Trustee Directors Liability Update

Introduction

Background

Using a trust to own investment assets has advantages from both a tax and an asset protection perspective. However, many investors mistakenly assume that if a problem arises and the trustee of a trust is sued, they can merely change the trustee and thereby escape any liability, keeping the assets held within the trust safe from attack. What these investors have perhaps not been made aware of is a legal concept called the trustee’s “right of indemnity”.

In a nutshell what this means is that the trustee (whether the trustee is a real person or a company) has a right to be indemnified out of the trust assets for liabilities the trustee properly incurs in the conduct of the role of trustee. Assume for example that a trustee owned a substantial share portfolio and several rental properties. If the trustee negligently failed to repair some dodgy stairs at one of the rental properties and that resulted in an injury to the tenant then all the assets of the trust would be at risk when the tenant successfully sued the trustee. The tenant when seeking to enforce a judgement against the trustee would “step into the shoes” of the trustee and be able to sell the properties and shares to recover the judgment debt.

 

Liability of corporate trustees

Liability of corporate trustees

A prudent asset protection step is for investors to not personally be the trustee of their trust but rather to set up a company to act as trustee with the investors merely as the directors of the trust. A great benefit of using a company is that it is a separate legal “person” to its directors and shareholders and this creates an additional element of separation between the investor and their assets. However, as noted above it’s not just a case of discarding your “$2 company” and slotting in a new one if there’s a problem on the horizon. There is an innocuous section of the Corporations Act which has potentially significant consequences for directors of company trustees.

What section 197(1) of the Corporations Act says is that if a trustee company incurs a liability and subsequently loses its right to indemnity (due for example to it action outside the scope of its permitted activities under the trust deed) then the directors of the company will be personally liable for the loss. This of course is a complete reversal of the usual scenario of limited liability for directors. Usually, directors only risk personal liability when they are fraudulent, knowingly breach their obligations or permit the company to trade whilst insolvent.

Hanel v O’Neill

The decision of the South Australian Supreme Court in Hanel v O’Neill (2003) 48 ACSR 378 caused caused a great amount of uncertainty and concern about the scope of section 197(1). Prior to Hanel it was generally accepted that directors of trustees would not be held personally liable for the loss if the trustee was acting within the scope of the trust and the trustee’s right of indemnity was not limited by the trust deed. However, two of the three judges in Hanel decided that it was not only where the right to indemnity was lost that s197(1) kicked in but merely where the trusts assets were insufficient to meet the liability. That would mean for example that if the tenant’s damages claim noted above was say $800,000 but the net assets of the trust were only $500,000 then the trustee company’s directors would be personally liable for the whole $800,000 judgment with the company trustee (although the tenant would not be able to recover more than the judgment). In effect this mean trustee directors were guaranteeing the trust and circumvented the asset protection benefits of using the corporate trustee in the first place.

Corporations Law changes

Plainly, the above outcome was not the intent of the legislation. The purpose of s197(1) and its predecessor sections was to ensure that company trustees which had knowingly done wrong could not avoid liability merely because the assets of the trust had then been stripped out. Fortunately, after some extensive lobbying from disparate groups such as the Australian Medical Association and state and federal law societies and accounting bodies, the Government has introduced the Corporation Amendment Bill (No 1) 2005 to clarify the effect of s197(1) and reverse the effect of Hanel’s case.

The amendment will remove the ambiguity in drafting that was exposed in Hanel’s case and return the law to the position it was thought to be prior to the court decision.

The Bill will amend the Corporations Act to ensure that directors of corporate trustees will only be liable in limited circumstances. The existing section 197(1) will be deleted and a new replacement section inserted in its place. The new wording will read:

“A person who is a director of a corporation when it incurs a liability while acting, or purporting to act, as trustee, is liable to discharge the whole or a part of the liability if the corporation:

has no discharge, and cannot discharge, the liability or that part of it; and
is not entitled to be fully indemnified against the liability out of trust assets solely because of one or more of the following:
a breach of trust by the corporation
the corporation’s acting outside the scope of its powers as trustee;
a term of the trust denying, or limiting, the corporation’s right to be indemnified against the liability
The person is liable both individually and jointly with the corporation and anyone else who is liable under this subsection.

Note: “The person will not be liable under the subsection merely because there are insufficient trust assets out of which the corporation can be indemnified”.

The amending regulation was introduced to Parliament on 2 June 2005 and will become effective in relation to this change to s197(1) when it receives the Governor-General’s assent (which should happen later this year.

Not a complete solution

As noted above, generally speaking company directors only risk personal liability when they commit fraud, deliberately breach the law or for insolvent trading. However, under the new section, it seems that directors are potentially liable for breaches by the trustee company, regardless of whether they were involved in that breach.

Without getting too technical, that’s a bit unfair when compared with the position of directors of companies which are not trustees. For example, the directors of a company normally have access to a number of defences to a charge of insolvent trading – those defences would seem to be unavailable to directors of trustee companies facing liability via the operation of s197(1).

Another point of concern is whether the section will operate retrospectively. There is likely to be a small group of directors of trustee companies whose liability may arise in the interim period between the decision in Hanel and the new section becoming operative. The Government should have made it clear that it did intend the section to be operative from the date of the decision in Hanel’s case.

 

Summary

Summary

So once the new section 197(1) is in place we can all rest a little easier as directors of trustee companies. The amendment should consign Hanel’s case (and the two New South Wales decisions which followed it) to the legal scrapheap where they belong. Although the legislative clarification is a positive outcome it’s disappointing that the Government did not remedy both the inequality of position between trustee and non-trustee companies and the effective date issue.

See also

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