Learning Outcomes
This article explains the nature of proprietary claims against trustees who have breached their trust by misapplying trust assets. It outlines the process of tracing trust property, particularly focusing on the rules developed by equity for allocating withdrawals when trust funds are mixed with the trustee's own money or with funds from another trust. Understanding these rules is essential for determining the extent of a beneficiary's claim to recover misappropriated assets or their proceeds, especially in insolvency situations. Your understanding will enable you to apply these principles to SQE1-style multiple-choice questions.
SQE1 Syllabus
For SQE1, you are required to understand the principles governing a trustee's liability for breach of trust, specifically concerning proprietary remedies available to beneficiaries. This includes the rules for tracing trust assets, particularly into mixed funds held by the trustee.
As you work through this article, remember to pay particular attention in your revision to:
- The distinction between personal and proprietary claims following a breach of trust.
- The concept of equitable tracing and its requirements.
- The rules for tracing into mixed funds held by a trustee, including the application of Re Hallett's Estate, Re Oatway, and the lowest intermediate balance rule.
- The rules for tracing funds mixed from two trusts or with an innocent volunteer's money, including Clayton's Case and proportionate sharing (pari passu).
- The circumstances where tracing may be limited or defeated (eg dissipation, bona fide purchaser).
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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A trustee mixes £10,000 of trust money with £5,000 of their own money in their personal bank account. They then withdraw £7,000 and spend it on a holiday. Which principle generally determines how much trust money remains in the account?
- Re Oatway
- The lowest intermediate balance rule
- Clayton's Case (FIFO)
- Re Hallett's Estate
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Following on from Q1, the trustee then withdraws the remaining £8,000 and buys shares, which are now worthless. Which principle might allow the beneficiaries to claim the shares were purchased with trust money?
- Re Hallett's Estate
- Re Oatway
- The pari passu rule
- Dissipation
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A trustee mixes £5,000 from Trust A and £10,000 from Trust B in their current account. They withdraw £6,000. According to the rule in Clayton's Case, how much of the withdrawn money belongs to Trust A?
- £2,000
- £3,000
- £5,000
- £6,000
Introduction
When a trustee misapplies trust property in breach of trust, beneficiaries have potential remedies. One type is a personal claim against the trustee for compensation for the loss caused. However, if the trustee is insolvent, this claim may be ineffective. An alternative, often more valuable, remedy is a proprietary claim. This involves asserting rights over the original trust property or property that now represents it, even if it has been mixed with other funds or changed form. This process relies on the equitable doctrine of tracing. This article focuses on the rules equity applies when tracing trust money mixed in a trustee's bank account.
Proprietary Claims and Tracing
A proprietary claim allows beneficiaries to assert ownership rights over specific assets. It gives them priority over the trustee's general creditors in insolvency and allows them to capture any increase in the value of the traced asset. The process used to identify the trust property or its substitute is tracing.
Key Term: Tracing
The equitable process of identifying trust property as it passes through different hands or changes form. It is a process of identification, not a remedy in itself, but it enables proprietary claims.
Equity allows tracing where there is an initial fiduciary relationship (like trustee-beneficiary) and the claimant has an equitable proprietary interest in the original property. The property must remain identifiable, even if mixed or substituted.
Tracing into Unmixed Funds
If a trustee misappropriates trust property and keeps it separate, or uses it solely to buy a substitute asset (clean substitution), tracing is straightforward. The beneficiaries can claim the original property or the substitute asset. If the substitute has increased in value, they benefit; if it has decreased, they may choose a personal claim secured by a charge (equitable lien) over the substitute asset for the value lost.
Tracing into Mixed Funds: Trustee's Own Account
Complexity arises when a trustee mixes trust money with their own money in a bank account. Equity has developed specific rules to determine ownership of the mixed fund and any assets purchased from it. These rules generally operate to the disadvantage of the wrongdoing trustee.
The Rule in Re Hallett's Estate
Where a trustee mixes trust funds with their own money in an account and then makes withdrawals which are dissipated (spent in a way that cannot be traced, e.g., on general living expenses or a holiday), equity presumes the trustee spent their own money first.
Key Term: Rule in Re Hallett's Estate
The presumption that a trustee who mixes trust funds with their own money in a bank account and makes withdrawals spends their own money first, preserving the trust fund.
This presumption aims to preserve the trust fund as far as possible. Any remaining balance in the account, up to the amount of the trust money paid in, can be claimed by the beneficiaries.
Worked Example 1.1
A trustee has £2,000 of their own money in a bank account. They wrongly deposit £4,000 of trust money into the same account, bringing the balance to £6,000. They then withdraw £1,500 and spend it on a weekend break (dissipation). What is the position regarding the remaining balance?
Answer: Applying Re Hallett's Estate, the trustee is presumed to have spent their own £1,500 first. The remaining £4,500 in the account contains the full £4,000 of trust money. The beneficiaries can claim this £4,000.
The Rule in Re Oatway
The presumption in Re Hallett does not apply if it would prevent the beneficiaries from tracing into a valuable asset purchased from the mixed fund while allowing the trustee to keep that asset. Instead, Re Oatway establishes that the beneficiaries have a first charge over the mixed fund and any asset purchased from it.
Key Term: Rule in Re Oatway
Where a trustee mixes trust funds with their own and buys an asset before dissipating the rest of the fund, the beneficiaries can claim the asset represents trust money, effectively reversing the Re Hallett presumption to achieve an equitable result.
This allows beneficiaries to 'cherry-pick' – they can claim that any valuable asset purchased from the mixed fund was bought with trust money, even if the trustee's own money was technically available first according to the chronology.
Worked Example 1.2
A trustee has £5,000 of their own money in an account. They wrongly deposit £10,000 of trust money, making the balance £15,000. They then withdraw £10,000 to buy shares. Subsequently, they withdraw the remaining £5,000 and spend it on general living expenses (dissipation). The shares are now worth £12,000. What can the beneficiaries claim?
Answer: Applying Re Hallett would mean the shares (£10,000 purchase) were bought with the trustee's £5,000 and £5,000 of trust money, and the remaining £5,000 of trust money was dissipated. This isn't the best outcome. Applying Re Oatway, the beneficiaries can assert that the £10,000 used to buy the shares was trust money. They can claim the shares (now worth £12,000) as representing the trust fund. The trustee's own money (£5,000) is deemed dissipated.
The Lowest Intermediate Balance Rule
The beneficiaries' proprietary claim against a mixed bank account is limited by the lowest balance the account reached after the trust money was paid in but before any subsequent deposits of the trustee's own money.
Key Term: Lowest Intermediate Balance Rule
The principle that trust beneficiaries cannot trace more money out of a mixed bank account than the lowest balance the account held after the trust money was deposited and before subsequent personal deposits by the trustee (James Roscoe (Bolton) Ltd v Winder).
Subsequent deposits of the trustee's own money are not treated as repayments to the trust unless the trustee clearly intended them as such.
Tracing into Mixed Funds: Two Trusts or Trust + Innocent Volunteer
Different rules apply when a trustee mixes funds from two separate trusts, or mixes trust funds with money belonging to an innocent third party (an 'innocent volunteer' – someone who received the trust property without giving value and without knowledge of the breach). Equity seeks to treat the innocent parties equally.
Clayton's Case (First In, First Out Rule)
The traditional rule for allocating withdrawals from a mixed current account containing funds of two innocent parties is 'first in, first out' (FIFO).
Key Term: Clayton's Case (First In, First Out Rule)
The presumption applied to mixed funds of innocent parties in an active current account, where the first sums paid in are deemed to be the first sums paid out.
This rule applies strictly based on the order of deposits and withdrawals.
Worked Example 1.3
A trustee wrongly deposits £2,000 from Trust X into their current account. A week later, they wrongly deposit £3,000 from Trust Y into the same account (total £5,000). They then withdraw £2,500 for personal use (dissipated). How much can each trust claim from the remaining £2,500?
Answer: Applying FIFO (Clayton's Case), the first £2,000 withdrawn is deemed to be Trust X's money. The next £500 withdrawn is deemed to be Trust Y's money. Therefore, the remaining £2,500 in the account belongs entirely to Trust Y. Trust X has a personal claim against the trustee for the lost £2,000.
Pari Passu Rule (Proportionate Sharing)
The FIFO rule can lead to arbitrary results depending on the timing of transactions. Courts may displace it in favour of proportionate sharing (pari passu) where FIFO is impractical, contrary to the parties' intentions, or would cause injustice (Barlow Clowes International Ltd v Vaughan).
Key Term: Pari Passu Rule (Proportionate Sharing)
An alternative to FIFO, where funds from innocent contributors in a mixed account are shared rateably in proportion to their contributions. Often applied to deposit accounts or where FIFO is impractical or unjust.
This rule is generally considered fairer when dealing with mixed funds from multiple innocent sources, especially in deposit accounts where the order of transactions is less relevant. If applied to Worked Example 1.3, Trust X contributed 2/5 (£2k/£5k) and Trust Y contributed 3/5 (£3k/£5k). The £2,500 withdrawal would be deemed taken 2/5 from Trust X (£1,000) and 3/5 from Trust Y (£1,500). The remaining £2,500 would belong £1,000 to Trust X and £1,500 to Trust Y.
Defences to Tracing Claims
Even if property can be traced, a proprietary claim may be defeated by certain defences:
Key Term: Bona Fide Purchaser for Value Without Notice
A person who acquires legal title to property by providing value (not a gift) in good faith, without actual, constructive, or imputed notice of any prior equitable interest (like a trust). They take the property free from the beneficiaries' equitable claims.Key Term: Dissipation
The trust property or its proceeds have been spent in such a way that they cease to exist and cannot be identified (e.g., spent on general living expenses, a holiday, or paying off an unsecured debt). Tracing ends here.Key Term: Change of Position
A defence available primarily to an innocent volunteer who receives trust property and, acting in good faith, subsequently changes their position (e.g., spends the money in an extraordinary way) in reliance on the receipt, making it inequitable to compel them to repay it (Lipkin Gorman v Karpnale Ltd).
Additionally, the general equitable defence of laches (unreasonable delay by the claimant causing prejudice to the defendant) may apply.
Key Point Checklist
This article has covered the following key knowledge points:
- Proprietary claims allow beneficiaries to recover trust property or its traceable proceeds, offering advantages over personal claims, especially in insolvency.
- Equitable tracing is the process used to identify trust property through substitutions or mixing, requiring a fiduciary relationship and an existing equitable interest.
- When a trustee mixes trust funds with their own money:
- Re Hallett's Estate presumes the trustee spends their own money first.
- Re Oatway allows beneficiaries to claim assets purchased with the mixed fund if advantageous.
- The lowest intermediate balance rule limits the claim to the lowest balance the account reached.
- When funds from two trusts or a trust and an innocent volunteer are mixed:
- Clayton's Case (FIFO) is the traditional rule for active current accounts.
- The pari passu (proportionate sharing) rule is often preferred where FIFO is unjust or impractical, or for deposit accounts.
- Tracing can be defeated by dissipation, transfer to a bona fide purchaser for value without notice, or potentially by the change of position defence (for innocent volunteers).
Key Terms and Concepts
- Tracing
- Rule in Re Hallett's Estate
- Rule in Re Oatway
- Lowest Intermediate Balance Rule
- Clayton's Case (First In, First Out Rule)
- Pari Passu Rule (Proportionate Sharing)
- Bona Fide Purchaser for Value Without Notice
- Dissipation
- Change of Position
