TRUSTS AND THE NO REFLECTIVE LOSS PRINCIPLE

1. TRUSTS AND THE NO REFLECTIVE LOSS PRINCIPLE by Victor Joffe QC

2. Trustee’s Primary Duties under Jersey Law • Subject to the Trusts (Jersey) Law 1984, a trustee must carry out and administer the trust in accordance with its terms: Art 21(2) • In the execution of its duties and in the exercise of its powers and discretions, trustees must (Art 21(1)) – (a)    act  (i)     with due diligence, (ii)    as would a prudent person, (iii)   to the best of the trustee’s ability and skill; and (b)     observe the utmost good faith.

3. What if the Trustee acts in Breach of Trust or Breach of Fiduciary Duty? Removal as Trustee? Personal Liability : Art 30(1) Equitable compensation – the restoration of the Trust Fund : Art 30(2) Litigation 3

4. How can Trustee liability arise? Improper investment Failure to supervise: Bartlett v Barclays Bank Trust Co [1980] Ch 515 Failure to exercise discretion Excessive compliance with wishes of settlor or beneficiaries Fraud on power Failure to keep proper accounts and records (Art 21(5)) 4

5. How can Trustee liability be avoided or mitigated? Exemption and anti-Bartlett clauses (Art 30(10) saving for trustee’s fraud, wilful misconduct or gross negligence) Release or indemnity by beneficiary: Art 30(6) and (7) Relief by Court: Art 45 Prescription: Art 57 5

6. Reflective loss – Another Way to Avoid Liability? The paradigm fact situation: 1. Trustee: X Trust Co Limited 2. Holds shares in ABC Limited 3. Whose directors Mr D and Ms E cause ABC to enter into a transaction 4. Which causes loss to ABC 5. Which in turn causes value of Trust’s shares in ABC to fall in value 6

7. What is reflective loss? G Limited is a company owned by H, its shares worth £250,000. It buys a piece of land for £100,000 to build on, but its Advocate negligently fails to notice a covenant prohibiting development Land is in fact worth only £10,000 – G Limited suffers loss Consequently, shares in G Limited worth only £160,000 and it can no longer pay dividends to H. H’s loss reflects that of G Limited 7

8. General Rule: Shareholder cannot sue the wrongdoer for reflective loss – ONLY the company can sue: Johnson v Gore Wood & Co [2002] 2 AC 1 Exceptions: Company has no cause of action Shareholder suffers separate and distinct loss caused by breach of duty owed to him independently [Quaere] Wrongdoer disables company from suing 8

9. Why a Rule Preventing Recovery of Reflective Loss? To prevent double recovery: protection of the Defendant To protect the company’s creditors: protection against the Plaintiff extracting value from the company 9

10. Position where Shares are Held by Trustees of Trust Exactly the same as the General Rule: The Trustee (as shareholder), director (even if he is the Trustee or is appointed by the Trustee) and the beneficiary cannot sue for the loss suffered by the Company – ONLY the Company can sue 10

11. Where the Trustee is the Wrongdoer Example: Trustee/director of Trust-owned company causes it to enter improvident transaction. The conventional position: Gardner v Parker [2004] 2 BCLC 554, 565: “…it appears clearly to have been determined in [Shaker v Al-Bedrawi [2003] 1 BCLC 157] that, even when the claim is brought by a beneficiary against a trustee for breach of fiduciary duty, it can be barred by the [no reflective loss principle]. ” 11

12. Trustee Failure to Supervise the Directors of Trust-Owned Companies Example: Trustee fails to prevent directors of trust-owned company from misusing company’s assets or diverting them to third parties Position in England: Walker v Stones [2001] QB 902: Beneficiary can sue Trustee where • He can establish Trustee’s conduct has constituted a breach of some legal duty owed to him personally; • The breach of duty has caused Beneficiary personal loss, separate and distinct from any loss that may have been occasioned to any corporate body in which he may be financially interested.

13. Is Jersey any Different? Freeman v Ansbacher Trustees (Jersey) Ltd [2009] JLR 1 The facts: Assets of a discretionary trust held by a company, SDR, the shares in which were all held by the Trustee. The plaintiff beneficiaries alleged Trustee failed to supervise SDR in respect of three transactions which caused it loss. Trustee sought to have the claim struck out, relying on the no reflective loss principle. The Royal Court proceeded on the basis that the claims raised were reflective of SDR’s losses, and held at that the principle formed part of the law of Jersey.

14. Does the No Reflective Loss Principle Apply to a Jersey Discretionary Trust? Birt DB: “I accept that, if the [no reflective loss] principle applies to the present case, the order of justice should be struck out. However, I am by no means convinced that the principle should necessarily be applied to a situation such as the present involving a discretionary trust. I think it is not entirely clear that the principle would necessarily be applied in England; but even if it were, I consider that there are strong grounds for believing that Jersey law should follow a different path…”

15. Possible Bases of Action against Jersey Trustee • Beneficiaries ask Trustee to replace directors so new directors can cause company to sue former directors • If Trustee refuses to replace directors, beneficiaries bring action against it for new breach of trust • Derivative action by beneficiaries

16. The DB’s Solution? Where Plaintiff seeks reconstitution of the trust fund, the remedy is at the discretion of the court: the court could arguably direct the Trustee to reimburse or refinance the trust-owned company. Thus the company would no longer have suffered any loss and could not bring any claim against its directors, thereby removing the danger of double recovery.

17. The Lesson to be Learned? • The no reflective loss principle may not protect a Trustee from action where it has failed properly to supervise the directors of a trust-owned company. • The Trustee should check its PI policy.

18. Protecting your Position as Trustee 2010 • Trusts and the no reflective loss principle: commentary Paul Tracey 1 October 2010

19. 1. What is the reflective loss principle? • a company has suffered a loss caused by the breach of a duty owed both to the company and to its shareholder/s • Johnson v Gore – Wood and Co [2002] 2 AC 1: “… where the company suffers loss caused by the breach of a duty owed both to the company and the shareholder. In such a case the shareholder’s loss, insofar as this is measured by the diminution in value of his shareholding or the loss of dividends, merely reflects the loss suffered by the company in respect of which the company has its own cause of action. If the shareholder is allowed to recover in respect of such loss, then either there will be double recovery at the expense of the defendant or the shareholder will recover at the expense of the company and its creditors and other shareholders. Neither course can be permitted. This is a matter of principle; there is no discretion involved. Justice to the defendant requires the exclusion of one claim or the other; protection of the interests of the company’s creditors requires that it is the company which is allowed to recover the exclusion of the shareholder. These principles have been established in a number of cases, though they have not always been faithfully observed.”

20. What is the reflective loss principle? • an exclusionary principle • a company law principle; not a trust law principle • clear it applies to shareholders in a company with cause or causes of action against directors (where the company also enjoys a cause or causes of action against directors) but should it apply to beneficiaries of a trust against a trustee who has acted in breach of trust?

21. 2. What is the rationale for the principle? • Proper plaintiff in respect of loss suffered by a company is the company, not its shareholders • Prevention of double recovery • Protection of company’s creditors (because any recovery would go to shareholder/s, not company) • How compelling are these reasons in a trust situation? • Do these reasons have the same cogency, weight or persuasiveness in the context of a trust compared with a situation of pure breach of directors’ duty?

22. 3. How does the principal operate in context of breach of duty by trustee causing loss to trust estate? • Companies the issued share capital of which is held in whole or in part on a trust (possibly through other companies) • Who does the plaintiff want to sue? Directors or trustees? • Lewin at para 39 – 37:“Questions arise … whether recovery of [a] loss [to a trust fund or estate] in an action against … trustees is barred by the rules against recovery of reflective loss if the loss is one in respect of which [a] company has, or has had, a cause of action and the loss is reflected in the diminution in the value of the trust shareholding.”

23. How does the principal operate in context of breach of duty by trustee causing loss to trust estate? • May involve positive action by a trustee (eg authorising the directors of the company to do something otherwise in breach of their duty and which causes loss to the company) or omissions by a trustee (eg failure to act or failure to supervise directors)

24. 4. What is the English position? • Walker v Stones [2001] QB 902 at 927: - defendants’ conduct breached a duty owed to plaintiff personally • - that breach caused plaintiff loss separate and distinct from any loss suffered by company in which plaintiff has an interest • - what is meant by a separate loss?

25. What is the English position? • But see now: Shaker v Al-Bedrawi [2003] Ch 350; Gardner v Parker [2004] 2 BCLC 554; Barnes v Tomlinson [2007] WTLR 377:

26. What is the English position? • All following Johnson v Gore-Wood & Co [2002] 2 AC 1 and authorities for the propositions that, first, “[t]he fact that the beneficiaries‘ claim may be a claim for breach of fiduciary duty is not a reason why the reflective loss principle should not apply” (Lewin at para 39-38) and “… the reflective loss principle normally does prevent the beneficiaries from recovering the diminution in the value of the trusts shareholding in a breach of trust action caused by a breach of duty by the trustee as adirector of the company concerned fro which the company has a claim against the director” (ibid; emphasis mine)

27. What is the English position? • But see also: • Giles v Rhind [2003] Ch 618: • Reflective loss principle does not apply if the defendant’s/s’ actions have stripped the relevant company of funds such that the company is unable to pursue action against the directors

28. 5. What is the nascent Jersey position? • Freeman v Ansbacher [2009] JLR 1 • The case’s facts: • - “at all material times the shares in [the company] SDR were the sole significant asset of the Trust and all the underlying assets were owned by SDR or its subsidiaries.” • (id at 8) • - application to strike out an order of justice on ground, in part, “that the losses claimed … were merely reflective of the losses suffered by SDR and were not therefore recoverable at the instance of the beneficiaries” • (id at 28)

29. What is the nascent Jersey position? • The Bailiff’s judgment and reasons: • “(None of the English cases has had to consider the position where there is a discretionary trust. It seems to me strongly arguable that the two reasons for the principle may have no application in a case such as the present. Rosanna has no entitlement to the trust fund. She will not be entitled to receive any moneys paid out by Ansbacher. She is merely seeking reconstitution of the trust fund. It seems to me strongly arguable that the remedy, were breaches of trust on Ansbacher’s part proved, is at the discretion of the court and, being an equitable remedy, may be moulded to suit the circumstances of the case.

30. What is the nascent Jersey position? • Thus, in the event of the breaches of trust being proved, the court could arguably order Ansbacher to reconstitute the trust fund exactly by reimbursing that particular part of the trust fund which had been primarily affected by the breach of trust. Thus, the court could order Ansbacher to reimburse SDR from where the funds had been lost in the first place. Alternatively, if it was felt that the court could only order Ansbacher to reimburse the trust fund itself by putting the appropriate moneys into the trust fund, it seems to me arguable that the court could nevertheless direct as a term of such relief that the funds be used to acquire new shares in SDR, so that the funds eventually find their way in to SDR. This would have the effect of exactly reconstituting the trust fund because it would take the value of the shares in SDR back to what they had been previously and the financial position of SDR back to what it had been. Such remedies may not be available in all cases but it seems to me strongly arguable that they are available where the company in question is wholly owned by a discretionary trust.” (id at 37-38)

31. What is the nascent Jersey position? • “Like Sir Christopher Slade, I consider that there are strong policy reasons for thinking very carefully before applying the Prudential principle in all its rigour to claims by beneficiaries of a discretionary trust in respect of alleged mismanagement of a company which is wholly owned by the trust and where the remedy sought is reconstitution of the trust fund. The case of Bartlett v. Barclays Bank Trust Co. Ltd. … (which confirmed the duty of trustees to supervise the affairs of a company of which they were the controlling shareholder) is a case engraved on the hearts of all trust lawyers. Like Sir Christopher, it seems to me that, if the Prudential principle is to be applied fuly to cases such as the present, that case must have been wrongly decided and it is difficult to envisage when such an action could ever be brought in future because the loss suffered by the trust will almost invariably be reflective of the loss suffered by the company.” • (id at 40)

32. What is the nascent Jersey position? • “I accept that these options are available to the beneficiaries. But they are complex and far removed from the real complaint, which is that the trustee failed to ensure that its employees (in the form of directors of the company) managed the investments prudently. Once can, for example, envisage the possibility of difficulty in finding a new trustee willing to embark on litigation against the old trustee or against the directors of the company. Alternatively, the new trustee might differ from the beneficiary on the strength of the case. A Beddoes application (with its additional costs) would certainly be necessary. In relation to the first alternative, one can envisage questions about when such a breach of trust would become actionable. Would the beneficiaries have to wait until the limitation period f or the company to claim against the directors had expired? All of the options would involve the beneficiary in becoming involved in satellite litigation rather than addressing the real complaint.” (id at 42)

33. What is the nascent Jersey position? • “In my judgment, it would not reflect well on the law or on Jersey as a centre for the administration of trusts if beneficiaries had to go through these considerable hoops unless it was absolutely unavoidable. It is of the first importance that beneficiaries of a trust whose assets have been mismanaged should have a simple and effective remedy available to them, whether such assets are held directly by the trustee or through a wholly-owned company. I consider that it is strongly arguable that the law of Jersey provides this simple and effective remedy in a case such as the present by enabling the court to order the defaulting trustee to reconstitute the trust fund by reimbursing the company for its losses, thereby removing both reasons for the application of the prudential principle.” (ibid)

34. 6. Should Jersey follow England here? • Lewin: “… it is necessary to consider whether the reasons for exclusion of recovery of reflective loss outside of a trust context apply also in the trust context” (para 39-40) • Trust investments and/or trading all but invariably carried out through companies • Obvious injustice arises from rigid and unbending application of principle • Any justification for not applying principle or applying it with greater discrimination where there is also loss to a trust estate?

35. Should Jersey follow England here? • Mischief at which principle directed can be prevented otherwise in a trust context • How convincing is the Bailiff’s reasoning in Freeman v Ansbacher? • How much weight do the English authorities have in Jersey compared with the Bailiff’s decision in Freeman v Ansbacher? • Where in English authorities is the reasoning for an unbending application of the principle in trust context?

36. Should Jersey follow England here? • One clear situation where principle will not apply: trustees’ authorisation (as sole shareholder/s) of prejudicial corporate action which, in absence of such authorisation, would be the basis of claim by company against directors (act of authorisation as shareholder a breach of duty as trustee but prevents company suing directors)

37. How safe are your trusts’ assets? The risks faced by third party tracing claims and fraud By Virginia Rylatt

38. Investment in English Companies Relianceon auditors’ reports to confirm accounts of a company give a true and fair view?

39. Caparo Industries v Dickman [1990] 2 AC 605

40. Stone & Rolls Limited In Liquidation v  Moore Stephens (a firm)

41. False letters or credit Funds Komercni Banka A.S. (“K.B.”) Stone & Rolls Funds paid to 3rd parties connected to Mr Stojevic (S&R’s Manager, Shadow Director and Mr Stojevic held a Power of Attorney)

42. Ex Turpi Causa The principle of public policy Ex Turpi Causa was explained by Lord Mansfield CJ in Holman v Johnson (1775) 1Cowp 341. “No court will lend its aid to a man who founds his cause of action on an immoral or an illegal act. If, from the Plaintiff’s own stating or otherwise, the cause of action appears to arise Ex Turpi Causa.... there the court says that he has no right to be assisted”.

43. Whether the knowledge of Mr Stojevic of the fraud should be attributed to the Company. If so then the Company itself will be part of the fraud and the “Ex Turpi Causa” principle would apply;

44. Whether the “Ex Turpi Causa” principle applied in respect of the auditors’ duty to spot fraud which was “the very thing” it was engaged to do.

45. Moore Stephens application to strike out Stone & Roll’s claim failed before Langley J.

46. Moore Stephens’s Case Stone & Rolls liable for its dishonest acts

47. Liquidator’s Case Stone & Rolls A victim of fraud with a £94m judgment against it.

48. Re: The Hampshire Land Company [1896] Ch 743 The Hampshire Land Principle A company will not have attributed to it knowledge of a fraud when that fraud is against the company itself

49. Moore Stephens’s Case In a one person company the directing mind and will of that person (Mr Stojevic) must be imputed to the company so The Hampshire Land principle does not apply.

50. Court of Appeal Hampshire Land will only apply where the Agent intends to harm the company or it is the target (as opposed to here when the bank was the target)