse. The ‘course of dealings’ between the trustees and that beneficiary should also be carefully documented - not just the history of distributions made, but also instances where the trustees have declined to exercise their powers.
If planning can be carried out sufficiently in advance of divorce proceedings, the trustees could ring-fence a sub-fund in favour of the beneficiary spouse to ensure that the remainder of the trust fund is excluded from consideration as a potential financial resource.
An independent family wealth solution is in the detail
These three lines of attack should be kept in mind at every stage of a trust’s lifetime. The detail is crucial on the establishment of any trust: the discretions afforded to the trustees, the identity of the beneficiaries, the choice of law, the formalities for execution and the trust’s underlying purpose will all be vital.
Once up and running, it will be imperative to see that the trustees are properly exercising their discretions and that they are genuinely independent from the settlor/beneficiary spouse in doing so. The key to demonstrating this independence is in the careful documentation of letters of wishes, decisions by the trustees and communications between trustees and beneficiaries.
Ultimately, the trustees, family/beneficiaries and their advisors must collaborate from day one to preserve and make clear, through a synthesised approach, the dynastic and independent character of the family wealth structure.
This article was written by Marcus Dearle & Jessica HensonFamily Asset Protection | BLP Private Wealth