Flexibility and regulation

Wednesday, 01 May 2013
Mirek Gruna and Ashley Fife on the growth of private trust companies.

The growth in use of private trust companies (PTCs) reflects ultra-high-net-worth clients’ desire to take an active involvement in the administration of trust structures with which they are associated, as well as their attraction to structures that are flexible and not subject to a high degree of regulation. Meanwhile, administrators of structures that involve PTCs may consider that their litigation risk is less than it would be for structures where the administrators, or their subsidiaries, act as trustees of trusts and directors of the trusts’ underlying entities.

However, in most jurisdictions regulations require administrators to perform continuing scrutiny of transactions in which trusts, and their underlying entities (UEs) (together, ‘the structures’), are involved, as part of the administrators’ client due-diligence requirements and regardless of whether or not the administrators provide trustees or directors to the structures. The position of administrators will vary depending on whether or not they provide trustees or directors to the structure. Appropriate service agreements, governing documents and clear communication with clients are crucial if administrators are to balance the competing considerations.

The current chapter in client control

Many clients wish to control the decisions made regarding ‘their’ structures, particularly if the wealth used to fund the structures has been generated by their entrepreneurial skill. Clients can provide expertise to facilitate the growth in value of the assets in structures – particularly where the UEs are trading entities managed by the clients. Clients can also provide useful information regarding the circumstances of the trusts’ beneficiaries.

However, on occasions administrators may consider that particular types of investments or transactions proposed by clients may not be in the best interests of the beneficiaries of the structure. Traditionally, trust law developed on the basis that trustees should hold conservative investments in order to fulfil their obligation to preserve and enhance trust property. However, this tradition does not match the objectives of many clients who wish to adopt a proactive role in the management of structures’ assets. Consequently, administrators have struggled to reconcile their desire to facilitate clients’ objectives with their fiduciary responsibilities to monitor structures’ investments.

In response, many jurisdictions introduced laws that seek to reduce administrators’ exposure by, in certain circumstances, removing or limiting trustees’ duties, powers and liabilities. Trust draftspersons have sought to achieve the same objective. However, many of these solutions have been criticised as repugnant to the ‘irreducible core’ of trustee duties needed for the existence of a valid trust. PTCs were introduced to facilitate and recognise clients’ proactive role in the management of structures and reduce administrators’ litigation risk.

Regulatory issues

In most jurisdictions, administrators of PTCs are required to scrutinise transactions undertaken throughout the course of business relationships to ensure that the transactions are consistent with the administrators’ knowledge of the clients, including the clients’ business activities and risk profile.

Situations may arise where:

  • clients authorise certain transactions, but the administrators refuse to implement those transactions because the information received may indicate a regulatory risk;
  • regulations do not permit administrators to fully explain to clients why they are unable to implement the transactions;
  • UEs or trustees of the trusts are unable to complete a transaction to which they are bound or otherwise miss an investment opportunity – and may arguably suffer loss as a result; or;
  • the relationship between the administrators and the clients deteriorates and the clients may threaten litigation.

The questions for PTC administrators are:

  • What are the most practical ways to ensure they receive, from clients and UEs, the information they require in a timely manner, to satisfy regulatory requirements?
  • How can administrators prevent transactions from proceeding where the information provided is inadequate or discloses a regulatory risk?
  • Without the receipt of the information they require, how can administrators efficiently end their involvement with structures and manage the risks associated with doing so?

Relationship between risk and the administrators’ function

An important factor affecting the ability of PTC administrators to obtain information is whether the administrators are ‘administrator only’ and do not provide directors to the PTC or the UEs, or whether they are ‘split boards’ and provide one or more directors to the PTC or the UEs.

Scenario 1: administrator only

In both scenarios, the scope of the administration services provided should be clearly set out in the service agreements. In administrator-only scenarios, it may be practical for service agreements to contain a representation from the clients and the PTC that they acknowledge that the administrators’ services do not include providing them with legal advice on the duties of trustees or directors, and that they shall obtain independent advice regarding their duties should they require it.

The challenge facing administrator-only scenarios arises because legislation generally does not give administrators the right to compel directors of PTCs or UEs to provide administrators with information. Similarly, standard governing documents used for traditional structures do not ordinarily provide administrators with these rights. It is therefore advisable to use templates for governing documents for PTCs that include rules regarding the communication between clients and administrators, to ensure that the clients who are directors of PTCs (CDs) shall be bound by the rules.

In administrator-only scenarios, administrators may more readily exit structures if the service agreements provide that failure to comply with the rules justifies the administrators’ termination of the services. Effective termination provisions in service agreements should reduce the likelihood of the administrators being exposed to any additional regulatory risks that accrue by reason of the continued inability of the administrators to obtain the required information. Effective provisions should also reduce the risk of litigation for an alleged breach of a service agreement. Administrators may be exposed to litigation risk for breaches of service agreements if transactions contemplated by PTCs or the UEs are delayed or not completed as a result of the administrators’ failure to make clear or timely requests for the information they require, as well as wrongful termination of a service agreement.

Scenario 2: split boards

Some clients may request that administrators also provide directors (ADs) who, along with the clients, sit on the PTC boards. It may be that the clients value the administrators’ expertise in ensuring compliance with the governing documents and regulation, and also their objective, independent input and expertise in certain decisions – including where CDs suffer incapacity or become politically or otherwise exposed.

Governing documents and company laws provide directors with rights to compel other directors of the same company to provide them with certain information about that company. Administrators can use information ADs obtain under those provisions to help them to fulfil their regulatory obligations.

Generally, in comparison to circumstances where administrators provide trustees to the trusts, administrators of PTCs with split boards are less exposed to litigation risk and more readily able to exit structures. In the split-board scenario, administrators’ litigation risk for losses arising from a failure to monitor investments remains, to some extent. Many jurisdictions have repealed legislation that made directors of corporate trustees into guarantors for breach of trust claims. However, beneficiaries or successor trustees may, albeit with arguably limited prospects of success, explore common-law dog- leg claims against directors who breach their duty to the PTC where those breaches cause loss to the trust. Administrators’ processes may be exposed to scrutiny from regulators where significant losses are incurred by structures, notwithstanding that the administrators may not be providing the trustees of the trusts, or directors of the UEs, as part of their services.

Clients may require that the governing documents provide CDs with the authority to make certain operational decisions and implement certain transactions for the trust without advance notice to ADs. This may be required, for example, to ensure that the PTC, as trustee of the trust, provides funds to UEs to pay for certain operational expenses. It may be impractical to require CDs to obtain prior approval from ADs, given the nature of the UEs’ business. Further, the administrator may not be a signatory on the trust bank accounts from which the funds are provided.

Risk management

A risk for administrators is that funds in the structure may be applied by CDs or the UEs in a manner not permitted by regulation. The administrators may wish to ensure that the clients’ obligations to provide the administrators with information regarding the UEs’ activities are reflected not only in service agreements, but in the governing documents (of the PTC, the trust and the UEs) to increase the administrators’ ability to compel provision of the required information.

To combat these risks, administrators should consider incorporating rules into service agreements that set out:

  • the nature of the information that shall be provided to the administrators and who is responsible for providing it;
  • the frequency with which the information shall be provided to administrators; and
  • any requirements for information to be provided (whether before or after certain specified transactions) within a specified time of CDs causing PTCs to enter certain transactions.

Furthermore, the clients shall ensure that UEs shall form part of the structure only if those UEs confirm, in writing, their agreement to adhere to the rules, and if the governing documents include specified provisions whereby the UEs:

  • must provide certain information to the administrators at certain times;
  • are not permitted to enter or complete transactions that would place the administrators in breach of regulation; and
  • have limited authority to effect transfers from trust bank accounts – even where ADs or administrators are not signatories on those bank accounts.

Conclusion

PTCs present exciting opportunities and particular challenges for administrators. Administrators should consider specific strategies for structures that include PTCs to ensure, for each structure, that administrators are well placed to obtain the information they require to satisfy regulation and to manage their litigation and regulatory risks. Moreover, administrators should, from the outset of each relationship, clarify with clients the administrators’ requirements for clients, CDs and UEs to provide information, and ensure the service agreements and governing documents reflect those requirements.

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Mirek Gruna and Ashley Fife

Mirek Gruna is Client Director at TMF Group and co-authored with Ashley Fife TEP.

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