Run Off Trusts
The use of trusts in the context of investment fund liquidations is on the up. Advocate Andrew Walters, a Director of Trust Corporation International, explains the merits of the trust as a means of facilitating dissolutions where circumstances prevent a straightforward realisation and distribution exercise.
When a collective investment scheme nears the end of its life, be that for commercial reasons, expiry of a fixed term, investor vote or court-order, those responsible for realising the scheme’s assets and settling its liabilities can be faced with the prospect of residual assets, interests or rights which cannot, or should not, be realised as swiftly as the remaining the portfolio. Such circumstances can arise where:
- a liquid market for the asset does not exist, or a willing buyer cannot be secured, at the relevant time • valuation of the residual asset is delayed or cannot be ascertained
- valuation of the residual asset is delayed or cannot be ascertained
- a contractual or other right is cannot be realised or a counterparty looks likely to default on an obligation to pay out
- the residual asset is the subject of litigation or a lengthy liquidation process
- a material enhancement in value can be achieved by delaying realisation
In such circumstances, the ability to formally conclude the winding up process can be delayed with the unfortunate consequence that the fund may have to continue, albeit in dissolution, and incur ongoing running costs that are no longer commensurate with the value of the residual asset. Such costs can include administrative, management, custody and regulatory expenses and those responsible for winding up the scheme may find themselves obliged to find an alternative means of preserving stakeholder interests in the residual asset whilst avoiding any remaining value being unduly eroded by such costs.
One solution might be to appoint a professional trustee to hold the residual asset on trust. A trust, by its very nature, is ideally suited to the preservation of value for identified or identifiable persons. In this context, the initial beneficiaries of the trust will usually be those persons appearing on the register of members or partners of the relevant fund at the time of dissolution. Under the trust instrument, each beneficiary might have an interest in the trust property commensurate with their proportional interest in the dissolving fund. In the right circumstances, beneficiaries can be granted a defined or fixed interest in the trust which is, in some ways, comparable with the rights of unitholders in a traditional unit trust. The exact nature of an investor’s interest in the trust, and the duties owed by the trustee to that investor, will depend on the terms of the trust instrument and the governing law of the trust.
Ordinarily, the identity of the beneficiaries will not change during the life of the trust. However, this is more often a reflection of the character of the residual assets rather than because a specific restriction on transfer has been included. In fact, the instrument can be drafted so as to permit the transfer of interests in the trust thereby providing a mechanism by which beneficiaries can dispose of their interests if they can find a willing and permitted transferee.
The trustee is duty-bound to operate the trust in accordance with the terms of the instrument and to act in the best of interests of the beneficiaries as a whole. Such duties tend to suit collective investment given the commonality of terms upon which participants invest in the first place. That said, such trusts can be drafted so as to provide considerable flexibility including different classes of beneficiary, restrictions or enhancements to trustee powers and/or the involvement of third parties to act alongside the trustee in its stewardship of the assets. For example, the instrument may well include provisions enabling, or even obliging, the trustee to appoint an investment manager to oversee the operation of the residual asset during the life of the trust. This can enable the outgoing manager’s continued involvement with the residual asset if there remains a need for asset-specific expertise. Equally, the trust can provide for the appointment of a protector whose consent must be obtained before the trustee takes certain action such as disposing of an asset, permitting a transfer of interests or distributing funds. We have also seen the concept of “protected assets” in respect of which the trustee must seek certain permissions before disposing or exercise any rights.
Whilst the principles underpinning the operation of these trusts are quite straightforward, there are a number of practicalities that should be born in mind. For example:
- Those responsible for effecting the dissolution of the fund will need to consider any potential tax consequences that might arise from the transfer of a residual asset to a trustee.
- It is important to ensure that there exists an appropriate right or power to make a transfer of assets to a trustee. This will come down, in part, to the constitution of the fund. In some instances, it may be necessary to seek permission or a resolution of the investors before contemplating a transfer of assets to a trust. In others, it may be advisable to seek court approval to the proposed transfer.
- As with any collective investment structure, regulatory considerations may well come into play and should be analysed carefully at the outset. Importantly, the regulatory status of the trust should be considered to ensure that it does not inadvertently stray into regulated fund territory.
- Ordinarily, the trustee remains subject to a duty to account to beneficiaries and to maintain financial records and prepare accounts. Consideration should be given at the creation of the trust to the optimum manner of keeping beneficiaries informed and ensuring that they have a mechanism by which to hold the trustee to account.
- In circumstances involving the trusteeship of illiquid assets, provision will need to be made for the running costs of the trust. In some instances, this may require the allocation of sufficient liquid funds to cover the life of the trust.
- The trustee remains bound to comply with applicable AML principles and, as such, is normally required to identify and verify beneficiaries through customer due diligence.
- The trust instrument will need to include a mechanism enabling the trustee to retire or terminate the trust in appropriate circumstances. For example, provisions should be included to allow appropriate action to be taken in circumstances where it becomes apparent that there remains no realistic prospect of deriving value from the asset or the running costs of the structure can no longer be met.
A trust may be equally useful in circumstances where some of the fund’s stakeholders cannot be easily contacted and verified. The appointment of a professional trustee to hold residual assets and to locate, identify and verify investors may be a cost effective alternative where the person responsible for liquidating cannot, for regulatory or compliance reasons, distribute the liquidation proceeds immediately after realising the assets. That said, careful thought should be given to the precise nature of a beneficiary’s interest until such time as the trustee has satisfied any obligation to verify their identity. The nature of their interest will be important in determining the extent of a trustee’s international reporting obligations and should therefore be given careful consideration when settling the terms of the trust.
Andrew Walters April 2020