Trustee/Director Of A Corporate Trustee - Are You Liable?

Monday 14 November, 2005

by Tony Macvean, William Khong and Nicole Tumiati

For some time, trusts have been a widely used vehicle for carrying on a business, particularly a small or medium-sized privately owned business. This is because a trust structure can provide business proprietors with a number of important benefits, like tax and ‘asset protection’ advantages.

In most cases, the trustee of the trust is a proprietary limited company. By having a company act as trustee of the trust, the controllers can take advantage of all the benefits of a corporate personality (including limited liability and perpetual succession), while retaining the flexibility of a trust structure. However, a trust structure is not impenetrable and individuals need to be aware of the following if they plan to act as a trustee or a director of a corporate trustee:

• In what circumstances will the trustee be liable for the debts of the trust?
  
• In what circumstances will a director of a corporate trustee be liable for the debts of the trust?

General position – The trustee is liable for debts incurred when acting on behalf of the trust

The fundamental characteristic of a trust is that the trustee owns the property legally, but not beneficially.
In other words, the trustee holds the property ‘on trust’ for the beneficiaries. The term ‘trust’ does not refer to a type of legal entity, but rather the trustee’s relationship to the trust property and to the beneficiaries of the trust. Consequently, since the trust is not a legal entity, it cannot enter into contracts or incur liabilities and the trustee, when acting on behalf of the trust, incurs liabilities in its own name.
In the case of a trading trust, the trustee will almost invariably be a corporation. The liability of the shareholders in the corporate trustee (generally the individuals who control or seek to benefit from the trust structure) is limited to their capital investment. This is often (if not always) a nominal amount (eg. $1 or $2). There is no requirement for the trustee to hold assets in its own right.
Running a business through a trust structure provides substantial scope for frustrating creditors of the business, since:

• While the trustee is liable for the debts and liabilities of the business, the business assets are held on trust and belong (beneficially at least) to the beneficiaries; and
  
• The trustee is often a corporate trustee with nominal capital and no assets owned in its own right. Accordingly, it does not have the ability to honour debts and liabilities incurred on behalf of the trust.

What rights do creditors have?

While a creditor has no immediate right to access trust property to satisfy liabilities incurred by the trustee, the creditor may, by virtue of its right of subrogation, be able to rely on the trustee’s right to be indemnified out of the trust assets.
Trustee’s right of indemnity

Trustee legislation empowers a trustee to reimbursement from trust property for expenses properly incurred in the execution of the trust or powers, and to pay such expenses out of trust property. The trust deed itself may also provide a further source of rights for recoupment and exoneration. There are also some limited circumstances when the settlor or beneficiary of the trust may be liable to indemnify the trustee.
However, the trustee is not initially bound to pay trust creditors out of its own pocket and then recoup the costs from trust property. Instead, the trustee can discharge liabilities directly out of the trust property. But there are limits on the rights of indemnity available to a trustee, namely:

• The trustee’s rights of indemnity are generally available only in respect of liabilities properly incurred;
  
• The trustee’s rights of indemnity may be denied or reduced because the trustee is in default of the terms of the trust (usually evidenced in the deed establishing the trust); or
  
• The trustee’s rights of indemnity may be denied or limited by the trust instrument.

Creditors’ right of subrogation
As noted above, it is the trustee that is directly liable to creditors for debts incurred while acting on behalf of the trust. However, the trustee will generally have a right to be indemnified out of the trust assets.
Creditors suing for payment of a debt have, in most instances, the right of subrogation (i.e. the right to effectively ‘stand into the shoes of the trustee’) and to enforce the indemnity against the trust assets.
However, the right of subrogation is only worthwhile if there are sufficient trust assets to cover the liability.

Liability of a director of a corporate trustee

If there are insufficient trust assets to indemnify the corporate trustee for the relevant liability (and the trustee has insufficient assets to cover the liability), it has been successfully argued that the directors of the corporate trustee may be personally liable for the debt.
In the case of Hanel v O’Neill [2003] SASC 409, the Supreme Court of South Australia held that if there were insufficient assets in the trust to cover the relevant liability, this could also mean there was no entitlement to be fully indemnified against the liability. Therefore, the directors of the corporate trustee could be personally liable.
Clearly this decision is significant to directors of corporate trustees since, if followed by the courts in other states, it greatly increases a director’s exposure to liability.
However, the Corporations Amendment Bill (No 1) 2005, which was passed by the Senate on 10 November 2005, and is awaiting royal assent, will make it clear that directors of a corporate trustee will only be personally liable when they are not entitled to be indemnified against the liability from trust assets for one the following reasons:

• A breach of trust by the corporation;
  
• The corporation acting outside the scope of its powers as trustee; or
  
• A term of the trust denying, or limiting, the corporation’s right to be indemnified against the liability.

However, it is important to note that directors have a general duty not to trade while insolvent (section 588G of the Act). Breaching this duty may attract civil and/or criminal penalties. Unlike section 197(1), however, there are defences available to a director for a breach of section 588G (e.g. if the director had reasonable grounds to expect the company would remain solvent if it had incurred the debt).

Limiting exposure to liability – what can be done

First and foremost, it is essential for directors and trustees to carefully monitor the assets, liabilities and activities of the trust. However, additional measures can be taken to ensure that an individual’s exposure to liability is limited. Therefore, when contracting with third parties, wherever possible, ensure:

• A provision is included in the contract that limits the trustee’s liability under the contract to the amount that the trustee can be indemnified out of the trust assets. (In practice, this may be difficult to negotiate);
  
• The directors are covered by adequate insurance; and
  
• The indemnity provided in the trust documentation is not artificially limited in any way.

Source:ceo-online.com