Learning Outcomes
This article explains proprietary claims available to beneficiaries when a trustee misapplies trust property. It covers the process of tracing assets, the rules for identifying trust property when mixed with other funds, and the defences available against such claims. After studying this material, you should be able to identify when a proprietary claim might be advantageous, apply the relevant tracing rules to different scenarios, and recognise the limitations and defences relevant to these equitable remedies, enabling you to address related SQE1 questions.
SQE1 Syllabus
- The nature of equitable proprietary remedies.
- The availability of tracing in equity.
- Remedies against trustees and third parties.
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.
- What is the fundamental difference between a personal claim and a proprietary claim against a trustee?
- Can beneficiaries trace trust money into an asset purchased entirely with that money if the asset has increased in value?
- What is the 'bona fide purchaser for value without notice' defence?
- True or false: If a trustee mixes trust funds with their own money in a bank account and makes withdrawals, the trustee is always presumed to spend the trust money first.
Introduction
When a trustee breaches their duty and misapplies trust property, beneficiaries may have recourse beyond simply suing the trustee personally for compensation. Equity provides powerful proprietary remedies that allow beneficiaries to reclaim the specific trust asset or property acquired with its proceeds. This article focuses on these proprietary claims, exploring the essential process of tracing and the rules applied when trust property becomes mixed with other assets. Understanding these concepts is essential for advising beneficiaries, particularly when a trustee is insolvent or the misapplied property has changed form or increased in value.
The Nature of Proprietary Claims
A proprietary claim asserts ownership rights over specific property. Unlike a personal claim, which seeks monetary compensation from the trustee personally, a proprietary claim aims to recover the actual trust asset or its substitute.
Key Term: Proprietary Claim
An equitable claim asserting a beneficiary's ownership interest in specific trust property or its traceable proceeds, allowing recovery of the asset itself.Key Term: Personal Claim
A claim against a trustee personally to compensate the trust fund for losses caused by a breach of trust, satisfied from the trustee's own assets.
Proprietary claims offer significant advantages, especially if the trustee is bankrupt. A successful proprietary claim gives the beneficiary priority over the trustee's general creditors because the property identified belongs in equity to the beneficiary, not the trustee. Furthermore, if the trust property or its substitute has increased in value, the beneficiary can capture that increase through a proprietary claim.
Tracing: Identifying Trust Property
Tracing is the process by which equity identifies what has happened to the trust property. It is not a remedy in itself but a mechanism to locate the value of the beneficiary's equitable interest, which may then be subject to a proprietary claim. Tracing can occur at common law or in equity, but equitable tracing is more flexible, particularly when funds are mixed.
Key Term: Tracing
The equitable process of identifying new assets as substitutes for original trust property that has been misappropriated or mixed with other funds.Key Term: Following
The process of pursuing the original trust asset as it passes from one person to another.
For equitable tracing, two prerequisites are generally required:
- A fiduciary relationship must exist (e.g., trustee and beneficiary).
- The claimant must have an equitable proprietary interest in the property being traced.
Tracing into Unmixed Assets
If the trustee keeps the misapplied trust asset separate or uses trust money alone to buy a new asset (clean substitution), tracing is straightforward.
Key Term: Clean Substitution
Where trust property is directly exchanged for another asset, with no mixing of funds.
The beneficiaries can choose either to claim the substitute asset itself or to take an equitable charge (lien) over the asset to secure their personal claim for the value of the original trust property.
Worked Example 1.1
A trustee misappropriates £50,000 from a trust fund and uses it to buy shares in Company X solely with that money. The shares are now worth £60,000. What can the beneficiaries claim?
Answer: The beneficiaries can trace the £50,000 into the shares. As the shares have increased in value, they should claim the shares themselves, thereby capturing the £10,000 profit for the trust. This is an example of clean substitution.
Worked Example 1.2
Assume the same facts as Example 1.1, but the shares are now worth only £40,000. What should the beneficiaries do?
Answer: The beneficiaries should bring a personal claim against the trustee for the £50,000 loss. They can also assert an equitable lien over the £40,000 worth of shares. This means the shares can be sold, the £40,000 proceeds returned to the trust, and the beneficiaries can still pursue the trustee personally for the remaining £10,000 shortfall (though they would rank alongside other creditors for this personal claim).
Tracing into Mixed Funds
Tracing becomes more complex when a trustee mixes trust funds with their own money or with funds from another trust. Equity has developed specific rules for these situations.
Mixing Trust Funds with the Trustee's Own Money
Mixed Asset Purchases
If a trustee uses a combination of trust money and their own money to buy an asset, the beneficiaries have a choice:
- Claim a proportionate share of the asset. This is advantageous if the asset has increased in value.
- Enforce an equitable lien over the asset for the amount of trust money used. This is preferable if the asset has decreased in value, securing repayment of the trust money in priority over the trustee's personal interest.
Withdrawals from a Mixed Bank Account
If the trustee mixes trust money with their own in a bank account and then makes withdrawals, specific rules apply to determine whose money was spent:
- Re Hallett's Estate (1880): The Presumption of Honesty: The trustee is presumed to spend their own money first. Any money remaining in the account (up to the value of the trust funds deposited) is presumed to be trust money.
- Re Oatway (1903): Beneficiary's Charge: If applying Re Hallett would prejudice the beneficiary (e.g., the trustee buys an asset with the first withdrawal and dissipates the rest), the beneficiary can claim a charge over the earlier withdrawal (the purchased asset) or any money remaining. Effectively, the beneficiary can choose which withdrawal represents the trust money to ensure recovery. This prevents the trustee from claiming a valuable asset bought with mixed funds was purchased with their own money first, while the trust money was dissipated.
Worked Example 1.3
A trustee pays £10,000 of trust money into their personal bank account, which already contains £5,000 of their own money (total £15,000). The trustee then withdraws £5,000 to buy shares, which are now worth £7,000. Subsequently, they withdraw the remaining £10,000 and spend it on a holiday (dissipated). What can the beneficiaries claim?
Answer: Applying Re Hallett would mean the trustee spent their own £5,000 on the shares, and the trust's £10,000 was dissipated on the holiday. This disadvantages the beneficiaries. Applying Re Oatway, the beneficiaries can assert a charge over the mixed fund and its withdrawals. They can claim the £5,000 used to buy the shares was trust money. Since the shares have increased in value, they can claim the shares themselves, now worth £7,000. The remaining £5,000 of trust money was dissipated.
- Lowest Intermediate Balance Rule: The beneficiaries' claim against a 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 (Roscoe v Winder (1915)). Subsequent deposits by the trustee are not treated as repayments to the trust unless intended as such.
Mixing Funds from Two Trusts or with an Innocent Volunteer's Money
When a trustee mixes funds from two different trusts, or mixes trust funds with money belonging to an innocent third party (an innocent volunteer), the rules aim for fairness between the innocent parties.
- Mixed Asset Purchase: If funds from two trusts (or a trust and an innocent volunteer) are used to buy an asset, the beneficiaries of each trust (or the trust and the volunteer) share ownership of the asset proportionately (pari passu) to their contributions, regardless of whether the asset's value has increased or decreased.
- Mixed Bank Account:
- Clayton's Case (1816): First In, First Out (FIFO): Traditionally, the first money paid into the account is presumed to be the first money withdrawn.
- Proportionate Sharing: Courts may depart from FIFO if it is impractical or unjust, instead dividing the remaining funds or assets purchased from the account proportionately between the innocent parties (Barlow Clowes International Ltd v Vaughan (1992)).
Defences to Proprietary Claims
Even if trust property can be traced, a proprietary claim may be defeated by certain defences:
- Bona Fide Purchaser for Value Without Notice: A person who buys the legal title to the property for value (not as a gift), in good faith, and without actual, constructive, or imputed notice of the beneficiary's equitable interest, takes the property free from the trust. This is often termed 'equity's darling'.
- Dissipation: The claim fails if the property or its traceable product no longer exists (e.g., money spent on a holiday, general living expenses, 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 rights of the lender.
- Inequitable Result: Equity will not allow tracing if it would produce an unfair result, particularly against an innocent volunteer who has changed their position based on the receipt of the property (Re Diplock (1948)). For example, tracing might be denied if an innocent volunteer used trust money for home improvements that cannot be easily separated or realised without forcing a sale of their home.
- Laches (Delay): Unreasonable delay by the beneficiaries in bringing their claim, which prejudices the defendant, may bar the equitable remedy.
Exam Warning
Be careful to distinguish between the different tracing rules. The rules applied against a wrongdoing trustee (presuming against their interest) differ from those applied between innocent parties (aiming for proportionate sharing or applying FIFO). Identify the parties involved before applying the relevant rule.
Key Point Checklist
This article has covered the following key knowledge points:
- Proprietary claims allow beneficiaries to recover specific trust property or its substitute, offering priority over general creditors in insolvency.
- Tracing is the process used to identify trust property or its proceeds through various transactions.
- Where a trustee mixes trust funds with their own, rules like Re Hallett (trustee spends own money first) and Re Oatway (beneficiary can claim assets purchased) apply, generally favouring the beneficiary.
- The lowest intermediate balance rule limits claims against mixed bank accounts.
- Where funds from two trusts or a trust and an innocent volunteer are mixed, the default rule is FIFO (Clayton's Case), but courts may order proportionate sharing if FIFO is unjust.
- Proprietary claims can be defeated by defences such as the bona fide purchaser for value without notice, dissipation of the asset, the claim producing an inequitable result, or laches.
Key Terms and Concepts
- Proprietary Claim
- Personal Claim
- Tracing
- Following
- Clean Substitution
