Settlor-Reserved Powers After Pugachev

Pugachev had set up five trusts under New Zealand law with New Zealand trustees; unfortunately for the defendant, the Judge, Mr Justice Birss, found that the true effects of the trusts did not transfer the assets from Mr Pugachev’s personal control.[i] Furthermore, the judge ruled that the trusts may be considered shams, but that this depended on the nature and application of the powers of the protector (Mr Pugachev himself). The effect of both of these decisions was to make the assets held in trust available to Mr Pugachev’s creditors.

In reaching his decision regarding the trust’s true effects, Birss J considered the fact that Mr Pugachev was, in all cases, the settlor, a discretionary beneficiary, and the protector – in which latter role he held extensive powers. Mr Pugachev’s extraordinary protector powers included the ability to remove and appoint trustees for any reason, veto any significant application of trust assets, revoke trustee powers, and veto any variation of the trust instrument, to name but a few.[ii] The powers were held to be personal and not fiduciary, which is an important consideration, as we will see later.

New Zealand does not have statutory protections for trusts, against settlor-reserved powers; unlike a number of offshore jurisdictions. Bermuda’s legislation to this effect is the Trusts (Special Provisions) Act 1989, which states:

2A(1): …the reservation by the settlor to himself…in a trust instrument governed by the laws of Bermuda of any limited beneficial interest in the trust property…or any or all of the powers specified in subsection (2)…shall not – (a) invalidate the trust; or (b) prevent the trust taking effect according to its terms; or (c) cause any or all of the trust property to be part of the real estate or personal estate of the settlor

The Act goes on to list nine different, wide-ranging powers including the appointment and replacement of trustees, the addition or exclusion of beneficiaries, and active direction of the trustees, regarding the spending, investment, payment or appointment of trust assets.

Furthermore, Bermuda has several so-called ’firewall’ provisions, found in section 11 of the above act, which essentially protect a Bermuda-law trust from foreign interference. Section 11(2) is particularly relevant in cases such as the above: “11(2): A foreign judgment shall not be recognized, enforced or give rise to any estoppel insofar as it is inconsistent with this section”.

So, let us speculate: how would the case have turned out differently if Mr Pugachev had settled Bermuda-law trusts with Bermudian trustees?

In order to carry out this exercise, we must change one fact of the case; that being that part of the trust fund in question was real property in London. A house situated in England will inevitably be subject to whatever judgment the courts of England and Wales hand down, no matter the intentions or design of Bermudian or other non-English legislation. Therefore, for our purposes we will assume all trust assets are outside the United Kingdom.

The complainants in Pugachev attacked the trusts on three grounds. The first concerned the ‘true effects’, as mentioned previously. Regarding the position of the Protector, Birss J wrote that “the true construction of these trust deeds is that the powers conferred on Mr Pugachev as First Protector are conferred to be exercised freely for his own benefit.”[iii] He therefore held that the trusts were not ‘illusory’, but rather bare trusts in favour of Mr Pugachev, which could therefore be broken. The second claim was that the trusts were shams. This was based on various facts, including that Mr Pugachev’s associates were involved with the trust administration; that his son was lined up to succeed him as Protector (including in the case of his becoming subject to litigation); as well as material statements about Pugachev’s ‘‘controlling’’ character. Birss J found “that at all material times he regarded the assets in these trusts as belonging to him and intended to retain ultimate control.”[iv] However, a sham claim also rests on all parties having the intention to carry on the trust as a sham – in this vein, it was noted that the trustees were at least quietly complicit[v]. However, the judge went on, somewhat confusingly: “Given Mr Pugachev's true intentions, the finding on the True Effect of the Trusts claim means that these trusts are not shams. They fulfil Mr Pugachev's true intention not to lose control.”[vi] The third claim was not addressed fully, but, if the other two claims failed, it was submitted by the complainants that the trusts should be set aside under s.423 of the Insolvency Act 1986 (that is to say, that the transactions were made specifically in order to defraud creditors), and Birss J agreed.

Would reserved powers legislation and firewall provisions have protected the Pugachev trusts? It is the opinion of the author that they would not. Let us examine the main claims once again.

Firstly, the true effects claim does not actually rest on the extensive protector powers themselves, but rather on how they were applied in practice. Nowhere does Birss J find that Mr Pugachev had too many powers per se, but rather that he could use those powers in order to have the whole of the trust fund applied to himself alone. Indeed, he notes that the exercise of these powers would be lawful. Similarly, the Bermuda legislation states that the reservation by a settlor of limited beneficial interest (nominally the case with the Pugachev trusts) and extensive powers shall not invalidate the trust, nor prevent the trust taking effect according to its terms. There is certainly an argument that Birss J found the trust invalid, or that the trust did not take effect according to its terms. If so, then the Bermuda legislation purports to prevent such findings. However, Birss J did not declare the trust invalid per se, nor (it is submitted) did he argue that the trust was prevented from taking effect according to its terms. Instead, having declared the protector powers basically lawful, the trust did take effect according to its terms, which were such that Mr Pugachev could exercise effective control.

It is generally understood that reserved powers legislation, like that of Bermuda, is designed to allow a settlor some control over the assets without the trust being found a sham. Even without reserved powers legislation in New Zealand, the trusts were not found to be shams despite the extensive reserved powers in the deeds. With this in mind, it is not unlikely that the extra protections of reserved powers legislation would have ensured the same result. However, that is irrelevant in this case. The trust assets were made available to creditors, nonetheless. Furthermore, the judge did offer a way to consider the trusts shams in this case, if;

construction of these deeds was to lead to a conclusion that the Protector’s relevant powers are fiduciary…and that in turn was to lead to a conclusion that under the deeds Mr Pugachev is not the beneficial owner, then those deeds are a sham.[vii]

Once again, the argument hinges on how the powers are used, or how they are supposed to be used, rather than the existence of the powers.

Secondly, would firewall provisions have helped in any way? Conveniently removing the issue of the UK property as we did, the provisions would have helped, since this was a judgment in an English court. Bermuda trustees would have no obligation under local law to respect the foreign judgment.

From the perspective of an offshore trust practitioner, this is a worrying judgment insofar as settlors have become used to being able to retain extensive control over the assets in trust in order to provide them reassurance. Here, however, we have a line of logic that would permit a judge to break a trust by essentially moving past the legislation. How, then, can settlors maintain a level of reassuring control but avoid this danger?

A key element here is that the powers cannot be exercised, or possibly exercised, for selfish purposes. In the first instance, this, of course, means not allowing any protector, appointor or similar position to compel the trustees to exercise their power of appointment, regarding capital or income, unless the settlor is not himself a beneficiary. This power is expressly permitted by the Bermuda legislation, but it is submitted that it should not be used. As it happened, Mr Pugachev did not have such a power, but his range of powers did mean that he could replace a non-compliant trustee, as well as veto any appointment of assets to other beneficiaries. In practice, this meant that he could frustrate any attempts to benefit anyone other than himself, which was his intention (as damningly noted by his partner and mother of three of his children).

As we have seen, powers should be fiduciary, rather than personal in nature. Birss J defined personal powers as those that may be exercised “selfishly if they wish”.[viii] The best way to prevent this is if the settlor cannot benefit from the trust, but if the settlor is a beneficiary, then the number of reserved powers must be limited in order to prevent selfish control. For example, even fundamental controls, such as the power to vary the trust instrument or restrict trustees’ powers, should be fine, since such powers can be exercised lawfully in ways that affect the discretionary class as a whole. The power to direct that assets be appointed to oneself, or ability to remove or exclude beneficiaries, has been shown by Pugachev to be dangerous. To reserve all of these together now looks like a grave mistake.

Prospective settlors can take comfort that a trust can still be settled while retaining a large degree of control. Powers to direct investment or make decisions regarding an underlying company are particularly attractive. However, settlors will need experienced trustees who are aware of the implications and dangers of particular powers, or combinations thereof – and one should be wary of trustees who promise full control, only with reference to the reserved-powers legislation.

[i] JSC Mezhdunarodniy Promyshlenniy Bank & Anor v Pugachev & Ors [2017] EWHC 2426 (Ch)

[ii] Ibid., para. 235-244

[iii] Ibid., para. 267

[iv] Ibid., para. 424

[v] Ibid., para. 434, 435

[vi] Ibid., para. 436

[vii] Ibid., para. 437

[viii] Ibid., para. 187

John Gibbons
John Gibbons is Trust Manager at Harbour Trust Company Limited in Bermuda.