How secure is your structure from an allegation of fraud? And what are the risks to trustees and directors?
Sophisticated global asset holding structures, including corporates and trusts, are often used to hold assets and structure wealth. Structures are usually put in place with great care and with legitimate aims; for example, to ensure effective succession planning. Unfortunately, the benefits associated with these types of structures also make them attractive to fraudsters who use them to hide assets. Consequently, the English courts (and the courts of many other common law jurisdictions such as Cyprus, British Virgin Islands, and the Channel Islands) have developed case law for unravelling structures in cases of fraud. Below we consider what can happen to trusts and asset holding structures where an accusation of fraud is made against the settlor or a beneficiary.
Why Are Structures Such A Focus In Fraud Disputes?
Fraudsters who perpetrate large-scale frauds are usually sophisticated. They often realise that a misappropriated asset can easily be recovered by a victim, and so seek to move and hide stolen assets using complex corporate structures, often overlaid by trusts, to put assets beyond the reach of creditors and victims.
How Can Structures Be Attacked?
Information is king
One legitimate reason for using structures is privacy. Wealthy individuals often do not want the world to know what and where their assets are for privacy or even safety reasons.
However, the very information that is often concealed for legitimate reasons is also information that fraudsters want to hide. The nature of the structure (such as the identity of directors, shareholders, or the beneficiaries of trusts) and banking information showing the flow of funds are vital if a victim wishes to recover misappropriated assets.
In fraud cases, the English Courts are able to grant orders for the delivery of information and documents against third parties (known as ‘Norwich Pharmacal’ orders). These orders can be made against any party that is not a defendant in the litigation, such as banks, financial intermediaries, trustees, directors, and even cryptocurrency exchanges. Generally, to obtain Norwich Pharmacal relief, the claimant needs to show that the target of the order is likely to have relevant information and is not likely to be a defendant to the claim (i.e. they are ’mixed up’ in the wrongdoing, but not a perpetrator of it). A key feature of these orders is that they usually include a ’gagging order’ which prohibits disclosure of the order to anyone for a set period of time. This means that, for example, a trustee may have to disclose information about trust assets, fund flows and the corporate structure below the trust but will be prohibited from telling the settlor and beneficiaries that they are doing so. For obvious reasons, settlors and beneficiaries often object strenuously to this when they later find out that it has happened.
Worldwide freezing orders
The English Courts can grant orders ’freezing’ assets. The orders will prohibit a defendant from dealing in their assets. Importantly, the order will also usually specify that any third party who helps the defendant deal in their assets can be held in contempt of court (which can lead to imprisonment of up to 24 months). This means that, for example, if a freezing order is granted against a defendant and served on the directors of a company he owns, those directors can be held in contempt if they facilitate a sale of the company.
Where complex structures exist, these often result in a position where the settlor or potential beneficiaries do not in fact own anything directly, or at all. In the case of discretionary trusts, there is usually no individual who has an actual interest in any assets; at best, they have a contingent future interest. However, the English courts have adapted to the fact that fraudsters often use structures for this very reason. The standard form English freezing order does not just freeze assets which a defendant ’owns’, it actually freezes any asset which the defendant “has the power, directly or indirectly, to dispose of or deal with as if it were its, her or his own”. A defendant is regarded as having such power “if a third party holds or controls the asset in accordance with its, her or his direct or indirect instructions”. In practice, this means claimants can freeze assets first and argue about the intricacies of ownership structures later.
This often leaves directors and trustees in an invidious position: the claimant will argue that assets are covered by the order and that if they deal with the assets in any way, they will be in contempt. At the same time, the defendant (who may be a settlor or beneficiary) will be accusing them of failing in their duties to the company or trust. Often, the directors/trustees face threats of litigation from both parties.
The situation is usually straightforward where the English Court has jurisdiction over them; beneficiaries/settlors will usually not get very far in bringing claims against directors or trustees for complying with a Court order.
The situation is far more complicated in cross border litigation involving international structures. Despite their name, worldwide freezing orders are very limited in their effect abroad, other than as against the defendant personally.
The position is more complex where the order does not have effect on trustees/directors or there is doubt as to whether it does. In this situation, the directors/trustees cannot say that they are simply complying with a domestic court order. However, they will often not wish to be involved in the movement of assets that are subject to litigation and there are good reasons to be cautious.
For example, the English Supreme Court has held that third parties who conspire with defendants to commit contempt of court (by, for example, facilitating a breach of a freezing order) may find themselves directly liable in a claim for civil damages for the tort of conspiracy.
Litigation against the structure
Finally, if claimants manage to secure assets with a freezing order, the next step will often be for them to litigate against the structure or trust or corporates in the structure. There are a variety of ways this can be done, from arguing that trusts were shams to claiming that assets held in a structure were proceeds of a fraud or transferred into the structure so as to remove them from the reach of creditors. The prospects of such claims succeeding are highly fact-specific.
A significant practical difficulty that directors/trustees often face in this situation is the question of how to pay legal fees: beneficiaries/settlors will usually want the directors/trustees to use assets within the trust/structure to pay their legal fees. This may be prohibited by some freezing orders and, in any event, the directors/trustees may feel uncomfortable doing this. The prudent course may often be to ask the defendant to fund the litigation.
What Can Be Done To Minimise Risk?
There is no substitute for careful due diligence on clients. If the risk profile is higher, then the documentation setting up the structure should ensure that the directors/trustees are protected in the event of fraud. For example, if it is permissible under local law, the documents should provide that:
1. They have a unilateral right to resign in the event of an allegation of fraud or dishonesty by a third party against the settlor/beneficiary.
2. They have an indemnity for legal fees out of trust/corporate assets. In some cases, an indemnity from a third party of financial substance may also be prudent.
3. Advice should also be sought on domestic legal obligations and how these might interact with foreign court orders. For example, Swiss privacy laws are severe and do not usually permit disclosure pursuant to court orders such as Norwich Pharmacal orders and so, if there is a Swiss element to the structure, this question will need to be considered in relation to any individuals based in common law jurisdictions.
Once the structure is set up, it is vital that it is managed in a manner that demonstrates true independence, as this will make it materially more difficult for a claimant to allege that a structure is a sham. It is vital that trustees act in the best interests of trusts and directors act in the best interests of the corporate. It is also important that this is documented, and that there is no appearance of those individuals blindly following the instructions of a settlor or beneficiary. Documenting matters appropriately will be of significant assistance in litigation. For example, care should be taken to maintain written records of:
In addition, it is prudent to consider carefully what documents are being produced on a day to day basis, and how those would look to a Court. What may seem like a friendly, innocuous email exchange with a settlor can, with hindsight, look like a lack of independence.
If the worst happens and litigation begins, it is important to take legal advice early – even if the trustees/directors are not, at that stage, defendants. Often mistakes made in the correspondence at the outset of proceedings haunt the parties for the duration of litigation.
Ros Prince is a partner and co-head of Stephenson Harwood's market-leading fraud and asset recovery team. She has extensive experience of obtaining and defending injunctions, including freezing orders, search and seizure orders, third party disclosure orders and other injunctions. Most of her cases are international, and she has particular expertise in cases originating from Russia, CIS and other emerging markets. Ros has extensive experience of disputes involving offshore structures and parallel litigation in jurisdictions such as BVI, Cyprus, Cayman, Mauritius and the Isle of Man. She often works on cases involving parallel civil and criminal proceedings, both domestically and internationally. Ros has been described as "a leading light of asset tracing in London" and "impressive, strategic and very well respected" by Chambers and Partners and a "top-notch lawyer and strategist" by The Legal 500. Ros undertook her Legal Practice Course at BPP Law School and her Postgraduate Diploma in Law at the College of Law. Prior to this, she studied her Bachelor of Arts degree in Modern European History at the University College London, University of London.