28 April 2009

Protection for trustees in uncertain times - Claims in respect of failed investments

What should trustees be considering?

As a result of the ongoing economic turmoil, and particularly in the wake of the Madoff collapse, aggrieved investors must weigh the costs of pursuing fund managers, advisers, brokers and auditors (among others) in complex and expensive litigation against their keenness to recover investment losses. This dilemma is particularly difficult for trustees who must reconcile their duty to act to protect and preserve the trust and their potential personal liability for costs if litigation is unsuccessful. Trustees in this position must take steps to protect themselves before commencing or defending potentially costly proceedings; failing to do so will place them at considerable risk.

As a general rule, where a trustee engages in litigation against a third party for the benefit or protection of the trust fund and the action is successful, the costs of litigation can be recovered from the trust fund pursuant to the trustee’s right to be indemnified. However, if the trustee’s case is unsuccessful, the beneficiaries may challenge the trustee’s attempt to be indemnified by the trust fund in respect of not only his own costs but also any costs that the trustee is ordered to pay to his successful opponent. In an extreme case, the costs could exceed the value of the trust.

Taking steps before commencing or defending proceedings

  1. Seek legal advice
    Before taking any steps towards litigation, trustees must seek advice to understand the merits of their case and the possible implications of litigation. Among other issues, it is important that trustees understand the costs regime of the jurisdiction in which the action will be brought; it is not the case that costs follow the event in all jurisdictions as they do in most offshore jurisdictions. There may be ways – such as insurance – of reducing the risks of unsuccessful litigation. In addition, trustees must ensure they have received advice about enforcement and the chances of recovery if an order is made in the trust’s favour.
  2. Consult with the beneficiaries
    Trustees must, of course, consult with the beneficiaries to ascertain their views. They should consider whether the trust can afford litigation.
  3. Explore the possibility of settling some or all of the claims
    Particularly where litigation is likely to be costly and drawn out, reaching an early settlement with the other side might be in the long-term interests of the trust. Again, trustees should seek legal advice to help them consider opportunities for settlement, including alternative dispute resolution.

If they decide to sue, how can trustees protect themselves?

  1. By agreement from beneficiaries
    Trustees may seek to protect themselves by obtaining a written agreement from all beneficiaries that litigation will take place at the expense of the trust. Unfortunately, this might not be practicable in the case of widely drawn discretionary trusts, for example. In addition, trustees must be alive to the fact that the agreement will only be binding if properly constituted. If a beneficiary challenges it on the grounds, for example, that he has not been fully apprised of the strengths and weaknesses of the case, trustees will be left exposed.
  2. By an indemnity from a beneficiary
    In the absence of an agreement by all beneficiaries, one or more of the beneficiaries may indemnify the trustees for the costs of litigation (except where there is a dispute between the beneficiaries as to whether litigation should be commenced). Trustees must bear in mind that the protection offered by an indemnity is dependent on the beneficiary’s future ability to pay.
  3. Apply to the court for guidance
    To avoid difficulties with beneficiaries after litigation has failed, trustees should consider applying to the court for directions in the form of a Beddoe application (named after the case of Re Beddoe in 1893) before bringing or defending proceedings on behalf of the trust.

_“A trustee who, without the sanction of the Court, commences an action or defends an action unsuccessfully, does so at his own risk as regards the costs, even if he acts on Counsel’s opinion…”
Re Beddoe [1893] 1 Ch 547_

Re Beddoe is an old English case but its principles are still applied to trustees of modern day trusts in England and across the offshore world. Through a Beddoe application a trustee, who is typically a wholly independent person, applies to the court for guidance on whether to bring the action at the expense of the trust estate. The court will consider all relevant facts including the beneficiaries’ views, the prospects of success, the likelihood of being able to recover if an order is made against the opponent and whether anything can be done to reduce the risks of heavy costs.

The application takes the form of a separate action and is heard by a different judge from the action against the investment manager or other third party. The trustees will ordinarily be permitted to take the costs from the trust so long as they make full disclosure of the strengths and weaknesses of the case.
If the court does not consider that the risks make the litigation worthwhile, it will not authorise the trustees to sue. This will protect the trustees from any future claims by the beneficiaries that they should have litigated. In the alternative, if the court authorises the trustees to commence litigation, and the action is unsuccessful, the Beddoe order will prevent the beneficiaries from challenging the trustees’ decision to litigate.

If a Beddoe application has not been made before the trustees commence proceedings, it is very unlikely that a court will give them a retrospective indemnity. Therefore it is crucial that trustees considering or facing third party litigation consider making a Beddoe application before they take steps in initiating or defending litigation.

Different considerations apply if the trustees are trustees of a charitable trust and specialist advice is necessary.

Are the trustees at fault themselves?

As well as seeking to recover investment losses from third parties, beneficiaries may decide to bring proceedings against trustees, claiming that trust losses are as a result of the way in which the trust was administered. Trustees who find themselves faced with breach of trust claims of this nature must urgently seek legal advice.


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