Equitable remedies and tracing - Comparison between common l...

Learning Outcomes

This article explains the comparative law of tracing at common law and in equity, including:

• the distinction between following and tracing, and the evidential nature of the tracing process;
• the requirements for common law and equitable tracing, with emphasis on fiduciary relationships and equitable proprietary interests;
• the operation of tracing where trust money is mixed with a trustee’s own funds, including Re Hallett’s Estate, Re Oatway and the lowest intermediate balance rule;
• the rules governing mixtures between two trusts or with an innocent volunteer, focusing on Clayton’s Case, pari passu sharing and fairness between innocent parties;
• the limits on tracing through bank accounts, the “no backwards tracing” principle and the coordinated scheme exception;
• the impact of dissipation, transfer to a bona fide purchaser for value without notice and other equitable constraints on proprietary claims;
• the range of proprietary remedies available after successful tracing, including constructive trusts, equitable liens and subrogation, and how these interact with personal claims for breach of trust;
• the practical implications of these principles for analysing SQE1-style multiple-choice questions and structured problem scenarios involving misapplied trust assets.

SQE1 Syllabus

For SQE1, you are required to understand the principles of tracing both at common law and in equity, particularly in the context of trusts and breach of fiduciary duty, and to be able to apply these rules to practical scenarios, with a focus on the following syllabus points:

• The distinction between tracing at common law and tracing in equity, including their respective limitations.
• The requirements for equitable tracing, namely a fiduciary relationship and an equitable proprietary interest.
• The rules applicable when tracing into mixed funds, including funds mixed by a trustee with their own money (Re Hallett’s Estate, Re Oatway), and funds mixed belonging to two trusts or an innocent volunteer (Clayton’s Case, pari passu sharing).
• The circumstances where the right to trace may be lost, including dissipation and transfer to a bona fide purchaser for value without notice (BFPFVWN).
• Defences available against an equitable tracing claim, such as change of position.
• The link between successful tracing and the availability of proprietary remedies.
• The limitations applicable to tracing into bank accounts (lowest intermediate balance), and when the coordinated scheme exception permits “backwards tracing”.
• How proprietary claims interact with personal claims for breach of trust and where subrogation may be used to replicate extinguished security rights.

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 form of tracing is generally unable to proceed once money is mixed in a bank account?
   1. Equitable tracing
   2. Common law tracing
   3. Both forms
   4. Neither form
2. A trustee mixes £5,000 of trust funds with £5,000 of their own money in an account. They then withdraw £5,000 and buy shares, which later increase in value. The remaining £5,000 is dissipated. Which principle allows the beneficiaries to claim the shares?
   1. Re Hallett's Estate
   2. Re Oatway
   3. Clayton's Case
   4. Lowest intermediate balance rule
3. What defence allows an innocent recipient of misapplied trust property to resist a proprietary claim if they have acted in good faith to their detriment based on the receipt?
   1. Bona fide purchaser for value without notice
   2. Laches
   3. Dissipation
   4. Change of position

Introduction

When property is misappropriated or misapplied, particularly in breach of trust or fiduciary duty, the rightful owner or beneficiary will want to recover it or its value. The legal process of identifying the property as it changes hands or form is known as tracing. It is important to distinguish tracing from the remedies available once property is identified; tracing itself is merely an evidential process. English law offers two distinct tracing mechanisms: common law tracing and equitable tracing. Understanding their differences, requirements, and limitations is essential for advising clients and succeeding in the SQE1 assessment. Equitable tracing, in particular, provides valuable tools for recovery where funds become mixed, a common issue in trust disputes.

Key Term: Tracing
The process of identifying a new asset as the substitute for an old one. It enables the claimant to identify their property or its value in the hands of another.

A second essential distinction is between following and tracing. Following is concerned with the physical asset, tracing with the value.

Key Term: Following
The process of pursuing the same asset as it moves from hand to hand. This is the primary mechanism available at common law.

Frequently, a claimant will both follow and trace across a series of transactions: follow the original asset while it remains identifiable, then trace into its proceeds or substitutes when the asset is swapped for another. Appreciating when common law rules run out and when equitable rules take over is central to applying the correct approach.

Related point: proprietary versus personal responses

Tracing is the route to a proprietary remedy: once the asset (or its substitute) is identified, the claimant may seek a constructive trust or an equitable charge/lien over that asset. By contrast, a personal claim (e.g., for breach of trust or undue enrichment) is against the defendant’s general assets and does not require identifying a specific asset. The sensible strategy is often to pursue both routes in parallel when available.

Common Law Tracing

Tracing at common law is based on the claimant asserting their legal title to the original property. It involves following the specific asset from person to person. Because the common law acts on specific assets, it is exacting about identity. If the asset loses its identity through mixing with assets of the same kind, tracing at common law is usually defeated.

The major constraint of common law tracing is its inability to function effectively once the claimant's property loses its specific identity through mixing with other property of the same kind. This is particularly true for money. If £100 cash is mixed with other cash, or paid into an active bank account containing other funds, the common law typically regards its identity as lost, and tracing ceases. This significantly limits its utility in many commercial and trust scenarios.

Common law tracing can, however, operate effectively where the asset or its direct proceeds remain unmixed and identifiable (e.g., a separate envelope of sale proceeds or a segregated bank account with no other credits or debits).

Worked Example 1.1

A client entrusts a unique painting to an agent for sale. The agent sells the painting for £5,000 cash and places this specific cash in a separate, labelled envelope. Before the agent can pass the money to the client, the agent becomes bankrupt. Can the client recover the £5,000 cash using common law tracing?

Answer:
Yes. At common law, the client can follow the painting to the purchaser (though the purchaser might have a defence). Importantly, the client can also trace the value into the specific £5,000 cash, as it is the identifiable, unmixed proceeds of their property, kept separate by the agent.

Related Topic: Bankruptcy / Insolvency 🔗

Establishing a proprietary claim through tracing can give a claimant priority over general creditors in an insolvency situation.

Equitable Tracing

Equity developed more sophisticated tracing rules, primarily to provide remedies for beneficiaries whose trust property had been misapplied, especially when mixed with other funds.

Prerequisites for Equitable Tracing

Generally, two conditions must be met for a claimant to trace in equity:

1. Fiduciary Relationship: There must be a pre-existing fiduciary relationship between the claimant and the party who misapplied the property (e.g., trustee-beneficiary, director-company). This establishes the basis for equity's jurisdiction. The courts have sometimes found such a relationship arises from the very act of misappropriation itself.
2. Equitable Proprietary Interest: The claimant must demonstrate they held an equitable proprietary interest in the original property (e.g., the beneficiary's interest under a trust).

Key Term: Fiduciary Relationship
A relationship where one party (fiduciary) owes duties of loyalty and good faith to another (principal/beneficiary), such as a trustee to a beneficiary.

Key Term: Equitable Proprietary Interest
An ownership interest in property recognised in equity, separate from the legal title, held for example by a trust beneficiary.

Practically, these requirements are usually straightforward to satisfy in trust cases. Academic debate exists as to whether a fiduciary relationship is a strict prerequisite for equitable tracing. Nonetheless, in the standard trust scenario, the presence of trusteeship removes difficulty. Focus then turns to what happened to the property and whether it can still be identified in some form.

Advantages over Common Law

The principal advantage of equitable tracing is its ability to follow the value of the claimant's property even when it has been mixed with other property, including money in a bank account, or used to acquire a new asset. Equity focuses on the value, not the specific physical item. It also allows the claimant to take advantage of increases in value of the substituted asset and to choose the most favourable proprietary response available.

Tracing into Mixed Funds

Equity applies different rules depending on whose money has been mixed.

Trustee Mixes Trust Funds with Own Funds

When a trustee (or other fiduciary acting wrongly) mixes trust money with their own personal funds in an account, equity applies presumptions against the wrongdoing trustee to protect the beneficiary:

1. Presumption of Honesty / Trustee Spends Own Money First (Re Hallett’s Estate): If the trustee withdraws money from the mixed account and dissipates it (spends it untraceably), they are presumed to have spent their own money first. The remaining balance, up to the amount of the trust money originally deposited, is presumed to belong to the trust.
2. Beneficiary's Right to Trace into Investments (Re Oatway): If the trustee withdraws money from the mixed account to purchase an asset (e.g., shares) and dissipates the rest, the beneficiary can trace their funds into the purchased asset. This prevents the trustee from claiming the profitable investment was made with their own money while the trust money was dissipated. The beneficiaries effectively get the 'first choice' to follow their money into the most advantageous outcome.
3. Lowest Intermediate Balance Rule (Roscoe v Winder): The trust's claim against the mixed bank account is limited to the lowest balance the account reached after the trust money was deposited but before any subsequent personal deposits by the trustee. Later deposits of the trustee's own money are not treated as repaying the trust unless this was clearly intended.

Key Term: Dissipation
The spending or use of funds in such a way that no asset or value remains which can be identified or claimed (e.g., spending on a holiday, general living expenses, or settling unsecured debts).

Key Term: Mixed Fund
A fund (e.g., a bank account) containing assets or money from more than one source, where the original components are no longer separately identifiable.

Key Term: Re Hallett's Estate presumption
The equitable presumption that where a trustee mixes trust funds with their own and makes withdrawals, they are deemed to spend their own money first.

Key Term: Re Oatway presumption
The equitable principle allowing beneficiaries to trace their money into an asset purchased from a mixed fund by a trustee, even if the trustee's own money was sufficient to cover the purchase, especially if the remaining funds are dissipated.

Key Term: Lowest Intermediate Balance
The rule limiting a proprietary claim against a mixed bank account to the lowest balance recorded after the claimant's money was paid in but before any subsequent deposits by the wrongdoer.

The reason Re Hallett and Re Oatway appear to point in different directions is that both are applications of a single equitable idea: everything is presumed against the wrongdoer. Use the rule that produces the fairest outcome for the beneficiaries on the facts.

In addition, where trust funds are used to acquire an asset that later appreciates, beneficiaries may elect to take a proportionate share in the asset (reflecting the trust’s contribution) and so benefit from the increase, or to take a charge/lien for the amount of the misapplied funds. The choice depends on which course is more advantageous.

Worked Example 1.2

A trustee mixes £20,000 of trust money with £10,000 of their own in a bank account (Total £30,000). The trustee then withdraws £15,000 to buy antique furniture (now worth £18,000). Later, they withdraw £10,000 which they spend on an expensive holiday (dissipation). £5,000 remains in the account. What can the beneficiaries claim?

Answer:
Re Oatway allows the beneficiaries to claim the purchased asset where the remaining balance has been dissipated. The trust can assert a proprietary claim against the furniture up to £15,000 (the amount of trust money traceable into it) and claim the £5,000 balance. Because the furniture has risen to £18,000, they may also elect to claim a proportionate share of the furniture reflecting the trust’s contribution (here, the entire £15,000 price was traceable to the trust on the Re Oatway analysis). Overall, the beneficiaries can recover value at least equal to £20,000 and potentially benefit from the increase in the furniture’s value.

Mixing Funds of Two Trusts / Trust + Innocent Volunteer

When a trustee mixes funds from two different trusts, or when trust funds become mixed with the funds of an innocent volunteer (someone who received the trust property without giving value and without notice of the breach), the rules are designed to achieve fairness between the innocent parties:

1. Clayton's Case Rule (FIFO - First In, First Out): The traditional rule presumed that money withdrawn from an active bank account was withdrawn in the same order it was deposited. This rule is often criticised as arbitrary and is now frequently displaced.
2. Pari Passu (Proportionate Sharing): The preferred modern approach, particularly where FIFO is impractical or unjust, is to share the remaining funds, or any asset acquired from them, rateably (pari passu) in proportion to the contributions made by the innocent parties (e.g., Barlow Clowes v Vaughan).

Key Term: Innocent Volunteer
A person receiving trust property (or its traceable proceeds) without providing consideration (value) and without having notice of the breach of trust.

Key Term: Clayton's Case rule
The traditional (often displaced) common law rule for mixed bank accounts that money is presumed to be withdrawn in the order it was deposited ('First In, First Out').

Key Term: Pari Passu
Meaning 'on equal footing'; a method of distributing assets or losses proportionally among parties based on their initial contribution or claim size.

Where misapplied funds are mixed with an innocent volunteer’s own funds and spent on improving land (e.g., adding an extension to a house owned by the volunteer), it may be inequitable to impose a proprietary claim if that would force a sale of the volunteer’s home. In such cases, equity may refuse a proprietary claim, leaving a personal claim (subject to defences), or apply rateable sharing only where a fund remains.

Worked Example 1.3

A trustee wrongly takes £6,000 from Trust A and £4,000 from Trust B, paying both sums into a new account (Total £10,000). The trustee withdraws £5,000 to buy shares. £5,000 remains. How might the funds/shares be allocated between the trusts?

Answer:
Clayton's Case (FIFO) would suggest the £5,000 shares were bought entirely with money from Trust A (first in), leaving the £5,000 balance belonging £1,000 to Trust A and £4,000 to Trust B. The more likely modern approach (pari passu) would allocate the shares and the remaining cash proportionately. Trust A contributed 60%, Trust B 40%. Therefore, Trust A gets 60% of the shares and 60% of the cash (£3,000 + £3,000 = £6,000). Trust B gets 40% of the shares and 40% of the cash (£2,000 + £2,000 = £4,000).

Tracing through bank accounts: limits and exceptions

Two well-known limitations are the “lowest intermediate balance” rule and the general prohibition on “backwards tracing”. There is, however, a recognised exception where the steps form part of a coordinated scheme.

Key Term: Backwards tracing (coordinated scheme exception)
An exception allowing tracing into assets acquired before misapplied funds are paid out, where the court is satisfied that the transactions formed part of a coordinated scheme to defeat tracing and the later payments were part of the financing of the earlier acquisition.

The key point is that the law looks at substance. If the wrongdoer uses a web of accounts and timing to disguise that trust money financed the asset (e.g., repaying a bridging loan used to acquire it), a court may permit tracing notwithstanding the usual chronological barrier.

Worked Example 1.4

A trustee pays £10,000 of trust money into a personal current account with a £2,000 credit balance. Several small withdrawals occur, leaving the account at a low of £500 before a later deposit of £7,000 of the trustee’s salary takes the balance to £7,500. The beneficiaries seek to trace into the account. How much can they claim?

Answer:
The lowest intermediate balance rule limits the proprietary claim to £500 (the lowest balance after the trust money was paid in and before any later deposits). Later deposits by the trustee are not treated as replacing the trust money unless specifically intended as restitution. The beneficiaries cannot claim more than £500 from the account, although they may have a personal claim against the trustee for any shortfall.

Worked Example 1.5

A fiduciary obtains an asset using a short-term facility, then a few days later channels misapplied trust funds through a sequence of accounts to repay that facility. The fiduciary argues the later trust money cannot be traced into the asset because the asset was acquired earlier with loan finance. Can the beneficiaries still trace?

Answer:
Yes, potentially. If the beneficiaries can show the withdrawals and repayments formed part of a coordinated scheme to use trust money to finance the acquisition (concealed by timing and movement between accounts), a court may allow “backwards tracing” so the proprietary claim reaches the asset notwithstanding the usual chronology.

Worked Example 1.6

A trustee misdirects £30,000 of trust money to an innocent volunteer (the trustee’s parent), who in good faith uses it to fund an extension to a home they already own. The house value does not increase by the same amount and a sale would be disruptive. The beneficiaries seek a proprietary charge over the house. Is that appropriate?

Answer:
Equity may refuse a proprietary remedy in these circumstances because it would be inequitable to impose a charge that forces a sale against an innocent volunteer and the improvement is inseparable from the land. A personal claim for restitution against the volunteer may be available, but the volunteer may also raise a change of position defence if they acted in good faith and have irreversibly altered their position.

Defences to Equitable Tracing Claims

The right to trace in equity can be lost or defended against:

1. Bona Fide Purchaser for Value Without Notice (BFPFVWN): If legal title to the asset (or its traceable product) passes to a BFPFVWN, the equitable interest is destroyed. Tracing stops. This is the strongest defence.
2. Dissipation: As noted, if the property or its value ceases to exist in any identifiable form, tracing is impossible.
3. Inequitable Result: Equity will not permit tracing if it would produce an unjust outcome, particularly against an innocent volunteer (e.g., forcing the sale of a home improved with traced funds).
4. Change of Position: An innocent volunteer who, acting in good faith, irreversibly changes their circumstances relying on the receipt may have a defence against a restitutionary claim based on tracing. This defence requires more than just spending the money; it needs a demonstrable, detrimental change linked to the receipt.

Key Term: Bona Fide Purchaser for Value Without Notice
An innocent party who purchases legal title to property for valuable consideration without any notice (actual, constructive, or imputed) of prior equitable claims.

Key Term: Change of Position
A defence in restitution law available to an innocent recipient who has detrimentally changed their position in reliance on the receipt, making full repayment inequitable.

Two points are worth emphasising. First, change of position is primarily a defence to personal restitutionary claims; proprietary claims may be refused where it would be inequitable to impose them, arriving at the same practical outcome. Secondly, the BFPFVWN defence turns on the purchaser taking legal title for value without notice; if they merely receive an equitable title or gave no value, the defence fails.

Associated Remedies

If tracing successfully identifies property or its value, the claimant can seek proprietary remedies from the court, including:

• An order declaring the claimant owns the asset (or a proportionate share), typically via a constructive trust. This allows the claimant to benefit from increases in value, but also to bear a share of any decrease.
• An equitable charge or lien over the asset for the value traced. This secures repayment up to the traced sum (with priority on insolvency) but does not give a share of profits.
• Subrogation to extinguished rights, particularly where misapplied funds were used to discharge a secured debt. Subrogation puts the claimant in the shoes of the paid-off creditor so they can assert the security that would otherwise be lost.

Choice of remedy is strategic. If the substituted asset has increased in value, a constructive trust over a share is often preferable. If the asset has decreased in value or is volatile, or where the claimant wishes to retain flexibility, an equitable lien may be safer. Where misapplied funds have paid off a mortgage or similar security, subrogation replicates the position the claimant would have had if their money had been earmarked to create the security from the outset.

Worked Example 1.7

A trustee misapplies trust money to pay off the final £100,000 of a bank’s first legal mortgage over a property owned by the trustee personally. The beneficiaries seek to assert priority over later creditors of the trustee. What proprietary remedy best protects them?

Answer:
Subrogation to the discharged mortgage is appropriate. The beneficiaries are subrogated to the bank’s former security and can claim as if the mortgage in favour of the bank still existed to the extent of the £100,000 payment. This places them ahead of unsecured creditors and subsequent encumbrancers who would otherwise take free of an extinguished security.

Summary

The table below summarises the key differences between the two tracing methods.

Key Point Checklist

This article has covered the following key knowledge points:

• Tracing is a process to identify property, not a remedy.
• Following concerns the same asset; tracing concerns value as it changes form.
• Common law tracing follows specific assets but is usually defeated by mixing, especially of money.
• Equitable tracing requires a fiduciary link and an equitable interest (noted debate notwithstanding).
• Equity allows tracing through mixed funds and into substitute assets.
• Specific rules apply depending on who mixed the funds (trustee vs. innocent parties).
• Re Hallett presumes trustees spend their own money first from a mixed fund.
• Re Oatway allows beneficiaries to claim assets purchased from a mixed fund, ensuring wrongdoers do not benefit from their choices.
• The lowest intermediate balance rule limits claims against mixed bank accounts; later deposits are not automatically treated as reimbursement.
• Between innocents, Clayton's Case (FIFO) is often displaced by proportionate (pari passu) sharing.
• The coordinated scheme exception can justify “backwards tracing” despite usual chronological limits.
• Tracing is defeated by dissipation or transfer to a BFPFVWN.
• Defences like change of position or inequitable result may protect innocent volunteers.
• Successful tracing enables proprietary remedies (e.g., constructive trust, charge/lien) and, where appropriate, subrogation to extinguished securities.

Key Terms and Concepts

• Tracing
• Following
• Fiduciary Relationship
• Equitable Proprietary Interest
• Dissipation
• Mixed Fund
• Re Hallett's Estate presumption
• Re Oatway presumption
• Lowest Intermediate Balance
• Clayton's Case rule
• Pari Passu
• Bona Fide Purchaser for Value Without Notice
• Innocent Volunteer
• Change of Position
• Backwards tracing (coordinated scheme exception)