ENGLISH HIGH COURT FINDS SETTLOR RETAINED BENEFICIAL OWNERSHIP

In the latest decision in the long running Pugachev dispute, the High Court considered the effect of five trusts set up by Mr Pugachev, and whether the trusts were shams. Birss J held that he would have been prepared to declare the five trusts shams, but on the true interpretation of the trust documents and considering the powers reserved to Mr Pugachev as protector, all five trusts were, in effect, bare trusts for the benefit of Mr Pugachev.

The first part of the decision has potentially wide effects in relation to assets held in trust subject to freezing orders. Paragraph 6 of the standard form freezing order in the annex to PD25A refers to “any asset which [the Respondent] has the power, directly or indirectly, to dispose of or deal with as if it were his own”. Following Birss J’s decision, this may include discretionary beneficial interests where the settlor has retained sufficient powers so as to be able to exercise effective control.

While the decision does not alter the test applied to whether a trust will be a sham, it is a rare example of the courts being prepared to find that a trust arrangement constituted a sham, and shows that the courts will look critically at the intentions on the part of the establishing trustees. We consider the decision further below.

Background

Mr Pugachev founded the first claimant Mezhprom Bank in 1992. By 2008, Mr Pugachev had an estimated wealth of $15 billion. Following the financial crisis of 2008, Mezhprom Bank ran into financial difficulties and was declared insolvent by the Russian courts. In 2011, shortly after criminal investigations began into the collapse of Mezhprom Bank, Mr Pugachev fled Russia.

Since the collapse of Mezhprom Bank, there has been long-running litigation between Mr Pugachev and Mezhprom Bank (see our previous blog post in connection with this dispute at http://hsfnotes.com/asiadisputes/2015/09/22/england-extending-mareva-injunctions-to-trustees). The latest decision considered the claimants’ application that certain trust properties be vested in the claimants or a court-appointed receiver.

Between 2011 and 2013, Mr Pugachev arranged for five discretionary New Zealand trusts to be set up: (i) the London Residence Trust; (ii) the Kea Three Trust; (iii) the Riviera Residence Trust; (iv) the Wiltshire Residence Trust; and (v) the Green Residence Trust (together “the New Zealand Trusts”). Each of the New Zealand Trusts held valuable property assets, with the exception of the Wiltshire Residence Trust which held cash which had been earmarked for a purchase of property that did not in fact take place. All five New Zealand Trusts were set up by a New Zealand solicitor, Mr Patterson, who was also a trustee for each of the New Zealand Trusts.

Each of the New Zealand Trusts had two trustees, Mr Patterson and either Ms Dozortseva or Mr Liechti. Ms Dozortseva had been general counsel at Mezhprom Bank and Mr Liechti worked for Mr Pugachev’s family office. Both were regarded as nominees for Mr Pugachev, having acted on his instruction at all times. The discretionary beneficiaries were expressed to be Mr Pugachev, Ms Tolstoy (his partner), and the children of Mr Pugachev. Mr Pugachev himself was appointed as the trust protector.

The Issues

The claimants argued that the beneficial interests in the New Zealand Trusts belonged to Mr Pugachev, and sought orders requiring that the assets be vested in the claimants or a receiver. The claimants advanced three claims:

1. that the “True Effect of the Trusts” was that, properly construed, the New Zealand Trusts were not effective to deprive Mr Pugachev of his beneficial ownership (“the True Effect of the Trusts claim”);
2. that the trusts were shams;
3. that, if the trusts were effective to divest Mr Pugachev of ownership of the assets held by the New Zealand Trusts, pursuant to section 423 of the Insolvency Act 1986, such transfers of the assets into the New Zealand Trusts was carried out to prejudice the interests of the creditors, including the claimant. Given his findings on the sham and True Effect of the Trusts claims, Birss J did not consider the section 423 claim in detail.

The True Effect of the Trusts Claim

Birss J considered the scope of the powers reserved to Mr Pugachev as protector of the New Zealand Trusts. These included:

• the ability to remove and replace trustees with or without cause; and
• a negative consent, which requires that certain powers, including to distribute trust property, to appoint and remove discretionary beneficiaries, and to vary the trust deed, vested in the trustees can be exercised only with the consent of the protector.

Birss J considered whether the powers of the protector were fiduciary in nature, and if they had to be exercised in the best interests of the entire class of beneficiaries. After reviewing the authorities from several commonwealth jurisdictions, he held that as a matter of law, the powers of a protector were not necessarily fiduciary: it would depend on the “powers and duties conveyed by the trust deed on its true construction” (at [185]).

The New Zealand Trusts all expressly stated that the protector’s power to remove trustees was “with or without cause”. The protector’s powers were “purely personal, in the sense that they could be exercised in the protector’s own selfish interests” (at [203]). There was no restriction within the trust deed as to how Mr Pugachev was to exercise his powers: the powers did not have to be exercised with regard to the interests of the beneficiaries as a whole. Mr Pugachev was therefore free to prioritise his own beneficial interest under the trusts. In so doing, Mr Pugachev was able via his role as protector both to prevent any distributions being made to any of the beneficiaries, and to replace a trustee who refused to do his bidding with a more compliant new trustee. In combination, Mr Pugachev as protector therefore retained the power to ensure that none of the assets within the trust framework could be distributed to beneficiaries other than Mr Pugachev himself.

While the powers granted to Mr Pugachev may be legitimate for a protector to perform a “watchdog” role over the management of the trust, such wide powers could only result in the protector not being regarded as the beneficial owner where the protector was expressly excluded from the class of discretionary beneficiaries and therefore unable to benefit from the trust. The fact that Mr Pugachev was also the settlor “reinforce[d] the conclusion” that he had retained beneficial ownership of the trust assets (at [269]).

The New Zealand Trusts also provided that where the protector, Mr Pugachev, was under a “disability by operation of law”, he was to be temporarily replaced in the role of protector by his son, Victor. The definition of “disability by operation of law” in the trust deed for the New Zealand Trusts included:

“in relation to any person means any event or happening which renders the person temporarily or permanently incapable of exercising free will and includes imprisonment or other form of involuntary detention, being subject to coercion or duress whether physical or mental, including coercion by operation of law”

In Birss J’s opinion, the effect of the “disability by operation of law” provision was that:

“the arrangements have been set up so that if the Protector is subject to a court order requiring him to do something he does not want to do, he ceases to be the Protector…if required to act against his will Mr Pugachev can truly say to the court that he has none of the Protector’s powers. If the Protector’s powers under the deed were limited to acting only in the best interests of the Discretionary Beneficiaries as a class, rather than his own selfish interests, then I doubt this provision would be necessary. What it does is allows Mr Pugachev’s effective complete control of the trusts to cease to exist the moment he is compelled to do something he does not want to do, like hand over the assets to a creditor. It is an attempt to make the trust judgment proof and should not be accepted” (at [275]).

Accordingly, the “True Effect” of the New Zealand Trusts was that Mr Pugachev had retained beneficial ownership of the property within the five New Zealand Trusts.

The Sham Claim

At law, a trust will be a sham where the parties “intended to create different rights and obligations from those appearing from the relevant document, and in addition they must have intended to give a false impression of those rights and obligations to third parties” (per Arden LJ in Hitch v Stone [2001] STC 214, at [66]).

Birss J set out the principles in relation to when a trust will be a sham, citing Munby J in A v A [2007] EWHC 99 (Fam):

• a finding of a sham requires full analysis of the facts. Just because the parties later depart from an agreement does not mean that they never intended the agreement to be effective;
• there must be a common intention to create a sham: the unilateral intention of the settlor is not per se enough;
• reckless indifference to the effect of the deed can constitute the requisite common intention (per Midland Bank v Wyatt [1997] 1 BCLC 242);
• a trust which is not initially a sham cannot later become one.

Construed properly and given their “true effect” , the New Zealand Trusts did exactly what Mr Pugachev intended, and provided a means whereby Mr Pugachev still retained beneficial ownership of the trust property.

However, Birss J considered the sham claim in detail, on the basis that if he was wrong on whether the powers of the protector were in fact fiduciary, finding, albeit obiter, that:

• Mr Pugachev intended to “use the New Zealand Trusts as a pretence to mislead other people, by creating the appearance that the property did not belong to him when really it did” (at [424]).
• As to the trustees, both Mr Liechti and Ms Dozortseva were nominees from Mr Pugachev, and took instructions from him at all times. They were not in any way independent.
• As regards, the “shamming intention”, Mr Patterson’s evidence was that as he lacked any shamming intention, then the New Zealand Trusts could not be shams. This was rejected. Mr Patterson had drafted the trust deeds, and this was not a case analogous to Midland Bank v Wyatt, where one of the trustees had signed the deed without considering its terms. Mr Patterson too was held not to have any intention independent of Mr Pugachev. Birss J rejected the defendants’ suggestion that Mr Patterson did not regard Mr Pugachev as having control over the trust. Mr Patterson had referred to Mr Pugachev as the “ultimate beneficial owner” in correspondence, and his wider conduct in acting as trustee for the New Zealand Trusts. Mr Patterson was to be regarded as at best, entirely reckless as to the true intentions of Mr Pugachev.
• Instead, Birss J considered that the New Zealand Trusts had been deliberately and carefully drafted so that “the canny professional who drafted the document can even salve their conscience by presenting two inconsistent but arguable interpretations” depending on the context (at [439]).

In the circumstances, Birss J held that if his interpretation of the New Zealand Trusts was wrong, and that the New Zealand Trusts did in fact divest Mr Pugachev of his beneficial ownership of the trust property, then the trust deeds would be shams, and should not be given effect to.

Accordingly, the court made the declarations sought that Mr Pugachev was the beneficial owner of the assets held by the New Zealand Trusts, and invited further submissions as to the appropriate orders to be made.

Reserving powers to settlors or giving significant powers to protectors is of course not uncommon. However, this case demonstrates the need to be cautious when setting up trust structures. Settlors should be careful to consider the extent and nature of those powers in the round. This case demonstrates that the Court will look at their overall combined effect. The case also emphasises the need for trustees to be truly independent for the trust to be robust.