A recent High Court decision has delivered an important reminder that, although a trading trust can provide a useful mechanism to shield assets from creditors, it does not exempt directors from the duty to protect creditor interests.
Trading trusts have been used in New Zealand since at least the 1970s to run family businesses. A trading trust is a business operated by an asset-less company acting as corporate trustee for named beneficiaries. While legal ownership of any property remains with the company, beneficial ownership is transferred to the beneficiaries of the trading trust.
This delivers a number of advantages to the participants, including the avoidance of restrictive regulations and a more tax-effective distribution of business income (if the income is not distributed to beneficiaries during the year it is earned, or in the following six months). But trading trusts have attracted some controversy, because of the potential for the corporate trustee to defeat the interests of company creditors in the event of insolvency.
The issue of directors’ liability in a trading trust was explored by the High Court in OPC Managed Rehab Limited (in liquidation). The Court was clear that, although OPC was a corporate trustee, the directors owed all the normal obligations applying to company directors.
“If a director knowingly distributes trust assets over which he or she has control in priority to a creditor (in respect of a trust debt), the director breaches a duty not to give away assets of the company for the benefit of third parties to the detriment of a person known to be a creditor”, Heath J ruled. In other words, the directors still have to take into account creditors’ interests.
He also indicated that, although a trading trust may be used for legitimate purposes, the courts would in each case “consider the intention of those who settle the trust and trade through this commercial vehicle”. This was because “there is (rightly) a healthy degree of cynicism surrounding its use”, given the potential for an asset-less corporate trustee to defeat the interests of genuine creditors”. OPC was incorporated in April 2000. It contracted with ACC to provide rehabilitation case management services to Pacific Island communities. OPC invoiced ACC for its services. In December 2000, OPC became the trustee of the OPC Managed Rehab Trust (the OPC Trust) and transferred the business assets into the trust.
While to the outside world, including its trade creditors, OPC continued to operate as before, it now held its assets on trust for the benefit of various family trusts related to the company’s directors. OPC ran a “nil balance” policy, making distributions to the beneficiaries each month after payment of all of OPC’s outgoings.
At the expiry of OPC’s contract for services with ACC, ACC ran an audit of claims during the relevant contractual periods and formed a view that there had been an over-payment.
OPC was put into liquidation in 2006 when it was unable to meet ACC’s statutory demand for the outstanding sum as, by that time, all money received from ACC had either been paid out to beneficiaries of the OPC trust or used to meet day to day operating expenses.
The liquidators sought repayment from both the directors and the beneficiaries. Their case hinged on the contention that the directors ran OPC as an “empty shell” in order to defeat creditors and that they breached various duties owed by each of them to the company, on the basis that they had distributed OPC’s surplus funds to the detriment of the ACC. They sought an order that the two directors repay $1.45 million to OPC.
But the Court rejected this argument, saying: “I do not consider that any unconscionable conduct has occurred. Moneys were distributed to beneficiaries in circumstances where (the trustees) had paid all outstanding creditors known to them and had no knowledge of the accumulation of any further debt to OPC, by way of overcharging”.
However, importantly, the Court distinguished between disbursements made from the OPC Trust after 2 October 2002; which was the date when ACC first informed the directors of the audit results and the debt owed to ACC. Two payments were issued after that time – each for $4000.40 – and the Court has ordered that these be repaid.
So the facts of this case did not show impropriety. However, the result would have been very different had, say, the trust structure been used knowingly to avoid creditor payments and the directors had made distributions to beneficiaries without paying creditors first.
The OPC case shows that trading trusts can be used for proper purposes, but is also a useful reminder that directors of trading trusts are subject to the same duties as directors of private companies operating in the same way.
Regardless of whether directors are making distributions to shareholders or trust beneficiaries, they must be careful to remember their duty to act in a company’s best interests. Our courts have consistently said that this duty includes taking into account the interests of creditors.