Equitable remedies and tracing - Availability and limitations of tracing in equity

Learning Outcomes

This article outlines the equitable remedy of tracing, explaining how beneficiaries can identify and follow trust property that has been wrongfully transferred or mixed with other assets. It covers the prerequisites for tracing in equity, the specific rules applied when tracing into mixed funds or bank accounts, and the key defences that may defeat a tracing claim. Understanding these principles is essential for advising clients on potential remedies for breach of trust in the SQE1 assessments. Your comprehension will enable you to apply these rules to SQE1-style single best answer MCQs.

SQE1 Syllabus

For SQE1, you are required to understand the practical application of equitable tracing as a remedy for breach of trust. This involves identifying the circumstances in which tracing is available, the necessary preconditions, and the various rules and limitations that apply, particularly in relation to mixed funds.

As you work through this article, remember to pay particular attention in your revision to:

• The distinction between common law and equitable tracing, focusing on the requirements for tracing in equity.
• The requirement for a fiduciary relationship and an equitable proprietary interest.
• The process of tracing into substitute assets and mixed funds.
• The specific rules applicable to tracing into mixed bank accounts (Re Hallett, Re Oatway, Clayton's Case).
• Limitations on tracing, including dissipation and the defence of bona fide purchaser for value without notice.
• The relationship between tracing and other equitable remedies like constructive trusts and equitable liens.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is a prerequisite for tracing in equity?
   1. A contractual relationship between the claimant and defendant.
   2. The property must remain in its original form.
   3. The existence of a fiduciary relationship.
   4. The claimant must have suffered a quantifiable financial loss.
2. A trustee mixes £10,000 of trust money with £5,000 of their own money in their personal bank account. They then withdraw £5,000 and spend it on a holiday. According to the rule in Re Hallett's Estate, which money is presumed to have been spent?
   1. The trust money.
   2. The trustee's own money.
   3. A proportionate mix of both.
   4. The money deposited last.
3. Against which party is an equitable tracing claim least likely to succeed?
   1. The wrongdoing trustee.
   2. An innocent volunteer who received the property as a gift.
   3. A bona fide purchaser for value without notice.
   4. A person who dishonestly assisted the breach of trust but did not receive the property.

Introduction

When trust property is misapplied by a trustee in breach of trust, beneficiaries may seek remedies to recover the loss. While a personal claim against the trustee for compensation is available, it may be ineffective if the trustee is insolvent. Equity provides a more powerful set of remedies through the process of tracing, allowing beneficiaries to follow the trust property or its proceeds into the hands of the trustee or even third parties. This article explores the availability and limitations of tracing in equity.

Key Term: Tracing
A process by which a claimant demonstrates what has happened to their property, identifies its proceeds or substitutes, and justifies a claim that the proceeds or substitute can properly be regarded as representing their property. Tracing is not a remedy itself but a preliminary step to establish a proprietary claim.

Tracing in equity differs significantly from tracing at common law. Common law tracing requires the property to remain identifiable and unmixed. Equity, however, can trace property even when it has been mixed with other property or has changed form, provided certain conditions are met.

Availability of Tracing in Equity

To trace property in equity, two main prerequisites must usually be satisfied:

1. A Fiduciary Relationship: Historically, equity required a fiduciary relationship (e.g., trustee-beneficiary) to exist between the claimant and the person who misapplied the property. This requirement has been questioned, but it remains a conventional starting point. The relationship provides the jurisdictional basis for equity's intervention.
2. An Equitable Proprietary Interest: The claimant must have a pre-existing equitable proprietary interest in the property being traced. A beneficiary under a trust clearly satisfies this requirement.

Key Term: Fiduciary Relationship
A relationship where one party (the fiduciary, e.g., a trustee) owes special duties of loyalty, trust, and confidence to another party (the principal or beneficiary) and must act in that party's best interests.

Key Term: Equitable Proprietary Interest
An interest in property recognised and enforced by equity, such as the interest of a beneficiary under a trust. It allows the interest holder to assert rights against the property itself.

Once these prerequisites are met, tracing can proceed, allowing the claimant to follow the trust property through various substitutions and mixtures.

The Process of Tracing in Equity

Equitable tracing allows beneficiaries to follow trust property even when it changes form or becomes mixed with other assets. The specific rules applied depend on how the property has been dealt with.

Clean Substitution

If the trustee uses trust property exclusively to acquire a new asset (a "clean substitution"), the beneficiaries can choose either:

• To take the substitute property itself (electing to treat it as trust property). This is advantageous if the substitute property has increased in value.
• To take a charge (an equitable lien) over the substitute property to secure their personal claim against the trustee for the value of the original trust property misapplied. This is advantageous if the substitute property has decreased in value.

Tracing into Mixed Funds

Tracing becomes more complex when trust property is mixed with other money, typically the trustee's own funds or funds from another trust.

Mixing Trust Funds with Trustee's Own Funds

If a trustee mixes trust funds with their own money in an asset or a bank account, equity applies rules designed to protect the beneficiaries against the wrongdoing trustee.

• Purchasing Assets with Mixed Funds: If the trustee uses the mixed fund to purchase an asset, the beneficiaries can choose either:

  • To claim a proportionate share of the asset (beneficial if the asset increased in value).
  • To claim an equitable lien over the asset for the amount of trust money used (beneficial if the asset decreased in value).

• Withdrawals from a Mixed Bank Account: If the trustee makes withdrawals from a bank account containing mixed trust and personal funds:

  • The Rule in Re Hallett's Estate (1880): The trustee is presumed to spend their own money first. Any money spent on traceable assets or remaining in the account is presumed to be trust money first.
  • The Rule in Re Oatway (1903): If the Re Hallett rule would lead to an unjust result (e.g., the trustee buys an asset with the first withdrawal and dissipates the rest), the beneficiaries can claim a first charge over the asset purchased, effectively asserting that trust money was used first for traceable investments. Equity presumes against the wrongdoer.
  • Lowest Intermediate Balance: The beneficiaries' claim against the mixed bank account is limited to the lowest balance the account reached after the trust money was paid in and before any subsequent deposits of the trustee's own money (Roscoe v Winder (1915)). Subsequent deposits by the trustee are not presumed to replace trust money unless intended as such.
  • No Backwards Tracing (Generally): Traditionally, trust money cannot be traced into an asset acquired before the trust money was received, even if the trustee intended to use the trust money to pay for it (e.g., repaying a loan taken out to buy the asset). However, the Privy Council in Federal Republic of Brazil v Durant International Corporation (2015) allowed backward tracing where there was a close transactional link between the dissipation of trust funds and the acquisition of the asset, suggesting some flexibility where there is a coordinated scheme.

Key Term: Equitable Lien
A charge over property imposed by equity to secure a monetary claim, giving the claimant priority over unsecured creditors and the right to seek a court order for sale of the property to satisfy the debt.

Mixing Funds from Two Trusts or Trust and Innocent Volunteer

If a trustee mixes funds from two different trusts, or mixes trust funds with money belonging to an innocent third party (a volunteer who received the money without notice of the breach), the rules aim for fairness between the innocent parties.

• Purchasing Assets with Mixed Innocent Funds: The beneficiaries of the different trusts (or the trust and the innocent volunteer) share ownership of the asset proportionately (pari passu) according to their contributions. They share any increase or decrease in value rateably.

• Withdrawals from a Mixed Innocent Bank Account:

  • The Rule in Clayton's Case (1816): The traditional rule is "first in, first out" (FIFO). The first sum paid into the account is presumed to be the first sum withdrawn.
  • Pari Passu Distribution: Clayton's Case can lead to arbitrary results and is often displaced where impractical or unjust (e.g., numerous small investors in a failed scheme). Courts may instead favour a pari passu approach, sharing the remaining funds or traceable assets proportionately among the innocent claimants (Barlow Clowes International Ltd v Vaughan (1992)).

Worked Example 1.1

Tariq, a trustee, misappropriates £20,000 from the Smith Trust. He pays this into his personal bank account, which already contains £10,000 of his own money. He then withdraws £15,000 to buy shares in XYZ plc. Later, he withdraws the remaining £15,000 and spends it on a luxury holiday (dissipation). The shares are now worth £18,000. What proprietary claim can the beneficiaries of the Smith Trust make?

Answer: The trustee mixed trust funds (£20,000) with his own (£10,000). Applying the rule in Re Hallett's Estate, the trustee is presumed to spend his own money first. However, this would mean the £15,000 shares were bought with £10,000 of his own money and £5,000 of trust money, and the dissipated £15,000 included £15,000 of trust money. This disadvantages the beneficiaries. Applying the rule in Re Oatway, the beneficiaries can assert a charge over the mixed fund and choose to trace into the shares first. They can claim that £15,000 of trust money was used to buy the shares. As the shares have increased in value to £18,000, the beneficiaries can claim the shares themselves or a proportionate share. Here, as £15,000 of the £15,000 used was trust money (according to the most favourable tracing rule), they could claim the full £18,000 value. Alternatively, if the £15,000 withdrawal used £10,000 of Tariq's money and £5,000 trust money (Re Hallett), they could claim a lien for £20,000 (their loss) over the shares and remaining dissipated funds, or a proportionate share of the shares (£5k/£15k * £18k = £6k) plus the remaining £15k traceable to the dissipated funds (which is lost). Claiming the shares under Re Oatway seems most advantageous.

Limitations on Tracing in Equity

The right to trace in equity, while powerful, is not absolute and can be lost in several circumstances.

Dissipation

If the trust property or its proceeds have been dissipated without leaving any substitute asset, tracing is impossible. Examples include money spent on general living expenses, unsecured debts, or assets that have been destroyed (e.g., wine that has been drunk, money lost gambling).

Key Term: Dissipation
The spending or destruction of property in such a way that it leaves no traceable product or substitute asset.

Bona Fide Purchaser for Value Without Notice

Tracing cannot be pursued against a person who acquires legal title to the property for valuable consideration (value) in good faith (bona fide) and without notice (actual, constructive, or imputed) of the pre-existing equitable interest. This is often referred to as "equity's darling." The purchase extinguishes the beneficiary's equitable proprietary interest.

Inequitable Result

Tracing is an equitable process, and the court will not permit it where it would lead to an inequitable result. This defence is most relevant regarding innocent volunteers. For example, if an innocent volunteer uses mixed trust money and their own money to make improvements to their existing property (e.g., building an extension), it is generally considered inequitable to force a sale of their property to satisfy the trust's claim, especially if the improvements did not significantly increase the property's overall value (Re Diplock (1948)). This is sometimes known as the Re Diplock defence or the defence of change of position where it would be unfair to require repayment.

Worked Example 1.2

A trustee mistakenly pays £5,000 of trust money to Fiona, an innocent volunteer who believes it is a legacy she was expecting. Fiona uses the £5,000, along with £1,000 of her own savings, to install a new bathroom in her house. The installation does not increase the market value of her house. Can the beneficiaries trace the £5,000?

Answer: Fiona is an innocent volunteer. The trust money has been mixed with her own funds and used to improve her existing property. Although the money has been used to acquire an asset (the bathroom), forcing Fiona to sell her house to repay the £5,000 would likely be considered inequitable under the principles established in Re Diplock. The value of the house has not increased, making it difficult to identify a traceable 'product'. Tracing is unlikely to succeed. The beneficiaries may have a personal claim against the trustee or, potentially, a limited personal claim against Fiona under the Re Diplock principles if other remedies are exhausted.

Revision Tip

When faced with a tracing problem, always identify: 1. Is there a fiduciary relationship and equitable interest? 2. Has the property been mixed or substituted? 3. Who currently holds the property or its proceeds (trustee, volunteer, purchaser)? 4. Apply the correct tracing rules based on the parties involved. 5. Consider if any defences (dissipation, bona fide purchaser, inequitable result) apply.

Key Point Checklist

This article has covered the following key knowledge points:

• Tracing in equity allows beneficiaries to follow trust property or its proceeds, even when mixed or transformed.
• Prerequisites typically include a fiduciary relationship and an equitable proprietary interest held by the claimant.
• Tracing is possible into substitute assets and mixed funds.
• Specific rules apply to tracing into mixed bank accounts, including Re Hallett, Re Oatway, and potentially Clayton's Case or pari passu distribution for innocent parties.
• The lowest intermediate balance rule limits claims against mixed bank accounts. Backward tracing is generally not permitted but exceptions may exist.
• Tracing is defeated by dissipation of the property, or transfer to a bona fide purchaser for value without notice.
• Tracing may be denied if it would produce an inequitable result, particularly against innocent volunteers (the Re Diplock defence / change of position).

Key Terms and Concepts

• Tracing
• Fiduciary Relationship
• Equitable Proprietary Interest
• Equitable Lien
• Dissipation