Trustees' liability for breach: proprietary claims - Tracing trust property in equity

Learning Outcomes

This article explains the nature of proprietary claims against trustees who have breached their trust duties. It outlines the process of equitable tracing used to identify trust assets or their substitutes in the hands of trustees or third parties. For the SQE1 assessments, you need to understand when proprietary claims arise, the rules governing equitable tracing, particularly concerning mixed funds, and the key defences available against such claims. This knowledge will enable you to analyse scenarios involving breach of trust and identify appropriate remedies related to trust property.

SQE1 Syllabus

For SQE1, you are required to understand how beneficiaries can recover trust property following a breach of trust, focusing on proprietary remedies. This involves applying the principles of equitable tracing. Your understanding of these subjects will enable you to identify and apply the relevant legal rules and principles to SQE1-style single best answer MCQs.

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

• The distinction between personal and proprietary claims against trustees.
• The requirements and rules for equitable tracing.
• How tracing operates where trust funds are mixed with the trustee's own funds or other trust funds.
• The rules for tracing into assets purchased with mixed funds.
• The limits and defences to equitable tracing, such as the bona fide purchaser defence and dissipation.

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 key advantage of a proprietary claim over a personal claim against a bankrupt trustee?
   1. It allows the beneficiary to claim punitive damages.
   2. It gives the beneficiary priority over the trustee's general creditors regarding the specific trust asset or its traceable proceeds.
   3. It is subject to a shorter limitation period.
   4. It does not require proof of a breach of trust.
2. A trustee mixes £10,000 of trust money with £5,000 of their own money in their personal bank account. They then withdraw £8,000 and spend it on a holiday (dissipation). What amount of the remaining £7,000 can the beneficiaries trace in equity?
   1. £2,000
   2. £5,000
   3. £7,000
   4. £10,000
3. What is the primary requirement for equitable tracing to be available?
   1. The trustee must have acted dishonestly.
   2. The property must have increased in value.
   3. There must be an existing fiduciary relationship.
   4. The beneficiary must be a minor.

Introduction

When a trustee breaches their trust obligations, beneficiaries may suffer loss. While beneficiaries always have a personal claim against the wrongdoing trustee for compensation, this may be inadequate if the trustee is insolvent. Equity provides an alternative route through proprietary claims, which focus on recovering the trust property itself or property acquired with it. This involves the process of tracing, which allows beneficiaries to identify trust assets even when they have been mixed with other property or changed form. Understanding proprietary claims and equitable tracing is essential for advising beneficiaries on how to recover misappropriated trust assets.

Distinguishing Personal and Proprietary Claims

It is important to distinguish between personal and proprietary claims arising from a breach of trust.

A personal claim is brought against the trustee individually. The aim is to compel the trustee to compensate the trust fund for the loss caused by the breach, using their own personal assets. If the trustee is bankrupt, the beneficiaries will rank alongside other unsecured creditors, and recovery may be limited.

A proprietary claim, conversely, asserts ownership rights over specific assets. The beneficiary claims that the trust property (or property representing it) still belongs beneficially to the trust, even if it is in the hands of the trustee or a third party (unless they are a bona fide purchaser for value without notice). This claim gives the beneficiary priority over the trustee's general creditors in insolvency and allows recovery of the specific asset or its traceable product, including any increase in value.

Equitable Tracing: Core Principles

Equitable tracing is the process used to identify trust property that has been wrongfully mixed with other property or converted into a different form. It allows beneficiaries to follow the value of the trust asset through substitutions.

Key Term: Fiduciary relationship
A relationship of trust and confidence where one party (the fiduciary, e.g., a trustee) owes duties of loyalty and utmost good faith to another (the principal or beneficiary).

Key Term: Following
The process of identifying the original trust asset as it passes from one person to another.

Key Term: Tracing
The process of identifying the value of the claimant's property in other assets which have been substituted for the original property.

For equitable tracing to be available, certain conditions must generally be met:

1. Fiduciary Relationship: There must have been an initial fiduciary relationship (e.g., trustee-beneficiary).
2. Equitable Proprietary Interest: The claimant must have an equitable proprietary interest in the property being traced.
3. Traceable Property: The property must still exist in some identifiable form, whether original or substituted, and not have been dissipated.

It is useful to distinguish between 'following' and 'tracing'.

Key Term: Following
The process of identifying the original trust asset as it passes from one person to another.

Key Term: Tracing
The process of identifying the value of the claimant's property in other assets which have been substituted for the original property.

Tracing is necessary when the original asset has been replaced by another asset or mixed with other funds.

Tracing into Unmixed Funds

Where a trustee misappropriates trust property and keeps it separate from their own assets, tracing is straightforward.

• If the trustee still holds the original asset, the beneficiaries can simply claim it back (this is 'following').
• If the trustee has exchanged the original asset for a substitute asset (e.g., used trust money to buy shares), the beneficiaries can choose either:
  • To claim the substitute asset itself, including any increase in value (using a constructive trust).
  • To take an equitable charge (or lien) over the substitute asset to recover the value of the original trust property lost. This is preferable if the substitute asset has decreased in value.

Worked Example 1.1

A trustee misappropriates £20,000 from the trust fund and uses it to buy a classic car in their own name. The car is now worth £25,000. What proprietary remedy should the beneficiaries seek?

Answer: The beneficiaries should trace the trust money into the car. As the car (the substitute asset) has increased in value, they should claim ownership of the car itself via a constructive trust, thus capturing the £5,000 increase in value for the trust.

Worked Example 1.2

Assume the same facts as Worked Example 1.1, but the classic car is now only worth £15,000. What proprietary remedy should the beneficiaries seek?

Answer: The beneficiaries should still trace the trust money into the car. However, as the car has decreased in value, they should claim an equitable charge or lien over the car for the £20,000 misappropriated. This allows them to force the sale of the car and recover £15,000 from the proceeds. They retain a personal claim against the trustee for the remaining £5,000 shortfall.

Tracing into Mixed Funds

Tracing becomes more complex when a trustee mixes trust funds with other money, either their own or funds from another trust. Equity has developed specific rules for these situations.

Trustee Mixes Trust Funds with Own Money in Asset Purchase

If a trustee uses a mixture of trust money and their own money to buy an asset (a 'mixed asset'), the beneficiaries have a choice similar to that for clean substitutions:

• Claim a proportionate share of the asset. This is advantageous if the asset has increased in value.
• Claim an equitable lien over the asset for the amount of trust money used. This is advantageous if the asset has decreased in value.

The choice allows the beneficiary to secure the best outcome against the wrongdoing trustee.

Worked Example 1.3

A trustee uses £10,000 of trust money and £10,000 of their own money to buy shares worth £20,000. The shares are now worth £30,000. What can the beneficiaries claim?

Answer: The beneficiaries can trace into the mixed asset (the shares). Since the trust contributed 50% of the purchase price and the shares have increased in value, they should claim a 50% proportionate share, which is now worth £15,000 (£30,000 x 50%).

Worked Example 1.4

Assume the same facts as Worked Example 1.3, but the shares are now worth only £16,000. What should the beneficiaries claim?

Answer: Since the shares have decreased in value, the beneficiaries should enforce an equitable lien over the shares for the £10,000 of trust money used. This allows them to recover their £10,000 from the sale proceeds in priority to the trustee claiming their share.

Trustee Mixes Trust Funds with Own Money in Bank Account

Where a trustee deposits trust funds into their personal bank account, mixing them with their own money, and then makes withdrawals, specific rules apply to determine what happens to the trust money:

• Presumption of Honesty (Re Hallett's Estate): The trustee is presumed to spend their own money first. Any money remaining in the account up to the amount of the trust fund is considered trust money.
• Beneficiary's First Choice (Re Oatway): If the Re Hallett presumption would prejudice the beneficiaries (e.g., the trustee buys an asset with early withdrawals and dissipates the rest), the beneficiaries can assert a charge over the earlier withdrawal (or asset purchased with it) first. Equity presumes against the wrongdoer, allowing the beneficiary to choose the rule that best preserves the trust fund.
• Lowest Intermediate Balance Rule (Roscoe v Winder): The beneficiaries' claim against the mixed bank account is limited to the lowest balance the account reached after the trust money was paid in but before any subsequent deposits of the trustee's own money. Later deposits by the trustee are not presumed to replace spent trust money unless that intention is clear.

Key Term: Dissipation
The spending or wasting of trust funds in such a way that they cannot be traced into any substitute asset (e.g., spending on general living expenses, holidays, or paying off unsecured debts).

Worked Example 1.5

A trustee pays £5,000 trust money into their bank account, which already contains £2,000 of their own money (Total £7,000). The trustee then withdraws £3,000 for shares and later spends £3,000 on living expenses. £1,000 remains. How can the beneficiaries trace?

Answer: Applying Re Hallett, the trustee spends their own £2,000 first. The first £3,000 withdrawal (for shares) would consist of £2,000 trustee money and £1,000 trust money. The second £3,000 withdrawal (living expenses) would be entirely trust money. The remaining £1,000 would be trust money. This leaves the trust tracing £1,000 into the shares and £1,000 in the account balance, with £3,000 dissipated. However, applying Re Oatway, the beneficiaries can claim a charge over the shares first. The £3,000 withdrawal for shares can be claimed entirely as trust money. The £3,000 spent on living expenses would then be £2,000 trustee money and £1,000 trust money. The remaining £1,000 is trust money. This allows the trust to trace £3,000 into the shares and £1,000 into the account balance, with only £1,000 dissipated. This is the better result for the beneficiaries.

Trustee Mixes Funds from Two Trusts or Trust and Innocent Volunteer

Where a trustee mixes funds from two separate trusts, or mixes trust funds with money belonging to an innocent third party (an 'innocent volunteer'), the rules favouring the beneficiary against the wrongdoing trustee do not apply between the two innocent parties.

• Mixed Asset Purchase: If funds from two trusts (or a trust and an innocent volunteer) are used to buy an asset, the parties share ownership of the asset proportionately (pari passu) according to their contributions. They share any increase or decrease in value rateably.
• Mixed Bank Account: If funds from two trusts (or a trust and an innocent volunteer) are mixed in a bank account from which withdrawals are made:
  • Clayton's Case Rule (First In, First Out - FIFO): Traditionally, the first money paid into the account is presumed to be the first money paid out.
  • Pari Passu Distribution: Courts may depart from FIFO if it is impractical or unjust, and instead divide the remaining funds or assets purchased proportionately between the innocent parties (Barlow Clowes v Vaughan). This is now often preferred, especially for savings accounts.

Defences to Tracing

Even if tracing is possible, certain defences may prevent the beneficiary from recovering the property:

• Bona Fide Purchaser for Value Without Notice (BFPFVWN): Equity's darling. If a third party buys the legal title to the trust property (or its traceable product) for valuable consideration, in good faith, and without actual, constructive, or imputed notice of the beneficiary's interest, the beneficiary's equitable interest is extinguished. Tracing stops here.
• Dissipation: As noted, if the trust property or its traceable proceeds have been dissipated (e.g., spent on a holiday, general living expenses, or used to pay unsecured debts), there is no asset left to trace into. The proprietary claim fails, though a personal claim against the trustee remains.
• Inequitable Result: Tracing may be denied if it would produce an unfair result, particularly against an innocent volunteer. For example, if an innocent volunteer uses trust money to make improvements to their existing property which do not necessarily increase its sale value (or where forcing a sale would be highly unfair), the court may refuse a proprietary claim (Re Diplock).
• Change of Position: An innocent volunteer who receives trust property in good faith and subsequently changes their position relying on the receipt (e.g., spends the money in an extraordinary way they wouldn't otherwise have done) may have a defence against a personal claim for restitution, and potentially against a proprietary claim if enforcing it would be inequitable due to the change of position.

Key Term: Change of position
A defence available primarily to an innocent recipient of mistakenly paid money (or trust property) who has subsequently altered their position in reliance on the receipt, making it inequitable to require full repayment.

Key Point Checklist

This article has covered the following key knowledge points:

• Beneficiaries can bring personal claims (for compensation) or proprietary claims (to recover assets) against trustees for breach of trust.
• Proprietary claims offer advantages, especially if the trustee is insolvent or the trust property has increased in value.
• Equitable tracing allows beneficiaries to identify trust property even when mixed or substituted, provided a fiduciary relationship existed and the property is identifiable.
• Following tracks the original asset; tracing tracks its value into substitutes.
• Specific rules apply when tracing into mixed funds, depending on whether the funds are mixed with the trustee's own money (Re Hallett, Re Oatway) or with funds of another innocent party (Clayton's Case, Pari Passu).
• The lowest intermediate balance rule limits claims on mixed bank accounts.
• Defences to tracing include the bona fide purchaser for value without notice, dissipation of the property, and where tracing would lead to an inequitable result (including change of position for innocent volunteers).

Key Terms and Concepts

• Fiduciary relationship
• Following
• Tracing
• Dissipation
• Change of position