A trust issue: Is the financial distress caused by COVID-19 putting beneficiaries’ interests at risk?

Velocity Frequent Flyer Pty Ltd (VFF) is a distinct company from Virgin Australia Holdings and had avoided administration.

Furthermore, VFF had also set up a trust — the ‘Loyalty Trust’ — under which Velocity Rewards Pty Ltd holds money as trustee for VFF to secure the value of any loyalty points issued.

But it has now emerged that Velocity Rewards Pty Ltd had loaned $150 million to Virgin Australia Holdings in 2014 and that loan hasn’t been repaid.

The end result of this arrangement is that VFF now counts itself as one of Virgin Australia Holdings’ creditors.

This puts Velocity members in a precarious position even though the trust structure was introduced precisely to avoid this. If money owed by Virgin Australia Holdings cannot be recovered fully, the Velocity points held by Velocity Frequent Flyers will be worth less than their original value.

This example demonstrates just one way in which the current economic climate may force trust beneficiaries to ‘internalise’ or shoulder the risk of others going insolvent.

Normal protections at risk for beneficiaries of trusts

The trust structure is commonly used for wealth management and business structuring purposes because it normally insulates trust assets from a settlor’s, trustee’s or other related entities’ insolvency. Essentially, the idea is that a trust can protect assets from being used to shoulder costs associated with insolvency.

But the economic crisis caused by COVID-19 is exposing individuals and companies to unprecedented financial distress and this is putting trust beneficiaries’ interests at risk in various ways.

Suppose a trustee wrongly transfers trust money into its own current account or into a third party’s account. Ordinarily, beneficiaries can trace and recover the money even if the trustee or third party is insolvent.

However, because of the current financial distress, the trustee or third party’s account may have been overdrawn when the money was paid in, or any positive balance may have subsequently been spent. In these cases, the beneficiaries can no longer trace and recover the trust money.

Certainly, the trustee commits a breach of trust and must personally repay the amount lost. Similarly, those who assisted in the breach or who received and spent the money knowing of the trustee’s breach must personally compensate the beneficiaries. But beneficiaries stand to lose out because they rank as unsecured creditors if these parties become insolvent.

What if the trustee transfers trust money in an authorised manner, like for example for investment purposes?

As the plight of Velocity members demonstrates, the current economic crisis puts investments at unprecedented risk, and beneficiaries suffer when losses occur.

Moreover, beneficiaries will find it difficult to prove that their losses are caused by their trustee’s negligent investment rather than by the falling market conditions. And even if that can be proved, the beneficiaries will rank as unsecured creditors in the trustee’s insolvency.

Should trusts be avoided?

So, should the trust structure be avoided until the economy recovers? Not quite.

There is at least one way in which the trust may help those struggling in this current economic climate.

Usually, those facing financial distress find it difficult to obtain loans because a lender doesn’t want to take the risk of the borrower becoming insolvent. Those in financial distress are also often unable to provide any meaningful or sufficient collateral against borrowings.

However, the trust structure may be incorporated in a loan agreement to help put lenders on firmer ground, making it easier for people who desperately need loans to get them.

The borrower may agree to deposit the borrowed money into a separate ‘trust’ account, and further to utilise the money solely for a specifically agreed purpose. This agreement results in the borrower holding the money on trust for the lender until, and unless, the money is used for the agreed purpose.

This significantly improves the lender’s position because the trust insulates the loan money if the borrower becomes insolvent before the money is used. The lender also obtains a bargaining chip in negotiating the terms of the loan because it can prescribe how the borrower will use the money.

Putting the lender on firmer ground benefits the borrower, because the increased likelihood of securing the loan may be a lifeline for the borrower to trade its way out of insolvency.

Of course, the arrangement isn’t fool proof.

Once the borrower uses the money for the agreed purpose, the trust comes to an end. The lender is left with only a contractual right to repayment, and will become an unsecured creditor if the borrower then becomes insolvent.

But in an economic climate where even the most basic protective features of a trust are at risk of being eroded, it is encouraging that the trust structure can still be used in some way to help those in financial distress.

This article was first published on Pursuit.

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