The tangled Webb we weave

Rationale for reservation of powers

The advantages of using trusts as wealth‑planning vehicles are well recognised. However, for many high‑net‑worth individuals, it remains a daunting prospect to hand over control of their substantial assets to fiduciaries, no matter how strong the relationship. Several jurisdictions permit a settlor or another party who may be indirectly controlled by the settlor, such as a protector or beneficiary, to retain powers in the trust instrument. Typical reserved powers include powers:

• to revoke the trust (typically only held by the settlor);
• to amend or vary the trust;
• to appoint or remove trustees;
• to add or exclude beneficiaries;
• to appoint income or capital;
• related to investment, such as the power to appoint or remove investment managers or give directions;
• to change the law or forum of the trust; and
• to veto certain decisions made by the trustees.

Retention of such powers gives settlors some degree of input and control over the trustees’ administration and investment of assets. Other powers enable flexibility if the trust structure needs to be altered to account for changes in circumstances. Generally, the retention of powers is intended to provide an element of comfort to the settlor that their wishes are fulfilled. However, there is a fine line between providing comfort to the settlor and reserving so much control to the settlor that the arrangements may not legitimately operate as a trust.

In the cases examined below, the categorisation of the nature of the reserved powers is often determinative as to whether a challenge to the validity of the trust is upheld, i.e., whether the powers are fiduciary or personal in nature. Much depends on the context and particular circumstances of the power holder; but, generally, reserved powers that are held to be fiduciary in nature tend to support the argument that the trust is valid.

England and Wales

In order for a valid express trust to come into existence under the laws of England and Wales, it must meet the so‑called ‘three certainties’:

• certainty of intention: it must be clear that the settlor intends to create a trust;
• certainty of subject matter: the property that is held on trust must be clearly identifiable; and
• certainty of objects: the beneficiaries of the trust must be clearly identifiable.

When establishing a trust, a settlor must transfer ownership of the trust assets to the trustee or else the trust will fail for uncertainty of intention.

A further requirement is that there must be an irreducible core of obligations that the trustees owe to the beneficiaries of the trust that are enforceable against the trustees. Such obligations are fiduciary in nature, meaning that they must be exercised in the best interests of the beneficiaries as a whole, and the exercise of such powers is subject to the supervisory jurisdiction of the courts.

If too many powers are retained by the settlor, this undermines the certainty of intention of the settlor to create a trust (on the basis that the powers are tantamount to retaining ownership of the trust assets) and erodes the irreducible core of obligations. These principles were explored in detail by the High Court of England and Wales (the High Court) in its 2017 judgment of Mezhprom v Pugachev. This decision caused commotion in the trusts world when the High Court held that a trust was invalid due to the extent of the powers reserved by the settlor.

Pugachev

Pugachev concerned several New Zealand discretionary trusts set up by Mr Pugachev for the benefit of his family. Independent New Zealand trust companies were initially appointed as trustee of the trusts, and Pugachev was also a beneficiary and protector of the trusts. As protector, he held typical protector powers, such as powers to appoint and remove trustees, direct a sale of specific trust property and veto certain trustee decisions. Pugachev did not have the power to appoint trust assets to himself, but he could veto any proposed appointments to others.

Pugachev founded the Mezhprom Bank in Russia, which was liquidated by the Russian government after the financial crisis in 2014, owing USD2.2 billion. The liquidator sought to recover the USD95 million worth of assets Pugachev settled on trust after he fled Russia by attacking the validity of the trusts. The liquidator argued that Pugachev effectively retained control of the trust assets through the powers he reserved in the trusts and also challenged the transfer of the assets into trust.

Even though there was nothing unusual about the powers that Pugachev held as protector, the High Court ruled that the trusts were invalid and that the assets were held by the trustee on bare trusts for Pugachev and were therefore available to his creditors. There is much to unpack from the High Court’s judgment, but the following points are of interest:

• The beneficiaries argued that all of the protector powers were fiduciary and must be exercised in the interests of the beneficial class; even if they were not fiduciary, the powers must be exercised in good faith and for their proper purposes such that the protector was subject to the supervisory jurisdiction of the court. The High Court rejected this argument and found that all of the numerous powers held by Pugachev as protector were purely personal in nature, meaning he was free to exercise them entirely in his own interests as a beneficiary rather than for the benefit of all of the beneficiaries. The High Court placed reliance on the fact that Pugachev was a beneficiary and had the power to remove trustees ‘without cause’. Accordingly, any exercise of these personal powers would not be subject to scrutiny by the courts. This finding contradicted a previous ruling by the Supreme Court of New Zealand (the Supreme Court) that Pugachev’s power to remove trustees in these trusts was fiduciary.
• The beneficiaries argued that the trusts were valid, given that the trustee had fiduciary powers and was accountable to the beneficiaries. The High Court agreed that the trustees owed fiduciary powers but stated that this would not prevent Pugachev from removing a trustee who did not administer the trust in accordance with his wishes and replacing them with a ‘friendly’ trustee that would comply with his directions (although commentators have suggested that the High Court would have jurisdiction to intervene in such circumstances).
• The High Court concluded that the terms of the trusts and the amount of powers held by Pugachev did not ‘divest’ him of his beneficial interests and effectively allowed him to retain his beneficial ownership of the trust assets. The High Court noted that if an independent or non‑beneficiary protector been appointed instead of Pugachev, it would have held that the protector powers were fiduciary.

The Pugachev decision was criticised at the time for the reasons set out above. The powers reserved in Pugachev were not unusual and practitioners were concerned that this might open the door for courts in common‑law jurisdictions to strike down similar trust arrangements as invalid.

To set the Pugachev decision in context, when considering the separate question of whether the trusts were shams, the High Court formed the impression that Pugachev had deliberately sought to use the trusts to hide his assets from his creditors. Further, it made findings on the evidence that the trustees were not sufficiently independent of Pugachev and followed his directions, and the transfers into trust were made for ‘asset protection’ purposes. It has been suggested that the High Court’s findings on the reserved powers was influenced by these findings and, consequently, the decision was dismissed by some as an anomaly.

Despite its critics, Pugachev remains good authority in England and Wales for the time being and has received favourable judicial comment. For example, in the recent High Court decision of Law Society v Dua, ^[1] Justice Sims stated that the criticism of Pugachev was ‘unfounded’, the reasoning relied heavily on the categorisation of powers supported by various practitioner texts and the conclusion could be labelled as ‘conventional’.

Offshore and other common‑law jurisdictions

Many other common‑law jurisdictions have developed their trusts law based on English and Welsh trust‑law principles. The requirement that settlors divest themselves of the trust property and the irreducible core of obligations are key principles, although the approach to reservation of powers in those jurisdictions has diverged in significant ways from England and Wales.

Case law

Over the past decade, there have been several judgments in common‑law jurisdictions that demonstrate the courts are prepared to unravel trusts based on the powers retained by settlors.

Bermuda

The first example is the Supreme Court of Bermuda’s (the Bermuda Court’s) decision in AQ Revocable Trust. ^[2] In that case, the settlor had settled assets on trust with the intention that the trusts take effect on his death. The Bermuda Court found that the document was a testamentary disposition as it complied with the formalities for the creation of a will. However, the testamentary disposition was revoked by the settlor’s marriage before his death, meaning that it did not operate to create a valid trust on his death. The Bermuda Court then considered whether a valid trust arose during the settlor’s lifetime. It noted that the fact the settlor had dealt with the property as his own prior to his death was not inconsistent with the trusts taking effect on the settlor’s death. The Bermuda Court referred to the legislation in force at that time in Bermuda, which expressed that the reservation of the specified powers was ‘not necessarily’ inconsistent with the existence of a trust. Nevertheless, it found that the combination of the extensive powers held by the settlor, including the power of revocation, rendered the trust invalid during his lifetime, as the settlor had no intention of the trusts taking effect until his death and continued to deal with the property as his own.

Privy Council: Cayman Islands

The UK Privy Council took a similar approach in its decision of TMSF v Merrill Lynch. ^[3] TMSF sought to recover a judgment debt from a former director of insolvent Turkish banks who had fraudulently paid away money from the banks and placed them in two Cayman Islands trusts. The discretionary beneficiaries of the trusts were the settlor, his wife and their children, and the settlor retained powers to revoke, vary or amend the trusts. TMSF sought an order to appoint a receiver over the settlor’s power of revocation. The Cayman Islands courts previously rejected TMSF’s claim on the basis that the power was not tantamount to property, but the Privy Council took a different view. It found that a power of revocation is similar in nature to a general power of appointment and that the power was not fiduciary in any sense (none of the parties suggested it was); the only discretion the settlor had was whether to exercise the power in his own favour. The Privy Council commented that: ‘The powers of revocation are such that in equity, in the circumstances of a case such as this, [the settlor] can be regarded as having rights tantamount to ownership.’ Consequently, the Privy Council found it had jurisdiction to order that the settlor delegate his power of revocation to a receiver. Interestingly, the trust was found to have been validly established until such time that the power of revocation was exercised (in contrast to Pugachev).

Privy Council: Cook Islands

In Clayton v Clayton, ^[4] the Supreme Court objectively examined the terms of the trust and concluded that the package of powers held by the settlor (who was also the sole trustee, a beneficiary and held a ‘protector‑type’ role) entitled him to appoint the trust property to himself without the need to account to the other beneficiaries. However, the Supreme Court did not rule on whether the trust was valid until those powers were exercised as the parties settled the dispute. The Pugachev decision (and the Webb case, below) analysed the Clayton decision in some detail.

The most recent example is the UK Privy Council’s 2020 decision in Webb v Webb, ^[5] which concerns discretionary trusts set up by a New Zealand individual, Mr Webb (H). Shortly after H’s second marriage to W in 2005, he set up a trust in the Cook Islands for the benefit of himself and his son from his first marriage (the A Trust), appointing himself as the sole trustee. H and W subsequently had a daughter. In 2013, the A Trust acquired property in the Cook Islands and the family moved from New Zealand to live there.

By 2016, the marriage had broken down and H and his son moved back to New Zealand. H started a new relationship with a new life partner (D) and set up a new trust in New Zealand (the W Trust) for the benefit of H and his children, with H and D appointed as trustees. H then arranged to transfer assets from the A Trust to the W Trust for nominal consideration.

W commenced proceedings in the Cook Islands seeking a matrimonial property order; although she had no beneficial interest under the trusts, she argued that the trust assets should be taken into account when the court determined the assets she would receive on divorce. H claimed that the trust assets were held in trust and were not available for division with W under the matrimonial proceedings. W argued that the A Trust and the W Trust were invalid such that H still owned the trust assets and that the trusts were shams.

W’s attack on the trusts failed initially and the court sided with H. However, the Court of Appeal of the Cook Islands reversed that decision and held that the trusts were invalid because:

• the trust deeds failed to record that H had divested himself of his beneficial interests in the trust assets; and
• H retained powers under the trust deeds, which meant that he could recover the property purportedly settled on trust at any time.

H appealed to the Privy Council, contending that the lower court’s analysis of his powers was wrong. In his capacity as trustee, his powers were fiduciary in nature, and consequently he owed obligations to the beneficiaries to act in their best interests when exercising them. This was inconsistent with a finding that he could deal with the assets as his own.

The Privy Council considered H’s various roles and powers under the A Trust (the terms of the trusts were similar and therefore the analysis applied to both):

• H was the sole trustee and was one of two beneficiaries.
• H adopted the role of ‘consultant’ as defined in the trust deed, which gave him various powers, including the power to remove and appoint new trustees.
• H had various powers as trustee that were fiduciary in nature, meaning they must be exercised in the best interests of the beneficiaries. However, the Privy Council considered that there were various ways by which H could exercise his various powers to vest the trust assets in himself personally:
  • As settlor, H retained the power to nominate himself as the sole beneficiary; this power was non‑fiduciary in nature.
  • The trust deed provided that the trustees could exercise their powers even where their interests conflicted with those of the beneficiaries.
  • As trustee, H had fiduciary powers to advance assets to another trust and to amend the trust deed, subject to the consent of the consultant (i.e., himself).
  • H had a wide fiduciary power as trustee to appoint capital and income to himself to the exclusion of other beneficiaries ‘in his uncontrolled discretion’. The Privy Council considered that this amounted to a general power of appointment and relied on several previous decisions (including TMSF) that have equated a general power of appointment with property ownership.

The Privy Council dismissed H’s appeal on the basis that H ‘had the power at any time to secure the benefit of all of the trust property to himself and to do so regardless of the interests of the other beneficiaries’. It also found that the trusts were invalid from the outset as ‘the trust deeds failed to record an effective alienation by Mr Webb of any of the trust property. The bundle of rights which he retained is indistinguishable from ownership’.

Interestingly, the Privy Council did not refer to the Pugachev decision in the Webb judgment (although, the lower courts referred to it in Webb). On the facts, Webb goes further than Pugachev, as H held wide‑ranging powers and held virtually all of the roles within the trust, namely trustee, consultant, settlor and beneficiary. The outcome, therefore, is perhaps not as surprising. In both cases, the courts held that the trusts were invalid from the outset because the powers they retained meant that the settlors never really surrendered their beneficial interests.

Reserved powers legislation

The above decisions suggest that the benefits associated with reservation of powers cannot be guaranteed. To mitigate this, several offshore jurisdictions have introduced reserved powers legislation, which states that the reservation of one or more specific powers to the settlor or a protector will not invalidate the trust. These jurisdictions include the Bahamas, Bermuda, the British Virgin Islands, the Cayman Islands, Guernsey and Jersey. The general range of powers permitted by the legislation include the powers listed at the beginning of this article. Some jurisdictions also expressly confirm that a trust will not be invalidated where a settlor retains a beneficial interest. Although there are differences in the legislation, it is designed to give some comfort to settlors that their chosen form of trust structure will be upheld.

Other jurisdictions have introduced a more restrictive approach to reserved powers. Singapore and Hong Kong permit reservation of powers of investment only. Australia, Gibraltar and the Isle of Man have also ratified the Hague Convention on the Law Applicable to Trusts and on their Recognition, which includes the general statement that a reservation of powers by the settlor is not necessarily inconsistent with the existence of a trust.

Webb is a Privy Council decision and will therefore have weight in offshore jurisdictions where the Privy Council operates as the court of final appeal. On the face of the reserved powers legislation, it seems that Webb will not have much impact in those jurisdictions. However, their courts have yet to interpret the reserved powers legislation, so it is still unknown as to how strictly the legislation will be applied. Will the reserved powers legislation operate to validate a trust even if the fundamental requirements for a valid trust are absent?

The editors of the latest edition of Lewin on Trusts suggest not: ^[6]

‘Such provisions may go no further than give effect to what is the position without statutory intervention in England and Wales, but have the advantage of eliminating doubt as to the scope of the common‑law rules and are no doubt a comfort to settlors who wish to establish lifetime trusts in those jurisdictions, reserving wide powers to themselves.’

In their footnote, the editors go on to suggest that the Pugachev decision is unlikely to be followed in jurisdictions with reserved powers legislation, but this commentary pre‑dates Webb.

Therefore, there remains a risk that even if the powers reserved are permitted by statute, if the combination of those powers and the factual circumstances has the true effect that the settlor still retains effective control of the trust property, the courts may find that the trust is not valid. With that in mind, the Webb decision is likely to have some sway in how reserved powers trusts are treated in the offshore world.

US

In the US, inter vivos revocable trusts are often used as an estate‑planning tool to avoid probate. A revocable trust is a testamentary vehicle treated as a valid trust under the various states’ laws. It is often used for administrative convenience in managing the settlor’s assets during incapacity and the time period between the settlor’s death and submission of the settlor’s will for probate, but the assets of a revocable trust are always reachable by the settlor’s creditors during the settlor’s lifetime and upon their death. The Uniform Trust Code (UTC) provides that ‘during the lifetime of the settlor, the property of a revocable trust is subject to claims of the settlor’s creditors’. ^[7] In states that have not adopted the UTC, various decisions treat the settlor of a revocable trust as the owner of the property.

Reservation of other powers, such as the right to amend or alter the trust, without the consent of an adverse party, which would have a similar effect of revoking the transfer of assets into trust, will likely treat the settlor as the owner of the assets and cause the assets of the trust to be includible in their estate for estate tax purposes and accessible by the settlor’s creditors during their lifetime and upon their death.

However, even with respect to an irrevocable trust, which is intended not to be accessible by the settlor’s creditors and not to be included in the settlor’s estate for estate tax purposes, the settlor may retain certain powers. For example, it was ruled that the settlor of an irrevocable trust may retain the ability to remove and replace trustees so long as they may not appoint themselves or a party related or subordinate to them as the replacement trustee. ^[8] The settlor may also swap assets of the trust for assets of an equivalent value (verified by the trustee) and reserve certain powers over investment of the trust assets, so long as it does not affect the beneficial interests of the trust. The settlor may also arguably participate in distribution decisions to the beneficiaries of the trust so long as the distributions are limited to an ascertainable standard. The settlor, however, cannot retain powers of unlimited or discretionary distribution or appointment of the trust’s assets that would allow them to affect the beneficial enjoyment of the trust assets without causing the trust to be includible in their estate for estate tax purposes. Although, the trust may still be respected as a valid trust and not necessarily be reachable by their creditors other than US taxing authorities.

Treatment of irrevocable trusts under which the settlor continues to be a beneficiary of the trust differs among the states. Some states have specifically enacted legislation that will allow a settlor to create an irrevocable trust under which they are a continuing beneficiary but have prevented access to the trust by the settlor’s creditors so long as the trustee is sufficiently independent and the settlor does not retain certain rights. Wyoming, for example, enacted additional legislation on 1 July 2021 that will make it even more difficult for creditors to access such trust assets. Other states, however, may not recognise the unreachability of the trust assets by the settlor’s creditors under such circumstances, creating a degree of uncertainty with respect to the enforceability of such trusts in the states. In any event, if the trust is created when there are known creditors with the intent to avoid their recovery, the trust will likely not be respected in the states.

In the US and other jurisdictions, it is important to remember the various ways in which trusts may be challenged in different courts. A trust may be attacked for:

• its validity under applicable state trust law;
• its reported tax characteristics by federal and local tax authorities; or
• the accessibility of its assets by creditors in a variety of contexts, including bankruptcy and divorce.

These analyses may focus on different factors and reach different conclusions regarding the respectability of a trust.

In SEC v Wyly, ^[9] for example, a federal district court in New York ordered that the trusts at issue, which had allegedly committed violations of certain Securities and Exchange Commission regulations, be disgorged by the amount that would have been due if the trusts had been treated as grantor trusts under federal income tax law, even though the case was not actually a tax case. The court found that the settlors of the trusts exercised continuous and unfettered control over the trusts through directions they gave to the protectors of the trusts, who were employees of the settlors and could remove and replace the trustees. The protectors then communicated those directions to the trustees of the trusts, who were professional management companies in the Isle of Man, but never refused a direction. Because the trustees had never refused or even questioned a direction they received during the administration of the trusts, the court determined that they should not be treated as truly independent with respect to the settlors, which was the exception to the grantor trust rules that the trusts were relying on to avoid grantor trust treatment (which would have caused all of the income earned by the trust to be taxable to the settlor, individually).

In Estate of Goodwyn v Commissioner, ^[10] however, the US Tax Court rejected this same ‘de facto trustee’ argument, creating a well‑established precedent in US tax law that the legally enforceable rights of the settlor under the trust agreement should generally be prioritised over the historical administration of a trust for US tax purposes. ^[11] However, the US Tax Court also has a long line of cases scrutinising a trust’s economic substance in determining whether to disregard a trust for tax purposes. If a trust is created for no other reason than to avoid taxes, it will likely be disregarded by the US Tax Court.

A four‑prong test is often used to evaluate such cases, examining whether:

• the settlor’s relationship to the property transferred to the trust materially changed after creating the trust;
• the trustee of the trust is independent with respect to the settlor;
• beneficiaries (other than the settlor) received a true economic interest in the trust assets; and
• the settlor respects the provisions of the trust agreement and applicable state trust law.

However, the US Tax Court’s finding that a trust is a ‘sham trust’ under this standard does not necessarily mean that the trust will be deemed to be invalid under applicable state trust law. The beneficiaries of the trust could still have enforceable interests under state trust law, and creditors of the settlor other than the taxing authority might still not be able to reach the trust’s assets, depending on the circumstances.

Conclusion

It is clear that attacks on the validity of a trust based on a settlor’s retained powers over the trust are becoming more commonplace.

In future cases where courts conclude that a settlor’s powers are tantamount to property ownership, in light of Webb and Pugachev, it seems that courts in common‑law jurisdictions will more readily find that no valid trust was established at all. Decisions such as Webb muddy the waters as to how robustly offshore courts will uphold their reserved powers legislation.

Although Webb should give settlors and practitioners some pause for thought, on its facts it was a more extreme example of a settlor retaining too much control over the trust assets through extensive powers. None of the cases referenced above prohibits settlors from retaining powers over trust structures, but similarly they do not give any guidance on how far settlors can go. It is a question of balance as to the type and amount of powers that a settlor can safely retain; individual powers may on their own be unobjectionable but in combination they may tip the balance.

To avoid potential creditor disputes, a prudent settlor should:

• avoid holding all of the roles in the trust, i.e., trustee, protector and beneficiary;
• engage an independent, professional fiduciary as a trustee or protector (on its own or in addition to the settlor), as its powers are more likely to be deemed fiduciary in nature;
• avoid granting powers that the settlor does not need in practice to protect the settlor’s interests, or which do not serve the purpose of the trust.

With careful thought and planning, settlors should be able to create sufficient safeguards to ensure that the trust serves its function, secure in the knowledge that the structure will remain intact and not be susceptible to challenge from creditors.