January 2023: Case update - The need for trustees to exercise their discretionary powers in good faith
Discretionary trusts are frequently used as business and investment vehicles as part of corporate groups and private wealth structuring. Discretionary trust deeds usually confer wide discretionary powers on trustees to invest, hold trust assets and distribute income and capital. It is frequently said that discretionary trusts provide better asset protection, tax and succession planning flexibility. This is predicated on the general principle that discretionary beneficiaries do not have a proprietary right over trust assets, but rather a mere right to due administration and to be considered when discretionary powers are exercised.
A key trustee power is the distribution of income and capital usually in their absolute discretion. Although trustees are not required to provide reasons behind their decisions, the Victorian Supreme Court of Appeal decision of Owies v JJE Nominees Pty Ltd [2022] VSCA 716 is a reminder that trusts cannot be simply be treated as ‘piggy banks’. Trustees have obligations to properly exercise their discretionary powers and a failure to exercise power in good faith will risk the trustee’s decision being set aside. In certain circumstances, the trustee can be removed and replaced by an independent party.
BACKGROUND
The Owies Family Trust was established in the 1970s by the John and Eva Owies (the parents). The named primary beneficiaries of the trust were John and Eva’s three children, Michael, Deborah and Paul. John and Eva were listed as additional general beneficiaries, and the general beneficiary class also included extended family relations. The trust had an estimated $23m of assets which generated substantial income each year.
John and Eva were the initial controllers of the trust, holding the positions of appointor and guardian and they were both the shareholders and directors of the corporate trustee, JJE Nominees Pty Ltd. The trustee had wide powers to distribute income in its absolute discretion and if no valid distribution was made by the end of a financial year, the primary beneficiaries (Michael, Deborah and Paul) were to take equally, in default.
As part of John and Eva’s estate planning, various amendments were made to the trust deed in an attempt to pass the control to their son Michael. John and Eva were estranged from their other two children Deborah and Paul for substantial periods of time.
The trust was administered in 2015 to 2019 where 40% of income was distributed to John, 20% to Eva and 40% to Michael. In 2019, 100% of the income was distributed to John and during that year, a unit was distributed to Deborah by way of a capital distribution. No distributions were ever made to Paul.
Eva passed away in 2018 at the age of 89 prior to proceedings being commenced and John passed away in 2020 at the age of 96, prior to the commencement of a trial. On Eva and John’s death, Michael together with Eva and John’s solicitor were appointed as the two directors of the corporate trustee.
PROCEEDINGS BEFORE THE COURT
Paul and Deborah commenced proceedings against the trustee and successfully argued that:
The amendments to the trust deed that purportedly changed the guardian and appointor to Michael, were invalid. This was because the amendment power under the deed was narrow and did not extend to changing the appointor and guardian.
The distributions of income between 2015 to 2019 were voidable on the basis that the trustee did not act in good faith and did not give proper consideration to all of the beneficiaries. This was largely because the trustee failed to enquire into Paul and Deborah’s circumstances prior to making distributions.
The trustee should be removed and an independent trustee should be appointed. This was due to the trustee’s conduct over a number of years and the damaged relations between the controllers and Paul and Deborah.
The appointment of John and Eva’s solicitor as a director of the trustee company was invalid. This was because the appointment did not follow the procedures required under the trustee’s memorandum and articles of association.
The Court based its decision on long standing legal principles that trustees need to act in good faith, and not for an improper purpose when exercising discretionary power. This issue will be closely analysed in this newsletter.
LACK OF GOOD FAITH
The Court held that whilst the trust deed in this case conferred broad discretionary powers on the trustee, trustees cannot simply do as they wish. The trustee failed to act impartially and failed to give real and genuine consideration to the interests of Deborah and Paul. This was in light of:
A failure to make any enquiries of Paul or Deborah;
The ‘irreconcilably damaged’ relationship between the parties managing the trustee (John, Eva and then Michael) and the disgruntled beneficiaries, Deborah and Paul;
The ‘total lack of trust’ between the parties;
The ‘history of antipathy’ between Eva and Paul, and Eva and Deborah;
The ‘grotesquely unreasonable’ outcome in 2019 where 100% of income was distributed to John who was 96 years of age at that time, in full residential care and had no need for any income from the trust; and
The purposes of the trust, reflected in the deed’s recitals which stated that the trust’s purpose was to provide for John and Eva’s children (ie, Paul, Deborah and Michael).
Orders were made for the trustee to be removed with an independent trustee to be appointed.
In reaching its decision, the Court highlighted that:
Whilst trustees are given broad and flexible discretionary powers under the trust deed, trustees are required to exercise their discretionary powers in good faith, upon real and genuine consideration and in accordance with the purposes for which the discretion was conferred (inferred from the trust deed in question). The exercise of discretion will not be examined or reviewed by the Courts so long as the essential component parts of the exercise of the particular discretion are present.
The starting point for the exercise of power must be the nature and purpose of the trust, having regard to the terms of the trust deed. In this case, the recitals noted that the settlor was ‘desirous of making provision for the primary beneficiaries and the general beneficiaries’ and it was expected that trustee decisions would primarily revolve around Michael, Deborah and Paul as the primary beneficiaries.
The trustee is expected to inform itself about the circumstances, needs and desires of each primary beneficiary in giving them ‘real and genuine consideration’ when exercising its discretionary power. Proper enquires ought to have been made but in this case, were not made.
The distributions in 2015-2019 were voidable rather than void. The Court did not order that the trustee pay Paul and Deborah one third of the annual income (as default beneficiaries). This is Paul and Deborah did not seek orders for the distributions to be set aside. Furthermore, they did not challenge the trial judge’s decision to refuse leave to amend their pleading to seek such relief.
Trustees are not required to give reasons for their decisions and no adverse inference should be drawn where the trustee does not give any reasons. However, the Court stated in this case that where the trustee chose not to provide any reasons, it left ‘the stark pattern of distributions to speak for itself’ as no reasonable person would have made such distributions.
QUESTIONS
Owies also raises some interesting issues and questions in practice:
How are void transactions dealt with from a tax perspective, particularly in light of the High Court decision in Commissioner of Taxation v Carter [2022] HCA 10 concerning disclaimers and section 100A of the Income Tax Assessment Act 1936 (Cth) concerning reimbursement agreements?
How far must the trustee’s enquires extend in discharging its good faith responsibility?
Can the trustee exercise its power to exclude beneficiaries to effectively avoid future claims?
What if the trustee simply accumulated income or distributed to a corporate beneficiary?
IMPLICATIONS GOING FORWARD
Whilst it can be said that possession is nine tenths of the law and that the trustee has broad discretionary powers, a trustee has always been required to act in good faith and for a proper purpose, in the best interests of the beneficiaries as a whole. Holding assets in a discretionary trust structure is not the same as personal ownership.
DURING THE ADMINISTRATION OF A TRUST
Trustees need to be aware of their obligations and beneficiaries ought to be aware of their rights:
The trustee must exercise their discretions in good faith including by making proper enquiries of at least the ‘main beneficiaries’ prior to distributing income. It is not simply a matter of distributing the income. Trustees should maintain evidence of such enquires made in the event decisions were ever queried. Enquiries are likely to take time and would need to commence well ahead of the end of the financial year and under tax law.
Where the exercise of power is voidable, an aggrieved beneficiary must seek a declaration from the Court that the transaction was void. The drafting of pleadings in the first instance is absolutely critical.
The Court has the power to remove a trustee to protect the interests of beneficiaries, to secure trust property and to ensure a sufficient and satisfactory execution of the trust and trustee powers.
Related party (eg family member) controllers need to be properly advised of their obligations. Trustees will need to be aware that the Court can have regard to the family dynamics in determining whether a removal of trustee would be in the best interests of the beneficiaries as a whole. Disgruntled beneficiaries may have grounds to seek the removal of a trustee where controllers are too clouded with emotion to properly discharge their duties or if there is evidence that the trustees have not acted in good faith.
Do not assume that an amendment power will always allow a change of controllers by variation. This is particularly the case in older trust deeds with narrower amendment powers. Furthermore, where there is a ‘break in the chain’ of amending or appointment deeds, this may have implications as to the proper controller of the trust and validity of exercise of power.
From a succession planning perspective, it is not a matter of simply passing control of the trust to an intended beneficiary. Where there are significant assets held in trust or where a dispute is likely, statements of wishes and/or independent controllers could be considered alongside or instead of family members in the succession plan.
Estate planning involving discretionary trusts involves more than simply passing control to the intended beneficiary.
PREVENTION IS FAR BETTER THAN A CURE: STRUCTURING THE TRUST DEED AT INCEPTION
Claims made by disgruntled beneficiaries can be avoided with careful structuring from the outset. For instance, the following factors should be considered when the trust is established:
The beneficiary class – including who’s included and excluded as beneficiaries.
Takers in default who are to receive if a valid distribution is not made by the end of a financial year or at vesting.
The purposes of the trust as set out in the recitals of the deed.
Additional provisions within the trust deed to preserve the trustee’s discretionary powers.
The ambit of the trustee’s power of amendment.
These issues should be carefully considered if future claims are to be avoided, rather than relying on overly generic precedents or off the shelf documents.
HAVE AN ISSUE? WE’RE HERE TO HELP
Our specialist team provides tailored advice to beneficiaries wishing to understand their rights and trustees wishing to understand their obligations in the context of trust administration, preventative planning and trust disputes. We also assist with the establishment of family discretionary and other bespoke and special purpose trusts.
For assistance, feel free to contact our office on 03 9070 5868 or email admin@nylawyers.com.au.