Most business people know that they should shelter their assets by keeping them out of their own name, so that if they go bankrupt, those assets are not available to the trustee in bankruptcy.
But it’s also important to make sure that the entities that control those assets are still under the individual’s direct or indirect control in the event of personal bankruptcy.
Recently a client* learned a hard lesson that was fortunately only a near miss.
He set up his interest in a business so a trustee company held it. The company was trustee of a unit trust. The only unit holders of the trustee company were he and his wife. The only shareholders of the trustee company were he and his wife. They were also the only directors.
The trustee company owned one third of a development site.
In the course of the business he and his wife had given personal guarantees over a business loan. Eventually the lender made a call on the guarantee for an amount of over $10 million. The guarantee had a very nasty clause in it (which he and his wife had not read) by which they agreed to give a mortgage over all of their real property to secure the loan.
When it became apparent that the loan may go bad, the lender placed caveats over all of the real property in the name of he and his wife which included 2 investment properties and a family home.
The client could not service the first mortgages on the family home and the investment properties, or service the business loan of which he was guarantor.
After a period the client and his wife each declared bankruptcy.
After they had declared bankruptcy, an opportunity arose to restructure the business and settle with the lender on favorable terms. The restructure required the transfer of the trustee company’s interest in the development site to a Newco.
Problem? The units in the unit trust vested in the trustee in bankruptcy of the client and his wife. They had ceased to be directors of the trustee company because they were bankrupt. And the shares in the trustee company vested in the trustee in bankruptcy. Further, the trust deed reserved the power to change trustee to the unit holders alone. (Frequently, the appointor of the trust, usually a family member, has that power, but that was not so in this case)
So the client and his wife could not cause the trustee to execute a transfer or change trustee to a new entity who could. And the trustee (ITSA) would not assist.
In the end, the client had a near miss, more through luck than anything else. It turned out that the units in the unit trust were held by he and his wife as trustees for another trust, their family trust, which fortunately was a discretionary trust. The trustee of that trust was a different company with different directors. The trustee of that trust was able to direct the trustee in bankruptcy to transfer the units to it. Then it was able to change the trustee under the provisions of the trust deed, and the new trustee could execute the transfer. Phew that was close!
So what are the lessons of this near miss?
- Unit trusts are not very good at sheltering personal assets because the units will vest in the trustee in bankruptcy. It is possible to use a hybrid unit trust/discretionary trust structure in their place.
- If for tax reasons unit trusts structures are necessary, the unit themselves should not be held by the individual seeking to shelter assets beneficially. They should be held by another entity that is sheltered. The same goes for the shares in the trustee company.
- Be careful to have directors of the trustee who are not likely to go bankrupt if the sheltered individual also goes bankrupt. Preferably appoint another family member not involved in the business, or an accountant or lawyer (if one is willing).
- Reserve a power to change the trustee to the appointor or to a family member in the trust deed.
*The facts have been changed slightly to protect the client