Learning Outcomes
This article outlines the circumstances in which third parties may become liable for breaches of trust, either through receiving trust property or assisting in the breach. It also explains the process of equitable tracing to follow misappropriated trust assets. After studying this article, you should understand the concepts of knowing receipt, dishonest assistance, and the rules governing equitable tracing, including relevant defences. This knowledge will assist you in applying legal principles to SQE1 scenarios involving third-party liability in trust matters.
SQE1 Syllabus
For SQE1, you need to understand the different ways third parties can become liable in equity when a breach of trust occurs, and how beneficiaries can recover misappropriated trust property. Pay attention to the following areas covered in this article:
- The distinction between personal and proprietary claims against third parties.
- The requirements for establishing liability for knowing receipt (recipient liability).
- The requirements for establishing liability for dishonest assistance (accessory liability).
- The principles and rules of equitable tracing, including tracing into mixed funds.
- Defences available against equitable tracing claims.
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.
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Which of the following is a necessary element for establishing liability for knowing receipt?
- The third party must have acted dishonestly.
- The third party must have received trust property for their own benefit.
- The third party must have provided consideration for the property.
- The trustee must have acted fraudulently.
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What is the standard required to establish dishonesty for accessory liability?
- Subjective dishonesty based on the third party's own moral code.
- Objective dishonesty based on the standards of reasonable and honest people.
- Negligence in failing to inquire about the trustee's actions.
- Proof of intention to cause loss to the trust.
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Which equitable tracing rule presumes that a trustee spends their own money first from a mixed bank account containing trust funds and their personal funds?
- The rule in Clayton's Case.
- The rule in Re Oatway.
- The rule in Re Hallett's Estate.
- The lowest intermediate balance rule.
Introduction
When a trustee commits a breach of trust, the beneficiaries primarily have personal remedies against the trustee to compensate for any loss. However, if the trustee is insolvent or cannot be found, these remedies may be ineffective. Equity provides further recourse by allowing beneficiaries to pursue claims against third parties who have become involved in the breach, either by receiving trust property or by assisting the trustee. Beneficiaries may also be able to assert a proprietary claim to recover the trust property itself, or its traceable substitute, even if it is in the hands of a third party. This article explores these remedies against third parties.
Liability of Third Parties
Third parties (strangers to the trust) can become liable in equity if they intermeddle in trust affairs, receive trust property knowing it was transferred in breach of trust, or dishonestly assist a trustee in committing a breach. Such liability often takes the form of the third party being treated as a constructive trustee.
Knowing Receipt (Recipient Liability)
A third party may be personally liable to the beneficiaries if they receive trust property transferred in breach of trust, provided certain conditions are met. This liability is often termed 'knowing receipt'.
The key elements are:
- A disposal of trust assets in breach of trust or fiduciary duty.
- The beneficial receipt by the third party of assets traceable to the breach.
- Knowledge on the part of the third party that the assets received are traceable to a breach, making it unconscionable for them to retain the benefit.
The level of knowledge required was clarified in BCCI v Akindele [2001] Ch 437, where the Court of Appeal held that the test is whether the recipient's state of knowledge is such as to make it unconscionable for them to retain the benefit of the receipt. This encompasses actual knowledge, wilfully shutting one's eyes to the obvious, and wilfully and recklessly failing to make inquiries that an honest and reasonable person would make. It may also include knowledge of circumstances that would indicate the facts to, or put on inquiry, an honest and reasonable person.
Key Term: Knowing Receipt
Liability imposed on a third party who receives trust property transferred in breach of trust with sufficient knowledge that the transfer was improper, making retention unconscionable.
Worked Example 1.1
A trustee fraudulently transfers £50,000 from the trust fund to his friend, Fiona. Fiona is told the money is a 'gift' from a successful business deal. However, Fiona knows the trustee has recently faced financial difficulties and has complained about his trustee duties. Fiona uses the money to buy shares. The beneficiaries discover the breach. Can they claim against Fiona?
Answer: Fiona may be liable for knowing receipt. Although she did not have actual knowledge, the circumstances (trustee's financial difficulties, unusual large 'gift') might have put an honest and reasonable person on inquiry. Her knowledge could be deemed sufficient to make retaining the benefit unconscionable under the Akindele test. The beneficiaries could bring a personal claim against Fiona for £50,000 or potentially a proprietary claim against the shares (see Tracing below).
Dishonest Assistance (Accessory Liability)
A third party who does not actually receive trust property can still be personally liable if they dishonestly assist a trustee or fiduciary in committing a breach of trust.
The core requirements are:
- Existence of a trust or fiduciary duty.
- A breach of that trust or duty by the trustee/fiduciary (though the trustee need not act dishonestly).
- Assistance by the third party in the breach.
- Dishonesty on the part of the third party assistant.
The test for dishonesty is objective. As established in Royal Brunei Airlines v Tan [1995] 2 AC 378 and confirmed in Barlow Clowes v Eurotrust [2005] UKPC 37, the court asks whether the third party's conduct was dishonest by the standards of ordinary, decent people, given their actual knowledge and attributes at the time. The third party's subjective view of their own honesty is irrelevant.
Key Term: Dishonest Assistance
Liability imposed on a third party who does not receive trust property but dishonestly aids or procures a breach of trust committed by a trustee or fiduciary.
Worked Example 1.2
An accountant prepares false invoices for a trustee, knowing this will help the trustee misappropriate trust funds for personal use. The accountant does not receive any of the funds but is paid their usual fee. Are they liable?
Answer: The accountant is likely liable for dishonest assistance. There was a breach of trust (misappropriation), the accountant assisted by creating false invoices, and preparing false documents knowingly to facilitate misappropriation would likely be considered dishonest by objective standards. The accountant is personally liable to compensate the trust for the loss caused by the breach they assisted.
Equitable Proprietary Claims and Tracing
Where trust property has been misapplied, beneficiaries may seek to recover the property itself or its substitute through a proprietary claim. This is distinct from a personal claim against the trustee or third party for compensation. Proprietary claims are particularly valuable if the defendant is insolvent, as the beneficiary can claim the specific asset in priority to general creditors.
Key Term: Tracing
The process of identifying trust property as it changes hands or form. It is not a remedy itself, but a mechanism enabling a proprietary claim to be made against the identified property or its substitute.
Tracing allows beneficiaries to follow trust property into the hands of trustees or third parties (except bona fide purchasers for value without notice) and into different forms (e.g., money used to buy shares).
Prerequisites for Equitable Tracing
Two main conditions must usually be met to trace in equity:
- Fiduciary Relationship: There must have been an initial fiduciary relationship (e.g., trustee-beneficiary). This relationship does not need to exist between the claimant and the defendant against whom tracing is sought.
- Traceable Property: The property must remain identifiable, whether in its original form, as a substitute asset, or as part of a mixed fund. If the property has been dissipated (e.g., spent on a holiday, used to pay off an unsecured debt), tracing is generally not possible.
Key Term: Fiduciary Relationship
A relationship where one party (the fiduciary, e.g., a trustee) owes special duties of loyalty and utmost good faith to another (the principal or beneficiary).
Tracing Rules
Different rules apply depending on whether the trust property remains separate or has been mixed with other property.
Clean Substitution
If a trustee uses trust money solely to purchase a new asset (e.g., shares) in their own name, the beneficiaries can choose either to take the new asset itself (including any increase in value) or to take an equitable charge (lien) over the asset to secure their personal claim for the amount misappropriated (useful if the asset has decreased in value).
Key Term: Clean Substitution
Where trust property is exchanged for another asset without being mixed with other funds. The beneficiaries can claim the substitute asset.
Mixed Funds (Trustee's Own Money + Trust Money)
If a trustee mixes trust money with their own personal money in a bank account or uses a mixed fund to buy an asset:
- Presumption against the Wrongdoer: Equity presumes everything against the wrongdoing trustee.
- Re Hallett's Estate Rule: The trustee is presumed to spend their own money first from a mixed bank account. Any remaining balance is presumed to be trust money.
- Re Oatway Rule: If the Re Hallett presumption would prevent the beneficiary tracing into a valuable asset purchased from the account (because the trustee's money would be deemed used first), the beneficiary can instead claim a first charge over the asset purchased with the mixed funds or the remaining balance. Essentially, the beneficiary gets the first choice to trace into the most advantageous asset.
- Lowest Intermediate Balance Rule: The beneficiary's claim against a 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. Later deposits by the trustee are not automatically treated as replacing trust money unless intended as such (Roscoe v Winder).
Key Term: Lowest Intermediate Balance
The principle limiting a tracing claim into a mixed bank account to the lowest balance held between the mixing and the claim, preventing tracing into subsequent deposits of the trustee's own money.
Mixed Funds (Two Trusts or Trust + 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 knowledge of the breach):
- Clayton's Case Rule: Traditionally, the 'first in, first out' (FIFO) rule applied to withdrawals from an active current account. The first sum paid in is presumed to be the first sum paid out.
- Pari Passu (Proportionate Sharing): The courts now often prefer to share the remaining mixed fund or any asset bought from it pari passu (proportionately) between the innocent claimants based on their contributions. This is considered fairer than the arbitrary FIFO rule, especially for savings accounts or where FIFO is impractical or unjust (Barlow Clowes v Vaughan).
Defences to Tracing
A proprietary claim based on tracing can be defeated by certain defences:
- Bona Fide Purchaser For Value Without Notice (BFPFVWN): If trust property passes to someone who gives valuable consideration (is a purchaser) and acts in good faith (bona fide) without any actual or constructive notice of the beneficiary's interest, the beneficiary's equitable interest is extinguished. This person is often called 'Equity's darling'.
Key Term: Bona Fide Purchaser For Value Without Notice
A person who acquires legal title to property for valuable consideration in good faith and without notice (actual, constructive, or imputed) of any pre-existing equitable interests. They take the property free from such interests.
- Change of Position: An innocent volunteer (who received the property without giving value and without knowledge of the breach) may have a defence if they have detrimentally changed their position in reliance on the receipt (e.g., spending the money irrecoverably on a unique, life-changing experience they wouldn't otherwise have afforded). This defence is not available to wrongdoers.
- Dissipation: Tracing ends if the property or its proceeds cease to exist in identifiable form (e.g., money spent on general living expenses, dinner, or paying off an unsecured debt). However, if trust money is used to pay off a secured debt (like a mortgage), the beneficiaries may be subrogated to the lender's security rights.
- Inequitable Result: Equity will not allow tracing if it would produce an unfair or impractical result, particularly against an innocent volunteer (e.g., forcing the sale of a volunteer's home significantly improved using a small amount of trust money).
Worked Example 1.3
A trustee misappropriates £10,000 from Trust A and £20,000 from Trust B, paying both sums into their personal bank account which previously held £5,000 of their own money (Total £35,000). The trustee then withdraws £15,000 to buy shares now worth £18,000. They then withdraw £10,000 and spend it on a holiday (dissipated). £10,000 remains in the account. How can the beneficiaries trace?
Answer:
- Against Trustee's Money First (Re Hallett): The trustee's own £5,000 is deemed spent first.
- First Withdrawal (£15K for shares): The remaining £10,000 of the trustee's money is deemed spent. The next £5,000 must be trust money. Which trust? Apply Clayton's Case (FIFO): £5,000 from Trust A (first in). The shares were bought with £10K trustee money and £5K Trust A money.
- Second Withdrawal (£10K for holiday): This must be trust money. Apply FIFO: the remaining £5,000 from Trust A is spent first, then £5,000 from Trust B. Both are dissipated.
- Remaining Balance (£10K): This must be Trust B money (£20K paid in - £5K spent on holiday = £15K initially remaining from Trust B, but only £10K left in account).
- Outcome using FIFO: Trust A traces £5K into the shares (can claim 1/3 of £18K = £6K or a lien for £5K). Trust B traces £10K into the remaining bank balance.
- Alternative (Pari Passu): If FIFO is unjust, the court might apply pari passu. The shares (£15K cost) and remaining balance (£10K) totalling £25K came from £10K trust A money and £20K trust B money (ratio 1:2). Trust A gets 1/3 (£8,333), Trust B gets 2/3 (£16,667). This would likely apply to the shares (£6K for A, £12K for B) and the remaining balance (£3,333 for A, £6,667 for B). Note: Application can be complex.
Exam Warning
Tracing rules, especially concerning mixed funds and bank accounts, can be complex. Focus on understanding the core principles (Re Hallett, Re Oatway, FIFO, pari passu, lowest intermediate balance) and the main defences (BFPFVWN, change of position, dissipation). Exam questions are more likely to test the application of these core principles in straightforward scenarios rather than highly complex calculations.
Key Point Checklist
This article has covered the following key knowledge points:
- Third parties can become liable for breaches of trust through knowing receipt or dishonest assistance.
- Knowing receipt requires receipt of trust property for the recipient's own benefit with knowledge making retention unconscionable.
- Dishonest assistance requires dishonest help given by a third party to a trustee committing a breach, judged by objective standards.
- Equitable tracing allows beneficiaries to follow trust property into new forms or into the hands of third parties (except BFPFVWN).
- Tracing requires an initial fiduciary relationship and identifiable property.
- Specific rules apply when tracing into mixed funds (Re Hallett, Re Oatway, FIFO, pari passu, lowest intermediate balance).
- Defences to tracing include BFPFVWN, change of position (for innocent volunteers), dissipation, and laches/inequitable result.
Key Terms and Concepts
- Knowing Receipt
- Dishonest Assistance
- Tracing
- Clean Substitution
- Fiduciary Relationship
- Lowest Intermediate Balance
- Bona Fide Purchaser For Value Without Notice
