Sham Trusts: Is Your Family Trust Valid In Law?

A trust is a legal arrangement that is created by a settlor (the founder of the trust) by transferring his or her assets to the trust and placing them under the control of a trustee for the benefit of their named beneficiaries. It can be classified as revocable or irrevocable, living or testamentary, simple or complex and can serve several specialized purposes such as estate planning, asset protection, accumulation of generational wealth, to name a few. The word sham refers to something that is manufactured to mislead third parties. Its ordinary meaning is something that is devised to delude, trick, hoax or defraud. A sham trust can therefore be defined as a trust arrangement that is devised to mislead onlookers that the settlor has transferred the control of the trust property to the trustee when in reality, the settlor has retained control. The relationship that is created between the settlor and trustee in this instance is one akin to a principal and agent relationship disguised in the form of a trust. A trust can also be considered to be a sham in the following circumstances:

1. when the settlor acquires too much control in the trust by being a trustee as well as a beneficiary of the trust; or
2. when the settlor transfers property to the trust for an illegal purpose for example, to avoid tax responsibilities or to prevent the recovery of assets in a bankruptcy or insolvency proceedings.

Nature of Sham Trusts

Common law dictates that for a trust to be valid, three certainties have to be met in the trust deed; the certainty of the object of the trust (trust properties), the certainty of the subject of the trust (beneficiaries) and the certainty of the intention to create the trust for the benefit of the named beneficiaries. In a sham trust, the clear and unequivocal intention of the settlor to create the trust and surrender control over their assets to the trustees for the benefit of their named beneficiaries is normally absent. More often than not, the settlor’s intention is to give a false impression to creditors, government agencies, third parties, including other beneficiaries and the court by using the trust as a smoke screen to mask their true intentions.

Proving a Sham Trust

The party that alleges that the trust is a sham has the burden of proving the same in a court of law. The standard of proof is on a balance of probabilities as it is in civil cases. In essence, courts may be inclined to declare that a trust is a sham if it is proven on a balance of probabilities that there is a clear and unequivocal intention by the settlor to deceive or misrepresent by creating a trust. To illustrate, in the renowned Jersey case of Rahman vs Chase Bank Trust Company Limited (1991) JLR 103, the deceased settlor had purported to constitute a trust under Jersey law. After the supposed constitution of the trust, the settlor continued to deal with the assets as though they remained his absolute property; giving investment directions without reference to the trustee. The Royal Court of Jersey held that the purported trust was void as it was sham because the trust property was solely controlled by the settlor as opposed to the trustees of the trust who had the sole mandate of managing the trust assets. In the UK case of Midland Bank vs Wyatt (1995) 1 FLR 697, Mr. Wyatt created a family trust for the benefit of his wife and daughter. He prepared the trust deed and appointed his wife as trustee. Thereafter, he kept the trust deed away in his safe and did not tell his wife about the existence of the trust. His true intention was to use the trust as a protection mechanism in the event of business failure. When his business did fail, he sought to protect his house from creditors by relying on the family trust. The court held that the trust was a sham as Mr. Wyatt did not intend to create the trust for the benefit of his wife and child but to protect his house from creditors. The trust was therefore held to be void.

Consequences of a Sham Trust

Once a trust is declared null and void by a court of law, the trust ceases to exist and the trust assets held by the trustees revert back to the settlor. As a result, the trustee losses the protection accorded by the trust. This opens the settlor to scrutiny of their personal assets, claims from creditors, tax obligations and intestacy succession proceedings upon their death.

Key Considerations to Ensuring The Validity of a Trust;

The settlor should make sure that they secure the services of a seasoned wealth and private client lawyer who will be able to advise them on the following before establishing a trust:

1. The importance of severability of obligations and rights of the settlor, beneficiary and trustee in the trust deed;
2. The trustees’ need to act independently in the management and administration of the trust assets;
3. The importance of appointing professional and reliable trustees of repute;
4. The importance of ensuring the accountability of trustees in the trust deed;
5. That once a trust has been created, the properties transferred to the trust cease to be the assets of the settlor and become the assets of the trust.
6. That it is not advisable for the settlor to reserve wide powers for himself, for example, a power enabling him or her to authorise transactions; and
7. The importance of creating the trust for the benefit of the named beneficiaries and not the settlor.

Should there be an existing trust, the settlor should ensure that:

1. They do not exercise powers over and above those reserved to them by the trust deed;
2. The trustees consider their discretion when requested to exercise certain powers and minute their decision; keeping proper records can prove the trustees’ independence;
3. The settlor is not the sole beneficiary and trustee of the trust;
4. The trust has been established for the benefit of the named beneficiaries; and
5. The trustees are solely in charge of managing the trust assets.

In the event any of the above is lacking in the current trust deed, the settlor should seek the services of a lawyer to review the terms of the trust deed and amend the requisite clauses, failure to which, the trust deed is at risk of being challenged as a sham.

Conclusion

Creating a trust can be likened to performing a delicate surgery. The surgeon has to know what they are doing as the life of the patient rests in their hands. In the same breath, a critical part of establishing a valid trust is securing the services of a seasoned lawyer to give you holistic and practical advice taking into account several factors such as your personal wishes, family goals, tax obligations and family businesses and succession. This is especially crucial when the property is in multiple countries or is vast in nature.

Contact Persons & Contributors

Dianah M. Gichuru –Partner & Head of Unit  Shalma E. Maina- Associate