Asset Protection: The Role Of Trusts In Protecting Bankrupt Beneficiaries An Analysis Of The Uk Case Of Smith V Michelmores Trust Corporation [2021]

Background of the Case:

The case of Smith v Michelmores Trust Corporation (2021) EWHC 1425 (Ch) (hereinafter referred to as “the Smith Case”)sheds light on an important aspect of trust law, specifically the limitations of using trust assets to settle the debts of a beneficiary of a trust.  

In this landmark case, the deceased established a testamentary trust (a type of trust that is created in a will) for the benefit of her son (hereinafter referred to as the “Son”) and grandchildren. The trust was to be funded by one-quarter of her estate which was approximately fifty thousand pounds (£50,000), an equivalent of Kshs. 8 to 9 million.

After the death of the deceased, the executors of the will found out that the Son owed the deceased some money. In a bid to increase the value of the estate, the executors instituted a case against the Son and successfully obtained a court order against him. The court order directed the Son to pay the estate approximately five hundred pounds (£500,000), an equivalent of Kshs. 85 to 87 million. The Son failed to pay the debt, therefore, the executors took a further step and successfully applied to court for the Son to be declared bankrupt.

Since the executors of the estate of the deceased were also the trustees of the testamentary trust, they applied to the High Court of England and Wales to be allowed to distribute all the funds in the trust to the Son despite him being bankrupt. They did so knowing that the Son would in turn be compelled to use this amount of money to settle part of the debt owed to the estate. 

The Son, pre-empting the intentions of the executors, applied to the court and objected to receiving the benefit on the basis that he was still bankrupt and the distribution will be of no benefit to him since it would be used to settle a small part of his debt. 

The Decision of the Court:

The court dismissed the application by the executors. It held that the distribution would not confer a direct financial benefit on the Son, since the funds would be redirected to his trustee in bankruptcy, and he would not personally receive any of the cash. The court highlighted the following circumstances of the case, that informed its decision to dismiss the case: -

a)       The Ratio of the distribution to debt:

Since the debt owed by the Son to the estate amounted to an equivalent of Kshs. 87 million, and the distribution made to the Son from the trust was an equivalent of Kshs. 9 million, the court observed that the ratio of the distribution to the debt was grossly imbalanced as the distribution would ultimately reduce less than 11% of the debt owed. 

Further, the court noted that other benefits could accrue to the beneficiary such as the ability to start a business or pay for the membership of a club that would be of much more benefit to the beneficiary compared to the options presented by the trustees (settlement of a small fraction of the debt).

b)      Other Beneficiaries of the trust:

The court took notice that the grandchildren of the deceased were also beneficiaries of the trust. By giving all the funds held by the trust to one beneficiary i.e. the Son, the trustees would be denying the grandchildren of the deceased their rightful benefit as beneficiaries of the trust. 

Since the trustees owed a fiduciary duty to all the beneficiaries of the trust, the trust assets could not be used for the sole benefit of only one beneficiary. Closer home, in the case of Re Eunice Wanjeri Njenga, ELC Miscellaneous Civil Suit 62 of 2013 [2013] eKLR, the court held as follows concerning the duty of trustees to treat the beneficiaries of a trust equally:

“In summary, the general duties of Trustees in relation to the trust property are to safeguard the assets of the trust, to invest any trust money in his or her hands, and to distribute the assets to the beneficiaries and satisfy any claims of the beneficiaries. With relation to the beneficiaries, Trustees are under a duty to maintain equality between beneficiaries and to provide accounts and information to the beneficiaries.”

Additionally, the grandchildren of the deceased had an equitable right to enjoy the trust property by being a beneficiary of the trust. Therefore, if all the funds in the trust were to be used for the sole benefit of the Son, the trustees will be grossly denying the grandchildren their vested interest in the trust property.

 c)       Conflict of Interest:

The court also took notice that the trustees of the trust were also the executors of the estate of the deceased. The executors had a duty to maximise the value of the estate, which involved following up on the debts owed to the estate of the deceased and recovering as much as possible. 

Inversely, the executors of the estate owed a fiduciary duty to the beneficiaries of the trust as trustees of the trust. Therefore, there was a conflict of interest in performing their duties as trustees of the trust as well as executors of the estate of the deceased. This was exacerbated by the trustees’ decision to distribute the benefit to the beneficiary while he was an undischarged bankrupt. It was apparent that they wanted the beneficiary to apply the benefit to settle part of the debt.

The Rationale of the Decision:

While it is essential to protect the trust assets, it is equally crucial to ensure that beneficiaries are not unduly deprived of their entitlements. It is clear that the judge carefully examined the circumstances surrounding the proposed distribution to the Son, who was an undischarged bankrupt and balanced the interests of the creditors seeking repayment with the rights and expectations of all the beneficiaries of the trust. The court ultimately found that the proposed distribution would not serve the best interests of the Son, particularly when compared to alternative options available to the trustees.

Implications for Trust Law and Future Cases:

One of the fundamental principles of trust law is the protection of trust assets from the debts and liabilities of beneficiaries. The assets held in a trust are separate and distinct from the personal assets of the beneficiary and should not be accessible by creditors seeking to recover debts owed by the beneficiary. This principle serves to safeguard the integrity of the trust and ensure that trust assets are held and used for the overall benefit of the named beneficiaries.

The Smith Case sets an important precedent regarding the use of trust assets to settle the debts of beneficiaries. It reinforces the notion that the primary purpose of a trust is to provide direct benefits to the beneficiaries and not to shield assets from creditors. It also underpins that Trustees must exercise prudence and act per their fiduciary duties when considering distributions to beneficiaries facing financial challenges, especially in a discretionary trust. They should carefully evaluate the potential benefits, both direct and indirect, of distribution against the interests of creditors and be guided by the overall objectives of the trust.

Asset Protection:

The Smith Case strengthens the principle that a family trust is an excellent asset protection mechanism that shields trust assets from claims by creditors as well as claims from other parties such as spouses in matrimonial property disputes.  

Notably, section 6 (2) of the Matrimonial Property Act in Kenya is clear that trust property does not form part of matrimonial property. Moreover, Section 3F (3) of the Trustee Perpetual Succession Act states that a trust shall not become void by virtue of, the settlor’s bankruptcy, liquidation of settlor’s property, or even proceedings or a suit against the settlor by his or her creditors. 

We shall discuss the role of trusts as an asset protection mechanism in matrimonial property disputes in our next article; be on the lookout.

Trust law remains focused on safeguarding the interests of the named beneficiaries of a trust by ensuring that trust assets are appropriately protected and that they receive their intended benefits as provided in the trust deed. That notwithstanding, it is very important to engage a seasoned Wealth and Private client lawyer to assist you in devising a suitable trust structure for your family. An excellent private wealth lawyer will be able to carefully draft your trust deed and include clauses that can be leveraged to further protect the trust assets without your trust being declared a sham .

 How can we help?

The Wealth and Private Clients team at CM Advocates LLP prides itself in having a wide variety of resources, skills, and experience on matters of estate planning, wealth management, and trust administration spanning across the East African Region. We offer an edge to our clients based on our legacy of having structured, re-structured, amended, and incorporated several forms of trusts and therefore well capable of guiding you through the process of creating a valid trust.

Should you have any questions regarding the subject of establishing a trust, or a related topic, please do not hesitate to contact us at law@cmadvocates.com or privatewealthlawyers@cmadvocates.com