Trading trusts are a popular business structure for SMEs, with the number of trading trusts nearing parity with the limited liability company in many entities nationwide (Australian Taxation Office Taxation Statistics 2016-17). This popularity is due to the greater structural flexibility of trusts for business owners and their many tax advantages. However, these benefits are often embraced without an appropriate understanding of the risks that come with adopting a trading trust structure, especially when insolvency arises. Although some of these consequences are unavoidable, well-advised directors, creditors, and other counterparties can benefit from good legal advice and an informed understanding of the relevant hazards. Accordingly, this article simplifies this complex topic and makes you aware of some of the significant risks associated with trading trusts when they become insolvent.

 

What is a trading trust?

Trusts are an alternative to companies in establishing and carrying on a business in Australia. However, the origin of the trust is primarily as a legal instrument of Equity, not as a corporate structure. This means that although they appear to function the same as a company in the ordinary course, they were never designed to trade a business in this way. This is because trusts lack a separate legal personhood which is afforded to most other corporate structures under our legal system. Legal personality is the sum of traits that allows a corporate structure to trade at arm’s length from (and limit the liability of) its corporate officers. The term refers to the capacity to sue or be sued in its name, to hold assets, or even incur debts in its own right. These qualities are essential for any business wishing to meaningfully participate in the broader economy. To get around this, businesses structured as trading trusts must trade through their trustee, which is most commonly a limited liability company. In this way, a trading trust consists of two entities operating in concert:

  • A trust that conducts the business and holds the assets of the enterprise on behalf of the beneficiaries of the trust (usually the Director and other related parties); and
  • A trustee company which exists as the legal person. It transacts with external counterparties, incurs debts, and assumes responsibility for the actions of the enterprise in its capacity as trustee.

 

Together, these entities effectively replicate the corporate structure of the Company in a manner that distances the assets of the business from its liabilities and other legal obligations. Although this may sound desirable, the consequences of adopting this structure can be severe, especially when the business is experiencing financial pressure. The Corporations Act contains a very sophisticated set of provisions which provide certainty when a business is subject to a dispute or can no longer meet its financial obligations on an ongoing basis. However, this legal regime does not extend to trading trusts as it only applies to companies. The lack of legal personality afforded to the trust itself also increases the uncertainty and risk of adverse outcomes for stakeholders in the process of winding up the affairs of the enterprise.

 

The Trustee’s Right of Indemnity

The legal concept at the root of this uncertainty is the trustees right of indemnity. When a business can no longer meet its ongoing financial obligations and operate as a going concern, the director may resolve to wind up its affairs in an orderly manner and place it into a formal insolvency arrangement. When control passes from the director of a trustee company to the liquidator of that company, the liquidator is empowered to deal with trust assets also by inheriting the office of trustee. It may be undesirable for beneficiaries of the trust to have a trustee enter an insolvency arrangement. As such, any well drafted trust instrument will contain a clause that automatically removes the trustee from office when an insolvency event is initiated. This is known as an ejection clause. Once this clause takes effect the trust property is held on a “bare trust”, and the outgoing trustee company’s powers are limited. Until a new trustee is appointed, the ejected trustee can only take conservative steps to protect the remaining trust assets or distribute them as directed by beneficiaries. However, the ejected trustee is still the legal person. This means that it continues to carry personal liability for debts incurred by the trustee but has no authority to use the trust assets to satisfy these debts. The only means available to the now insolvent trustee company to pay the creditors of the trust is its right of indemnity, more specifically, the right of exoneration. The right of exoneration is an equitable principle that entitles a trustee to apply trust property to pay outstanding trust liabilities incurred by the trustee.

 

The Amerind and Killarney Decisions

How the right of exoneration is properly exercised by an ejected trustee with limited powers to access trust property has been the subject of decades of legal disputes and judicial debate. The most recent development in the juris prudence comes from two decisions in the higher courts: Carter Holt Harvey Wood Products Australia Pty ltd v Commonwealth of Australia (2019) 368 ALR 390; [2019] HCA 20 (the “Amerind” decision); and Jones (Liquidator) v Matrix Partners Pty Ltd; in the matter of Killarnee Civil and Concrete Contractors Pty Ltd (in liq) (2018) 260 FCR 310; [2018] FCAFC 40 (the “Killarnee” decision). In these decisions, judges endorsed the opinion that even though the property of the enterprise is beneficially owned by the trust, proceeds obtained from the exercise of the trustee’s indemnity constitutes property of the company. Although, this property cannot be used in a general and unconstrained way. Use of the proceeds extracted from trust property under the indemnity are to be applied in direct fulfillment of the trustees right of exoneration. This is to say that trust property can only be used by the trustee to satisfy debts incurred in its capacity as trustee. These decisions brought welcome clarity to the indemnity issue, and even extended the priority distribution regime under the Corporations Act to trading trusts when proceeds from the indemnity are applied to pay trust creditors.

 

Enduring Risks of the Trading Trust Structure

Following the Amerind and Killarnee decisions, liquidators of corporate trustees are now capable of applying proceeds from the exercise of the indemnity to pay trust creditors. Although this provides certainty for stakeholders as to how the affairs of an insolvent business trading through trust can be wound up, there are ongoing risks for stakeholders which the recent decisions do not address.

 

In the first instance, the right of indemnity itself is not a perfect mechanism through which to pay trust creditors. For example, if there is an outstanding debt owed by the trustee to the beneficiaries, then the trustee will still be barred from accessing trust property to pay the indemnity. If all of the assets are owned by the trust, then the trustee will likely be unable to clear the debt to the beneficiaries and access the indemnity. To access the indemnity, there are significant cost burdens for creditors and beneficiaries. The liquidator must hire lawyers to oversee expensive court applications, and also spend significant additional time and money on tasks associated with court matters. Since these costs are paid from the proceeds accessed under the indemnity, the likelihood of creditors and beneficiaries receiving a dividend at the end of this process is substantially diminished. Directors and creditors of corporate trustees may also experience increased difficulty in claiming a valid defence against voidable transaction claims when a trust is involved, since such defences rely on the relevant party having a detailed understanding of the solvency position of the business at the time of the transaction. This can be a complex affair, even for registered liquidators with decades of experience. These complexities are further increased when the solvency position of both the trust and the trustee must be considered.

 

Quality Advice

Despite a heightened degree of certainty provided by recent decisions in Amerind and Killarnee, there are still many risks associated with adopting the trading trust structure that become realized at the initiation of an insolvency event. This article has provided a simplified overview of what a trading trust is, and how the current framework succeeds and fails at alleviating the negative consequences of corporate trustee insolvencies. However, the potential complexity of issues associated with trading trusts cannot be understated. Our partners at RRI Advisory are experienced professionals with decades of experience dealing with trading trusts, and other insolvency matters. If you have questions about an insolvency matter, contact enquiries@rriadvisory.com.au to be put in touch with a registered accounting and insolvency professional.

 

Disclaimer

This information and the contents of this publication, current as at the date of publication, is general to offer assistance to RRI Advisory’s clients, prospective clients and stakeholders, and are for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.