16/07/18

Pugachev, the Illusionist: Shams and powers

By Ashley Fife, Counsel, Appleby (Bermuda) Limited

Prior to the UK High Court’s decision in Pugachev’s case [2017] EWHC 2426 (Ch) late last year, many may have considered that the law in Commonwealth jurisdictions in respect of so called sham trusts was clear. Pugachev’s case has reignited debate regarding whether the current law applying to so called sham trust instruments:

• is clear at all;

• should be restricted or expanded; or

• is, ironically, a diversion from the legal questions that ought to be considered and ought to be abandoned.

Does Pugachev’s case bring about or reflect a movement toward:

• a new cause of action for creditors to set aside trusts of it can be demonstrated that the trusts are illusory? 

• the view that the settlor’s intention alone is relevant? 

• an objective test or otherwise lower threshold for determining whether a party subjectively had a shamming intention?

In Pugachev, the trusts were governed by New Zealand law and each had a New Zealand corporate trustee.  Would the decision in Pugachev have been different if the trusts were governed by the laws of an offshore jurisdiction that has modern reserved powers legislation?  What guidance should trustees, settlors and trust draft-persons take from Pugachev’s case?

The decision in Pugachev

In Pugachev, Justice Birss concluded that in respect of the so-called:

(1) true effect of trusts claim (i.e. the illusory trusts claim): the terms of the trusts did not result in Sergio Pugachev, the trusts’ settlor, giving up control sufficient to divest himself of beneficial ownership of the property purportedly transferred into the trusts- with the consequence that the trustees held the property on bare trusts for Pugachev.

(2) sham trusts claim: in the alternative to the illusory trusts claim, to the extent that the terms of trusts purported to divest Pugachev of control and ownership:

• Pugachev only intended that they did so to deceive his creditors and other third parties as to his real intention which was to retain ultimate control;

• the corporate trustee, acting by its directors, who declared the trusts, had no independent intention from Pugachev and were recklessly indifferent to Pugachev’s intention to deceive third parties; 

and as a consequence the trust deeds were shams and invalid.

(3) section 423 Insolvency Act UK claim: if it had been found that Pugachev had successfully divested himself of ownership when he transferred property to the trustee, the Court would have held that he did so with the “real and substantial purpose” to defeat the claims of creditors and the transfers consequently should be set aside.

The facts

The facts in Pugachev’s case could be used for a John Grisham story:

• A Russian oligarch (Pugachev), a former senator of the Russian Federation with ties to President Putin establishes Mezhprom Bank which grows to become one of Russia’s largest private banks;

• Mezhprom Bank becomes insolvent and its liquidator successfully claims that Pugahev embezzled large sums from Mezhprom Bank;

• The liquidator obtains judgments in Russia and England requiring Pugachev to pay approximately US$1 billion;

• Pugachev flees Russia to England and purports to establish 5 irrevocable discretionary trusts over assets worth approximately $95 million for the benefit of himself and, as the case may be, his children respectively of his estranged wife and Alexandra Tolstoy (a relative of Leo Tolstoy, the author of “War and Peace”);

• The liquidator brings proceedings in the UK High Court claiming that the assets in the trusts actually belong to Pugachev and are therefore available to satisfy the liquidator’s judgments against him;

• Pugachev, amidst fears for his safety from agents of the Russian state (and in contempt of orders from the English courts), flees England to France.

Additionally:

• Pugachev established the trusts at times when he was aware that creditors may bring claims against him personally to recover funds that he allegedly misappropriated from Mezhprom Bank;

• Pugechev was the first protector of each of the trusts (his son Victor, described as “a young adult” and also a discretionary beneficiary, was named as successor protector);

• The protector’s powers were quite extensive and included powers to:

o   veto the trustee’s proposed exercised powers of investment, distribution, removal of beneficiaries; and vary the trust deed; and

o   add beneficiaries; and

o   remove or appoint of trustees “with or without cause”;

• the trust instrument did not express whether or not the protector powers were fiduciary powers but did provide that: a protector’s powers would cease if that protector was “under coercion by operation of law”; and protectors could be remunerated and reimbursed for their expenses in connection with the trusts;

• the trustees of the trusts initially were New Zealand companies owned by Mr Patterson and Ms Hopkins (partners in a small New Zealand law firm) and were subsequently replaced in 2015 by trustees who were more closely controlled by Pugachev;

• Patterson prepared the trust deeds; and

• the directors of the trustees in each case included Patterson, Hopkins and associates of Pugachev.

Mr Pugachev

The evidence persuaded Birss J that Pugachev was “not a person who would lightly relinquish control of anything and he is a person quite willing to lie and put forward false statements deliberately if it would suit his purpose.”  These views may have contributed to Birss J's willingness to draw certain inferences (some which may be controversial) which in turn were influential to the Court’s judgment.  For example:

• Pugachev’s son, Victor, transferred property into the trusts but Birss J inferred that he did so as nominee or agent for Pugachev- and consequently Pugachev was deemed to be the sole settlor;

• the trusts provided that Victor was to succeed Pugachev as protector but it was considered that, provided Pugachev was alive and able, Victor would act as directed by Pugachev- thereby supporting the conclusion that Pugachev only intended that the protector act in Pugachev’s own interests;

• until such time as the trustees (by their directors) were under scrutiny it would comply with Pugachev’s directions without independent consideration;

• the granting to the protector the power to remove trustees “without or without cause” indicated that the power was a personal power that the protector could exercise selfishly free of fiduciary or other duties and, for example, appoint himself as trustee to get the trust assets back directly into his control; and

• the provision providing that a protector could not exercise his powers if “under coercion by operation of law” added weight to the view that Pugachev could exercise his protector powers in his own selfish interests because if a Court ordered him to approve the transfer of assets to a creditor he could say he did not have the power to so.

Illusory Trusts and Protector's powers

Pugachev’s case considered whether there was a cause of action to set aside the trusts on the grounds that they were illusory trusts.  Other cases have referred to illusory trusts.

In Re AQ Revocable Trust [2010] 123 IELR 260 (Bermuda) the settlor was the sole trustee, was entitled to the income and entitled to distributions of capital, held a power to revoke and had power to absolve himself from breaches of trust.  The Bermuda Court concluded that the facts “rendered this trust illusory during his lifetime…”, in other words the terms of the trust did not result in the settlor during his lifetime divesting himself of the property that was purportedly held in trust.

In Clayton v Clayton [2015] NZSC 29 the New Zealand Supreme Court held:

“For the present we observe that a finding that a trust deed is not a sham does not seem to us to preclude a finding that the attempt to create a trust failed and that no valid trust has come into existence. That would lead to a finding that the trust is illusory, to use the terminology adopted in the Courts below. For our part we do not see any value in using the “illusory” label: if there is no valid trust, that is all that needs to be said.”

This suggests that references to illusory trust claims may be academic.  It does not appear that Birss J intended to create a new cause of action for setting aside particular trusts on the grounds that they are found to be illusory.  The question in this regard remains: “Do the terms of trusts as construed in accordance with the applicable law, effect a transfer of the settlor’s beneficial ownership of the property into a (substantive) trust?.” Birss J acknowledged that this question does not require a determination of whether the parties to the trust instrument had a common intention to administer the trust property on terms other than those set out in the trust instrument.

Birss J categorised all of the protector’s powers as personal powers that Pugachev could exercise selfishly in his own interests as opposed to fiduciary powers (e.g. powers that the trustee must exercise in good faith, subject to the terms of the trusts, for the interests of the beneficiaries as a whole) or limited non-fiduciary powers.  This conclusion primarily appears to have been reached because:

• Pugachev was the settlor and a discretionary beneficiary and in those circumstances it could be inferred that he was appointed as protector to protect his own interests; and

• Pugachev’s conduct prior to the declarations of trusts and at all material times indicated that he intended to retain control and exercise the powers as he wished, unfettered by any duties.

Since Re Skeats’ Settlement (1889) 42 Ch the power to appoint trustees has generally been regarded as a fiduciary power.  The conclusion in Skeats seems to have reached by considering the inherent nature of the power to appoint trustees in the context of a family trust.

There are only a small number of, some might say, anomalous circumstances where the power to appoint trustees might be considered not to be a fiduciary power.  For example, where the:

• facts are such that it can be inferred that the settlor intended to confer a non-fiduciary or personal power, such as when a widow who is granted a life interest in the family home has the power to appoint and remove trustees;

• trust deed expressly provides that the power to appoint or remove trustees is a non-fiduciary or a personal power; or

• relevant statute prescribes the nature of the power as personal or non-fiduciary. 

In the absence of an express provision in the trust instrument, it may take quite extreme facts for a Court to conclude, as Birss J did in Pugachev, that all the protector’s powers, including the power to appoint or remove trustees, were personal powers that may be exercised selfishly by the power-holder. 

The categorisation of all of the protector powers as personal powers appears to have been crucial to Birss J’s conclusion that Pugachev did not divest himself of beneficial ownership of the property purportedly transferred into the trusts (i.e. the so called illusory trusts claim).  Birss J view was that if the powers could be properly construed as fiduciary then the:

• terms of the trusts themselves;

• appointment of an ostensibly independent trustee;

• “elaborate” provisions dealing with trustee powers and a logical defined class of discretionary beneficiaries,

would have been consistent with the settlor divesting himself of the trust property- in other words, the so-called illusory trusts claim would fail. 

In Pugachev, it was accepted that for the purposes of the proceedings, New Zealand and English trust law was the same in all material respects.  Neither New Zealand trust law nor English trust law includes reserved powers provisions.  The absence of such statutory provisions does not preclude the reservation of powers to the settlor.  However, a Court may have greater scope to conclude that the terms of an English law trust or a New Zealand law trust did not divest the settlor of his beneficial interest in the trust property in circumstances where the settlor reserves a large number of powers. 

Article 2 of the Hague Convention on the Law Applicable to Trusts and on their Recognition (Hague Trusts Convention), are expresses that:

“The reservation by the settlor of certain rights and powers, and the facts that the trustee may himself have rights as a beneficiary, are not necessarily inconsistent with the existence of a trust.”

Article 2 of the Hague Trusts Convention may simply confirm the common law position.  It does not provide any guidance as to the extent of powers that may be reserved by a settlor without invalidating the trust. The United Kingdom has enacted legislation to give effect to many provisions Hague Trusts Convention, including Article 2.  New Zealand is a signatory to the Hague Trusts Convention, although it does not appear that even current pending reforms will incorporate language to substantively reflect Article 2 of the Hague Trusts Convention.  However, New Zealand trust legislation appears to contemplate settlor reservation of control to some degree and New Zealand case law does not reflect a policy that settlor reservation of powers or granting of powers to protector is necessarily inconsistent with the existence of a trust.

The terms of the trusts did not grant Pugachev a fixed beneficial interest in the trust property.  He was named as one of a number of discretionary beneficiaries that the trustee may, or may not, decide to exercise its discretion to make a distribution to.  Further, the terms of the trusts did not grant Pugachev a general power of appointment or a power to revoke the trusts.  The facts in Pugachev and the liquidator’s claims therefore contrast with those in TMSF v Merilll Lynch [2011] UKPC 17 where it was accepted that the Cayman law trust was valid but the settlor’s power of revocation was deemed to be “in equity tantamount to ownership” and, as such, capable of being delegated to the settlor’s receiver. 

Most of Pugachev’s powers were only veto powers, which may be inconsistent with retaining ultimate control over the trust or the trust property.

Offshore jurisdictions: reserved powers legislation and categorisation of powers

A number of offshore jurisdictions have enacted legislation expressly providing (to take section 2A of Bermuda’s Trusts Special Provisions Act 1989 (TSPA) as an example) that a settlor may reserve, or grant to another person any or all of a wide range of powers and beneficial interests in the trust property shall not:

• invalidate the trust;

• prevent the trust taking effect in accordance with its terms; and

• cause any or all of the trust property to form part of the estate of the settlor when deceased.

Not all jurisdictions expressly provide that all of the listed powers may be so reserved.  Jersey, Channel Islands, has recently amended the Trusts (Jersey) Law 1984 (TJL) to clarify that “any of all” of the powers listed in 9A(2) of the TJL may be reserved.

Section 2A(7) of the TSPA provides that:

“In relation to any trust governed by the laws of Bermuda created after the commencement date of the Trusts (Special Provisions) Amendment Act 2014, in the absence of any contrary provision of the trust—

(a) in the case of the reservation by a settlor or the grant to a beneficiary of any of the powers specified in subsection (2), where so long as the holder of the power is not the sole trustee, such powers shall be personal and non-fiduciary; and

(b) in any other case, such powers shall be fiduciary.

 

In Pugachev, the trusts were created before the commencement date applicable to section 2A of the TSPA.  For the purpose of the analysis that follows it is assumed that the trusts were created after that commencement date.The powers specified in subsection 2A(2) of the TSPA include the powers granted to the protector in Pugachev’s case and, in particular, include the “power to appoint, add, remove or replace any trustee, protector, enforcer or any other office-holder…”.  There may be a debate as to the meaning and effect of the phrase “personal and non-fiduciary” section 2A(7).  Are the terms personal and non-fiduciary intended to be interchangeable? What duties, if any, the holder of personal and non-fiduciary powers may owe? 

In the matter of an application for information about a trust [2013] SC (Bda) 16 Civ (12 March 2013), a protector, who was also a beneficiary, had the power to veto a trustee’s decision to provide trust documents to a beneficiary. The trust instrument provided that the protector’s powers were non-fiduciary.  The initial protector was not a beneficiary.  Kawaley CJ determined that: “The Protector is implicitly to have regard to the interests of the beneficiaries in exercising his admittedly non-fiduciary powers of supervising the trust’s administration.”  Based on that, a non-fiduciary power is not necessarily a power that the holder may exercise without regard to the interests of the beneficiaries as a whole. 

It is submitted that expression “personal and non-fiduciary” in section 2A(7) simply intends to reflect that the powers are not fiduciary.  It is then up to the Court, who has the benefit of construing the particular trust instrument, to determine the relevant duties of the power-holder and other nuanced characteristics of the powers held. 

Section 15(2)(b) of the Trusts (Guernsey) Law 2007 provides that the reservation or grant of powers or interests referred to in subsection (1) does not, subject to the terms of trust, impose any fiduciary duty on the holder.  The powers in subsection (1) include a wide range of powers and interests, including the powers to amend the trust and “appoint or remove any trustee, enforcer, trust official or beneficiary”.  It is understood that Guernsey’s legislature may be considering amendments with the view of avoiding a construction that the default position is that powers reserved to a settlor or granted to another person (other than a trustee) are non-fiduciary powers in the absence of a contrary intention in the trust instrument. 

Cook Islands’ trusts law provides that, subject to the trust’s terms, a protector shall not owe fiduciary duties. 

Belize and St Kitts trust statues provide that, subject to the terms of the trusts, protector powers are fiduciary powers.

Jersey, Cayman Islands, Isle of Man, Bahamas, British Virgin Islands and Seychelles trusts laws do not appear to set a default position in respect of whether a settlor or other power-holders’ powers are fiduciary or otherwise.  

Can the Court intervene in respect of the exercise of personal powers?

In circumstances where the power is a personal power that may be exercised selfishly by the holder, there may be an argument as to whether the Court has jurisdiction to intervene if the power is exercised in a manner contrary to the interests of the beneficiaries as a whole.  After all, the holder of such a personal power does not have a duty to consider the interests of other beneficiaries.

The question perhaps should be, not “Can the Court intervene?” but “On what basis may the Court intervene?.  In Pugachev, Birss J accepted that, given the Court’s inherent jurisdiction over the administration of trusts, Courts have jurisdiction to intervene, irrespective of whether or not the appointor’s power was fiduciary, if the appointment of a particular trustee would seriously place the trust property at risk or if such trustee’s conduct was seriously placing the trust property at risk.  In those circumstances the Court is not being asked to set aside the power-holder’s exercise of the power to appoint of a trustee on the basis that the power-holder breached any duty.  Instead, the Court is being asked to exercise its inherent powers over trustees and the administration of trusts to make appropriate orders to protect the trust property.

Did the trustee have a common intention with settlor to deceive third parties?

Birss J concluded that, in the circumstances, if Puguchev intended the protector’s powers to be construed as fiduciary, he only held such intention with the view of deceiving third parties and the reality was that he would exercise the powers selfishly and the trustee recklessly would not stand in his way from doing so.

During the course of the trial in Pugachev’s case, the claimant withdrew from any suggestion that it was maintaining an argument that only the settlor’s intention mattered to a finding of sham. 

The defendant did pursue an argument that a finding that the trustee shared the settlor’s dishonest intention for the trust to be a sham.

However, in Midland Bank v Wyatt [1997] 1 BCLC 242, a husband and wife executed a declaration of trust, whereby the husband would hold the property for the benefit of his wife and daughters.  The Court concluded that the trust was a sham because, although the wife did not share the husband’s dishonest intention for the trust instrument to deceive third parties, she gave no thought as to the trust instrument and its effect.

In A v A [2007] EWHC 99, Munby J carefully considered the authorities and made the following points:

• a finding of sham requires careful analysis of the facts. External evidence is relevant. The fact that an arrangement is artificial is not the same as saying it is a sham. The fact that parties subsequently depart from an agreement does not necessarily mean they never intended the agreement to be effective. (Hitch v Stone [2001] STC 214);

• the unilateral intentions of the settlor are not enough to establish a sham, there must be a common intention;

• reckless indifference will be taken to constitute a common intention. That is the way to interpret the point made in Midland Bank about a person “going along with” the shammer neither knowing or caring about what he or she is signing;

• a trust which is not initially a sham cannot subsequently become one; and

• a finding of sham is a serious matter especially for professional trustees.

Birss J accepted Mumby’s J’s points and made the following observations:

• “Just because the trustees do something later which is in accordance with the trust deed, that is not necessarily indicative of no sham. And that will be all the more so when the trustees are acting at a time when they know they are under scrutiny. Evidence of proper behaviour when the trustees know they are being watched may not count for much. Actions when no-one was looking carry more weight”; and

• to ascertain the intention of trust companies one needs to consider the principles for the attribution of intention to companies and make a determination on the facts. The intention is that of the natural person or persons who manage and control the relevant actions of the company, the directing mind(s) in respect of the relevant act or omission (see El Ajou v Dollar Land Holdings [1994] BCC 143 at 150-151).

Given the seriousness of a finding of shamming intention on the part of a professional trustee, some may be surprised that Birss J was able to reach such a conclusion in respect of Patterson, given his background.  Birss J found that Patterson may not have known what Pugachev’s intentions actually were when forming the trust but did not accept that Patterson inferred that Pugachev was prepared to relinquish control.  Birss J noted Patterson prepared the trust deeds and did nothing to suggest to Pugachev that they might leave Pugachev “in ultimate control”.  Ultimately, Birss J concluded that Patterson “prepared and signed these deeds entirely recklessly as to the settlor’s true intentions.”  One might query whether Birss J actually applied a subjective test to ascertain Patterson’s intention or whether he objectively inferred Patterson’s intention from the facts as he understood them.

Birss J noted:

“Given Mr Pugachev’s true intentions, the finding on the True Effect of the Trusts claim    means that these trusts are not shams. They fulfil Mr Pugachev’s true intention not to lose control.”

Guidance

Notwithstanding that Pugachev’s case may not break new legal ground, there may be a debate regarding the factual inferences that Birss J was willing to draw which led to his conclusions.  When setting up trusts, settlors, trustees and advisers may be wise to ensure that they do not render the structure open to such adverse inferences.  From an asset protection perspective, the following should be considered in a trust context:

• if a settlor retains a fixed beneficial interest in trust property, such property will generally be available to creditors in enforcement proceedings;

• if a settlor retains a power to revoke, general power of appointment in trust property, such powers may be regarded in equity as tantamount to ownership and available to creditors in enforcement proceedings;

• generally, trust property will be less vulnerable to attack from claims brought against a settlor or protector if:

o the protector is independent of the settlor and neither the protector nor settlor may be beneficiaries;

o the powers reserved to the settlor or granted to the protector are not extensive;

• consideration ought to be given to the choice of governing law, whether the governing law has:

o reserved powers legislation and the nature and extent of powers that can be reserved without invalidating the trust; and

o robust firewall legislation;

• consideration ought to be given regarding the nature of trust property (movable or immovable) and the jurisdiction where it is situated;

• settlors should receive independent advice as to the nature of the trust instrument and the powers the settlor and the settlor’s agents will and will not have in relation to the trust property thereunder;

• trusts should be administered in accordance with their terms and the formalities and duties thereunder complied with- administering a trust in an informal manner may tempt an inference that the parties never intended the property to be administered in accordance with the trust instrument;

• if a private trust company is the trustee, consideration should be given to educating those of the private trust company’s directors who have limited trust experience of the nature of trusts and trustee duties;

• consideration should be given as to whether certain powers in the trust instrument ought to be designated as fiduciary or otherwise; and

• the consequences and effect of using blanket provisions to categorise all non-trustee power-holders’ powers in the trust instrument as non-fiduciary or personal (and even in some cases, fiduciary) should be carefully considered before adopting that approach.

Conclusions

Be under no illusions, Pugachev’s case does not provide claimants a new avenue for setting aside trusts based on the so-called illusory trust claim and does not purport to alter the existing requirements for parties to have a common intention to deceive third parties in order for the trust instrument to be a sham. 

Based on the particular findings of facts in Pugachev’s case, a number of which may be controversial, the Court reached the conclusion that the terms of the trusts as construed under New Zealand law, reflected that Pugachev did not divest himself of beneficial ownership of the property.  It is not the first time that such a conclusion has been reached in trust cases and trusts referred to as illusory.  However, it may be difficult to accept the Court’s conclusion given the nature of the powers reserved by Pugachev, many of them veto powers and some apparently inherently fiduciary powers. Courts in offshore jurisdictions may be reluctant to reach a similar finding irrespective of whether or not they are required to apply modern reserved powers legislation.Further, it is submitted that the UK High Court would unlikely have been able to reach that conclusion if the trusts’ governing law had modern reserved powers legislation.  If the UK Court nevertheless would reach the same conclusion, depending on the trusts’ governing law, well drafted firewall legislation in place under that governing law should require the Courts in that jurisdiction not to recognise, enforce or otherwise give effect to a foreign judgment that did not properly apply the governing law. 

In Pugachev, the Court held that the corporate trustees, through Patterson, held the common shamming intention because they had no independent intention from Pugachev and were recklessly indifferent to his intentions.  Recklessness was considered sufficient to constitute a trustee’s shamming intention prior to Pugachev.  However, in Pugachev, the facts were of a nature that it may be difficult to find that Patterson was, applying a subjective test, recklessly indifferent to any intention that Pugachev had to deceive his creditors. 

In Pugachev, Birss J had the task of performing a challenging analysis of the facts to determine whether Pugachev has divested himself of beneficial ownership or whether the trust was a sham, a conclusion which may have been tempting to reach. The outcome of the trusts’ assets being available to the liquidator would have been achieved with seemingly less controversy, had Birss J simply held, as he readily did in the alternative, that Pugachev’s transfers into the trust were invalid transfers under section 423 Insolvency Act.