Bankruptcy and insolvency — Consultation on the treatment of trusts under insolvency law

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Australia’s current corporate insolvency regime does not expressly cover how companies that structure themselves through a trust or companies that have a corporate trustee (corporate trusts) should be treated during the insolvency.

On October 15, 2021, the government released a consultation paper seeking stakeholder input on whether the treatment of corporate trusts in Australian insolvency law needs further clarification. Comments were also sought on what benefits this might bring and how any new framework might work.

This consultation process closed on December 10, 2021.

What is a business trust?

A corporate trust structure arises when a company acts as a trustee of one or more trusts. A trust is an obligation imposed on a person or other entity with respect to property held for others. Under this arrangement, a person or company (the trustee) holds assets (trust property) “in trust” for its beneficiaries.

A trust can be thought of as a fiduciary relationship between the trustee and the beneficiary. This relationship is not a separate legal entity, but a set of recognized rights and responsibilities. This means that a trust cannot incur debt, sue or be sued on its own. The relationship operates in accordance with the Trust Deed, which sets out the terms, conditions and rules for establishing and managing the trust. It is also governed not only by company law, but also by trust law.

Tax data from 2018-2019 shows there were more than 630,000 trusts with a corporate trustee, including “business trusts”1. Therefore, the use of trusts for business activities is very common, especially for SMEs and family businesses. This means that there is merit in aligning the insolvency process for trusts with that for corporations, if possible.

Trusts and insolvency

When a company that does not employ a trust structure becomes insolvent, the company and its creditors benefit from a clear legal regime established under Chapter 5 of the Corporations Act. This defines when the company is insolvent, the consequences of insolvency, the rights, duties and obligations of the parties involved, the order in which debts must be repaid in the event of liquidation and which conducts any external administration to control the ailing business and its future.

However, there is no such clear regime for insolvent business trust structures. In contrast, when a business trust becomes insolvent, an outside trustee can ask the court for directions on how to administer the assets and liabilities subject to the trust. The court must rely on case law, general principles of trust law (mostly contained in case law), and the particular facts of the particular trust to determine how an individual trust should be wound up. This may result in delays and additional costs.

This uncertainty can affect companies and creditors in several ways. For example:

  • • uncertainty may prevent a distressed business involving a trust from being able to use the insolvency system to survive,
  • • the pool of assets to be distributed to creditors may be reduced due to the costs of legal proceedings or other delays and expenses, and
  • • This may impact the confidence of creditors to lend to business trusts, which in turn would impact the cost and availability of credit.

Key consultation questions

Here are some of the key questions for stakeholders to consider as part of the consultation process:

  • 1. Clarify when a trust with a corporate trustee is deemed insolvent — Comments were sought from stakeholders on whether this should be expressly stated in the statute. This would provide greater certainty to creditors and other parties and align more closely with the framework used for insolvent companies under the Corporations Act.
  • 2. Clarify the role of the outside administrator — Due to the uncertainty surrounding the power of an outside administrator to administer the assets and liabilities of the trust, outside administrators often ask the court to be appointed receiver of the assets of the trust. This is particularly the case when a trust deed attempts to limit a fiduciary’s right to indemnification. If the power of an insolvency practitioner to administer the assets and liabilities of the trust were expressly provided for in law, this would provide greater certainty. It could also extend to allowing the same insolvency practitioner to administer both the company and the assets and liabilities attributable to any trust of which the company is a trustee.
  • 3. Allocation of assets — It may be beneficial to expressly define how the assets and liabilities attributable to trusts are treated under external administration. One approach is to treat the assets and liabilities of the trust separately from those attributable to a corporation. This approach could also include a clear statutory order of priority for the repayment of debts attributable to trusts, similar to what is already contained in the Corporations Act, for example under s. 556. Clarification of who can claim the proceeds of the trustee’s right to indemnification and how such claims are prioritized should also be considered.
  • 4. Ejection and Indemnification Clauses — Certain trust indentures may include “ejection clauses” which provide for the automatic removal of a trustee in the event of insolvency, including the appointment of an outside administrator. The intention is to remove a trustee who may have become undesirable to beneficiaries due to insolvency or external administration. However, ejection clauses can impede the progress of outside administration and seeking court orders to suspend such clauses adds time, complexity and cost. A trust deed may also include a clause to remove a trustee’s right to indemnification in the event of insolvency. It would be beneficial to clarify the applicability and limits of these clauses in legislation, rather than simply relying on the advice of the courts.

Further reading

You can read more about trusts and business trusts on our platform © Pinpoint here.

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Sources: Treasury Department consultation, Clarifying the treatment of trusts under insolvency lawDecember 10, 2021, accessed March 29, 2022.

Treasury Department, consultation documentOctober 15, 2021, accessed March 29, 2022.

CCH Pinpoint®, Trusts and business trustsaccessed March 29, 2022.

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