Trusts: Control ‘Freakery’ and the Dangerous Game of Shams

To sham, or not to sham?  That is the question.

The recent decision of an English High Court judge has again shone the spotlight on the issue of sham trusts, at least as viewed by the English court. His conclusion comes as something of a surprise, possibly even a shock, when the general thinking in the trust world was that, where an independent professional trustee is appointed as the original trustee, success in attacking a trust arrangement as a sham is near impossible. In his October 2017 judgment in Mezhprom Bank v Pugachev [2017] EWHC 2426 (Ch)  Birss J. held that Mr Pugachev (aka ‘Putin’s banker’) intended the five New Zealand trusts he created (primarily to hold UK residential property) to be shams; and that the independent New Zealand trust company, which took on the trusteeship, shared that shamming intent on the basis that its principal was reckless in failing to detect that intent of the settlor. Even leaving aside the sham finding, the judge also found that the reservation of extensive powers to the protector of the trusts (Pugachev himself), meant that he remained beneficially entitled to the whole of the settled assets. Hence, on either basis, the liquidators of the bank, who alleged that Pugachev had siphoned off its money, which funded the purchase of the properties that had been put into trust, were entitled to recover the assets as against the beneficiaries.

It Takes Two

It is an article of faith that it takes two to sham, where the trust has an original trustee who is not the settlor himself. It is not enough that the settlor has no intention of creating a ‘real’ trust which will operate according to its written terms. The trustee must also share that intention at the outset so that both are of the same mind. The documents may say one thing, but some quite different arrangement is intended by both of them, the formal documents being merely a smokescreen to mislead third parties.  This different arrangement is usually one in which the trustee is merely a cipher and understands that it is his role to do the bidding of a settlor without independent consideration of its powers. Needless to say it is not something which reputable professional trustees are usually willing to do. They are highly conscious of their fiduciary powers and duties, and although they may be sympathetic (perhaps sometimes a little too much so) to the wishes of the settlor, that is a very different matter. 

In this case the trustee in question was a reputable New Zealand trust company and the main director was a New Zealand solicitor of long experience in private client practice. As one might expect, there was no question of any actual agreement between the solicitor and Pugachev to depart from the terms of the conventional discretionary trusts which he established.  However, the judge found that the solicitor had been ‘reckless’ in failing to establish what the judge found to be  Pugachev’s real intention – that is to say to retain complete control over the trusts regardless of their written terms.  If that is right, it suggests that a trustee who is proposing to take on a trusteeship should press the settlor to answer the question whether he ‘really, really’ wants to create and operate a trust on the terms set out. It may not be good for business, but it may save the trust (and the trustee) from subsequent attack.  

The Control Freak

Pugachev’s partner and mother of their three children (all beneficiaries of the trusts) described him in her evidence as a ‘control freak’. These trusts contained a wide variety of provisions which gave Pugachev, in his character as the protector, considerable power over the actions of the trustee. There was nothing surprising or novel about those provisions, which are frequently found in trusts.  There is often a debate over whether, in a particular case, such powers of a protector are fiduciary or personal, or something in between.  In the this case, the judge concluded that all the powers were personal to Pugachev and that he could use them in his own self-interest, even if that conflicted with the interests of the beneficiaries. That was a surprising finding; not least because the New Zealand court had already found that at least one of the powers (to appoint and remove trustees) was a fiduciary power. This did not deter the judge, who disagreed with that finding, and the consequence, he said, was that on the true construction of the trusts, Pugachev held the whole beneficial interest in the trust assets. This is to say, they were his and therefore available to his creditors.   It was argued that such a situation should be described as an ‘illusory’ trust, that is to say, one which is not a trust at all. The judge rejected this terminology, preferring instead to call it ‘the true meaning of the trusts’ analysis. 

More Questions than Answers

It should be appreciated that in this case an ‘onshore’ court (where the assets were situated) was considering the terms of a trust and its administration, both of which were governed by the law of a different jurisdiction with which it was not familiar.  It was agreed by the active parties (the bank and the beneficiaries – neither Pugachev nor the trustee being represented) that the law of New Zealand was the same as that of England for these purposes. That may be so on the face of it, but of course the view that a New Zealand court might take of such a trust and its trustee might differ. We have already referred to one such example in the case of the power to remove and appoint trustees. The wider question is whether the result would have been different if the trusts had been governed by the law of a jurisdiction which has enacted ‘reserved powers’ legislation as many IFCs including the Cayman Islands have done. New Zealand is not amongst them. Such legislation typically provides that the reservation to the settlor or another of ‘one or all’ of certain specified powers does not render the trust ineffective. The lists vary between the jurisdictions, some being much more conservative than others. As we have mentioned, the raft of powers reserved to Pugachev was extensive but conventional in themselves. In such a case, it would not have been open to the parties to agree that the proper law of the trust was the same as that of England, and the court would have needed expert evidence of the content and operation of the foreign law. Whether, on the facts of the Pugachev case the result would have been different, we cannot of course say – but it is an intriguing question.  

Lessons Learned

Although criticisms can be levelled at the decision, both in relation to the finding of sham and the ‘true effect of the trusts’ analysis, it does sound a warning note in relation to the reservation of broad powers.  Automatic inclusion of wide reserved powers, whether or not local legislation allows for it, may leave the trust open to attack on those grounds, particularly by a foreign court where the assets are actually situated.  A tailored approach in each case, which asks exactly why particular powers are required and whether they really need to be unrestricted, might be a safer course to take.  Of course, Pugachev was a case in which it was alleged that the trust assets stemmed from a banking fraud leading to a major insolvency. But the decision’s possible implications for instances in which a disaffected beneficiary, spouse or heir is looking for grounds to challenge a trust should not be ignored.