Split-up trusts

Monday, 01 December 2014
What does Kan Lai Kwan v Poon Lok To Otto and HSBC International Trustee Ltd tell us about the application of the Charman test to trusts on divorce?

What does Kan Lai Kwan v Poon Lok To Otto and HSBC International Trustee Ltd tell us about the application of the Charman test to trusts on divorce?

Abstract

  • Hong Kong’s highest court – its Court of Final Appeal – has addressed the question of the treatment of discretionary trusts in divorce, in Kan Lai Kwan v Poon Lok To Otto and HSBC International Trustee Ltd.
  •  The assets of a discretionary trust will be a ‘resource’ if the Charman test is satisfied – i.e. if the spouse were to request the trustee to advance the whole or part of the capital or income of the trust to him or her, the trustee, acting in accordance with its duties, would, on the balance of probabilities, be likely to accede to that request.
  •  A third-party discretionary object is owed limited fiduciary duties and is not ‘a beneficiary’ with an ‘interest’ to be protected, as against the other beneficiaries.
  •  The court ‘looks at the reality of the situation’ and ‘regards past conduct as a useful guide’.
  •  The court can consider the following factors: the creation and terms of the trust; letters of wishes; the nature of trust assets; and previous distributions made by the trustee.

On 17 July 2014, Hong Kong’s highest court – the Court of Final Appeal – handed down its judgment in the appeal case of Kan Lai Kwan v Poon Lok To Otto and HSBC International Trustee Limited (Poon).1 In a closely reasoned judgment dealing with several issues arising on final appeal from an application for financial relief in divorce, the Court of Final Appeal allowed the wife’s appeal contending for attribution of the full value of the family trust of more than HKD1.5 billion as a ‘resource’ of the husband, and dismissed the husband’s cross-appeal arguing for a departure from equal sharing, based on an earlier separation date.

The outcome was an award constituting a total of HKD832.5 million (approximately USD107 million) 2 in value of the matrimonial assets, eclipsing an award in TCWF v LKKS that had been slashed on appeal to HKD524.5 million earlier in the year.3 The Financial Times (in an article headlined ‘Hong Kong divorce case rattles family trust industry’) said the judgment had ‘sent ripples through the city’s booming family trust industry’, and noted that it ‘came as a surprise to many lawyers.’4 The South China Morning Post followed up by reporting that Mr Justice Ribeiro PJ, giving the judgment of the court, had described the workings of the trust fund as ‘revealing’.5 Chinese-language press christened the case ‘samsing’, or ‘triple victory’, after the wife’s victories in the Court of First Instance, Court of Appeal, and Court of Final Appeal respectively.

Poon had in fact been a modest affair – a ‘slow burn’ conducted for the most part out of the media spotlight – of interest less for the details of the lives of its parties than for its litigation dynamics and nuanced legal issues. There was nothing here of the 28 cars, business jet, two yachts, millions of dollars’ worth of wine, and HKD100 million per year lifestyles described in Hong Kong’s other, scandal-ridden divorce case of TCWF v LKKS. In contrast, the husband and wife in Poon had lived lives of admirable modesty, the husband a ‘self-made’ industrialist, having built an engineering business from scratch, while the wife had made her full contribution as nurse, homemaker, and ‘corporate wife’ over four decades and in the face of great family tragedy, including the loss of two of the couple’s three children.

Where Poon offered little to the media, however, it offered much of interest to the lawyer. There were several interlocutory applications relating to discovery, expert evidence, and joinder; trust administration applications before the offshore court prior to the trial and after the final appeal; and a full appeal process engaging both Hong Kong’s intermediate and final appeal courts.

Of course, Hong Kong courts have looked to English and Welsh case law for persuasive guidance in ancillary relief matters, not least due to the close relationship between the relevant statutory provisions, and in particular between s7 of Hong Kong’s Matrimonial Proceedings and Property Ordinance (Cap 192) (MPPO) and s25 of the English and Welsh Matrimonial Causes Act 1973 (MCA), 6 which provide for the factors to which the courts are to have regard in the exercise of their powers in applications for financial relief on divorce. It was fortuitous, then, that the first instance trial came on in late 2011, giving the lawyers and court at trial the benefit of the seminal decisions in Charman v Charman,7 and Charman v Charman (No.4),8 as well as (and just as importantly) Whaley v Whaley.9 In a nine-day trial, the full range of Charman issues were canvassed, and evidence as to trust purpose, terms, letters of wishes, distribution history, administration, and reserved powers were brought before the court. Thereafter, as Poon rolled through the Hong Kong appeals process from 2012 to 2014, further trust-related cases were reported in England and Wales that prompted more nuanced approaches to the issue in Hong Kong.10 Save for the appeals, much of the Hong Kong case was heard in private and several judgments and rulings remain unpublished (the Court of First Instance decision notably retains its ‘restricted’ status); what appears in the public domain represents the proverbial tip of the litigation iceberg.

The fundamental issue

Perhaps more so than in the English and Welsh or offshore case authorities, the central issue in Poon was one of truly fundamental trust law, namely the precise nature of the interest or expectation of objects of a discretionary dispositive power, and the consequences of that for the attribution of assets in ancillary relief.

The trust in issue was a discretionary trust of which the husband was settlor, protector and beneficiary. The trust had been established in 1995 and, as at trial, comprised the 84.63 per cent shareholding in the holding company of his business, Analogue Holdings Ltd (‘Analogue’), valued at HKD1.56 billion. The trustee was authorised in its absolute discretion to appoint capital and income to any one member of the class of eligible objects, to the exclusion of any other.11 The trustee was also empowered to add beneficiaries at its discretion and remove beneficiaries with the consent of the husband, as protector. The husband, as protector, had the power to remove and appoint trustees. As at trial and on appeal, the beneficiaries were the husband; wife; their adult daughter, Karen; and the Hong Kong Polytechnic University, which had been appointed as an additional beneficiary in 1996, at the wish of the husband. The governing law of the trust was the law of Jersey.

The wife’s case in the ancillary relief proceedings (and on appeal) had been that the full value of the trust shareholding ought to be attributed to the husband as a ‘resource’ under s7(1)(a) MPPO on application of the test laid out in Charman v Charman (No.4). 12 The husband, on the other hand, ‘contended that the Court ought to treat Karen as if she had a “one-third” interest in the trust estate which should be protected from W’s [the wife’s] claims. His case was that only two-thirds of the value of the shares should be treated as matrimonial assets’.13 The trustee, HSBC International Trustee Ltd, adopted a position consistent with that of the husband.

Court of First Instance and Court of Appeal: ‘notional share’ approach

While the trial judge rejected the husband’s view that the three family members each had a one-third share as ‘not a correct appreciation of the position’,14 he nevertheless felt able to salvage something of the ‘notional share’ approach to attribution of trust assets by reference to trustee duties. The core of his reasoning was that: ‘…the trustee in exercising its duty of safeguarding the interests of all the beneficiaries fairly as between themselves would not… countenance any disposition which results in Karen’s interest being diluted to below something in the order of one-third’.15 The trial judge rejected the Charman test advocated on behalf of the wife, distinguishing the Charman case on the basis that the husband’s conduct had differed from that of Mr Charman.16 He believed (presumably as a consequence of what he thought was the trustee’s duty to safeguard the interests of beneficiaries ‘fairly as between themselves’) that, for the wife to succeed, it was necessary for her to prove sham or breach of trust – neither of which allegations were being advanced in these proceedings.

Where the Court of Final Appeal judgment assists practitioners is in its approach to the application of the Charman test and the factors to be considered

Although the Court of Appeal acknowledged the applicability of Charman,17 its reasoning proceeded on a similar basis to that of the trial judge, namely that ‘… the Trustee in exercising its duty of safeguarding the interest of all the beneficiaries would not countenance any disposition which results in K’s [Karen’s] interest being diluted below one-third’. 18 The Court of Appeal felt able to draw support from the stance taken by the trustee, as well as the Jersey-law expert opinions, and considered that several challenges raised on behalf of the wife on appeal were factual matters resolved by the trial judge. While allowing the wife’s appeal in respect of other grounds (namely liquidity, separation date, and post-separation accruals), the Court of Appeal, accordingly, rejected her arguments in respect of the trust issue, and allowed only two-thirds of the value of the trust shareholding to be attributed to the parties of the marriage under Charman.

Court of Final Appeal judgment: correct application of the Charman test

The Court of Final Appeal went right back to first principles, noting that the trial judge had fallen into error by ‘treating Karen as “a beneficiary” with an “interest” to be protected as against the other beneficiaries’19 and citing the joint judgment of Gummow and Hayne JJ in the Australian High Court decision of Kennon v Spry,20 in respect of the actual position of an object of a discretionary power:

‘The wife was an eligible object of benefaction of the Trust. She was one of the class of “beneficiaries” identified in [the instrument]. The use in that document of the term “beneficiaries” was inapt insofar as it suggested the existence of any vested beneficial interest in the assets held on the trust of [the instrument]. Dr Hardingham correctly identified the wife as one of the class of objects of the discretionary power conferred upon the trustee... Furthermore, as an object of these powers the wife had a right in equity to due administration of the Trust. The existence of such a right did not depend upon entitlement to any fixed and transmissible beneficial interest in the trust fund. The right of the wife was accompanied at least by a fiduciary duty on the part of the trustee, the husband, to consider whether and in what way he should exercise the power conferred...’

Like the wife mentioned in Kennon v Spry, Karen here did not have any fixed beneficial interest in the trust fund and was, in fact, merely owed ‘limited fiduciary duties of the kind described’.21 In addition to that, the trust deed itself had expressly provided at clauses 5 and 6 that the trustee was authorised in its absolute discretion to appoint capital and income to any one member of the class of eligible objects to the exclusion of any other. 22 Karen, like any other ‘beneficiary’, could be removed by the trustee at its discretion with the husband’s consent as protector. Generally, of course, as the Court of Appeal had itself accepted, there will be no duty on a trustee to act even-handedly between discretionary objects. As Lewin says: ‘The very discretion conferred is to prefer one over another; unfairness is not a ground of challenge.’23

As the Charman test had not been properly applied, it fell to the Court of Final Appeal itself to decide whether it should be satisfied ‘that, if H [the husband] were to request the trustee to advance the whole or part of the capital or income of the trust to him, the trustee, acting in accordance with its duties, would on the balance of probabilities be likely to accede to that request.’24

Where the Court of Final Appeal judgment assists practitioners is in its approach to the application of the test and the factors to be considered. These are: the creation and terms of the trust; letters of wishes; the nature of trust assets; and previous distributions made by the trustee.25 A considerable volume and variety of evidence can and did, in Poon, fall under these broad headings. The Court ‘looks at the reality of the situation’ and ‘regards past conduct as a useful guide’. 24

Creation and terms of trust

The Court carried out a close analysis of the trust deed, noting the following features in relation to the Charman test: (i) in making himself protector, the husband had reserved to himself important powers, including the power to remove the trustee, obviously intending his views as to the administration of the trust to be given great weight; (ii) in making himself a potential beneficiary, he intended to benefit from the trustee’s distributions of capital and income; (iii) he intended the trustees to have only the passive role of a shareholder, leaving it to him to run the Analogue Group; (iv) Karen was one of the discretionary objects and had no vested beneficial interest in the trust assets; (v) there was no impediment to the trustee appointing the whole or part of the capital or income to a single beneficiary to the exclusion of all the others.26

The letters of wishes

While it is true that the husband had indicated in his letters of wishes that he hoped for the trust fund to be divided after his death, he also made it clear that ‘he should be consulted by the trustee and that it should consider any suggestions which he might put to it during his lifetime’ and that there ‘is no suggestion that Karen or anyone else should acquire any vested beneficial interest in the trust assets during H’s [the husband’s] lifetime’.27 The trust, said the Court of Final Appeal, was principally intended to function as a substitute for the husband’s will: ‘Just as a testator is free to change his will, it was evidently understood that any changes desired by H [the husband] would be treated with respect by the trustee.’ 28

Nature of trust assets and previous distributions

The Court noted that the sole asset of the trust was the 84.63 per cent shareholding in Analogue, the holding company for a group of electrical and mechanical engineering companies. The trustee was assigned an entirely passive role as shareholder: it had been relieved even of any obligation to exercise voting powers or rights conferred by its shareholding and was in no position to second-guess requests by the husband as to how the shares should be voted. Unless a dividend was declared by Analogue, the trust had no income; when dividends were in fact declared, the trustee had ‘…invariably complied with H’s [the husband’s] wishes as to how the money which he has sent its way should be applied – namely, distributed to H [the husband] himself’.29

The modus operandi was ‘revealing’. For example, on one date in 2001 the husband wrote to the trustee as Analogue’s managing director, announcing the declaration of a substantial dividend, and sent it a cheque in the correct sum. On the very same day, the trustee wrote back to the husband stating that ‘… we intend to exercise our trustee power to make a distribution from the trust fund to you as a beneficiary thereof’. 30 Within three days the money was in his personal account. As at 2008, the procedure had been streamlined. By way of letter to the trustee, Analogue announced the declaration of a dividend and asked that the trustee simply issue a letter of instructions that the dividend be paid directly into the husband’s personal bank account. The trustee complied and the husband caused the dividend to be declared and notionally distributed to him from the trust ‘without the money ever passing through the hands of the trustee’.31

The trustee’s role

The trustee, which had been joined and submitted to the jurisdiction, had called no evidence at trial but had participated to the extent of submitting two notes comprising opening and closing submissions. In substance, what the trustee said was that the court should not order more than one-third of the value of the trust to be realised in favour of the wife on the basis that ‘innocent third-party beneficiaries’ – in particular, Karen – should not be adversely affected.

The Court of Final Appeal was critical of this approach. In particular, the trustee had ‘taken it upon itself to engage in advocacy as to the kind of order that the Court should avoid making’.32 What it had notably failed to do was to ask itself the Charman question, namely: what would it likely do had the settlor-husband asked it to make a distribution of the full Analogue shareholding back to himself? These are totally different questions.

It was also incorrect, for the reasons considered above, for the trustee to assume that Karen had ‘some sort of accrued one-third interest’ to be preserved.33

There was a basic logical weakness in the case that was advanced by both husband and trustee, which was this: even if the wife were to be awarded a half-share in the trust fund, that would leave another half from which one-third could comfortably be extracted on the husband’s death to be appointed to Karen. There would only be a difficulty here if the family members each had a one-third share concurrently, in which case adding to one share would take away from the others. None of the letters of wishes had, however, provided for that: for example, the 2010 letter of wishes provided for the husband’s wishes to be acted upon during his lifetime, and only upon his death for the fund to be held in equal one-third shares for (i) the wife, (ii) Karen and (iii) certain of his colleagues at Analogue.

Contrary to what those members of the trust industry who had been ‘rattled’ by the case may have feared, the Court of Final Appeal has in no way sanctioned the application of an incurious, unrigorous, or ‘excessively broad-brush’ approach to trusts in divorce

For these reasons, the Court of Final Appeal found that there was an ‘overwhelming likelihood’ that ‘the trustee, acting in accordance with its duties, would, if requested by H [the husband], advance the whole or part of the capital or income of the trust to him’, 34 and allowed the wife’s appeal.

Conclusion

Much has been said in recent years about the so-called ‘chancery versus family’ debate as to the treatment of trusts in divorce. ‘It is, of course, an inaccurate caricature,’ wrote Lord Justice Munby, ‘but I suspect that many who practise in the one Division think of those practising in the other as mere pedants; a feeling reciprocated by those who see the Family Division as lacking in curiosity and intellectual rigour and painting with an excessively broad brush’.35 It is perhaps this circle that Sir Mark Potter P hoped to square when he said famously in Charman that ‘… it is essential for the court to bring to it a judicious mixture of worldly realism and of respect for the legal effects of trusts, the legal duties of trustees and, in the case of offshore trusts, the jurisdictions of offshore courts’.36

It is in this context that Poon may be seen as something of a landmark case in Hong Kong. Contrary to what those members of the trust industry who had been ‘rattled’ by the case may have feared, the Court of Final Appeal has in no way sanctioned the application of an incurious, unrigorous, or ‘excessively broad-brush’ approach to trusts in divorce. In fact, the Court proceeded on the basis of a technically unimpeachable analysis of the legal effects of the trust arrangement and the legal duties of the trustees, followed by a close inquiry into the particular terms, circumstances and operation of the trust; indeed, the very basis of the Court of Final Appeal’s intervention was the overly broad-brush view of the nature and extent of the interests of the discretionary objects that had been taken below.

To the extent that the final outcome of the appeals process in Poon was unexpected to trust practitioners, this is a result not of any violation of chancery law principles but rather of the exercise of particular powers and discretions conferred by the matrimonial legislation that allow the Court to take into account the ‘financial resources’ a party ‘has or is likely to have in the foreseeable future’.37 In the context of a full and fruitful marriage of four decades with no factors justifying a departure from equal sharing, these were powers that the Court did not hesitate to exercise. The order for payment was, it is to be noted, made against the husband personally, and not against the trustee.

It would be wrong to assume that all discretionary trusts are now equally vulnerable in Hong Kong divorce proceedings. The Poon case was an example of (i) a spouse-settled trust comprising (ii) matrimonial assets (acquired during the marriage) that (iii) reserved significant powers to the settlor-husband (in his capacity as protector) and (iv) had been intended to act and had been acting in accordance with his wishes. At the other end of the spectrum will be ‘external’ or ‘third-party’ settled trusts comprising non-matrimonial assets of which a spouse happens to be a mere discretionary object among several others. The Charman test (applicable at either end of that spectrum) will require in each case a close consideration of the indicative factors but the outcome itself should in no way be predetermined by Poon.

Poon shows that – in the face of substantial evidence that a trust is a ‘resource’ of a spouse – it will not be enough to rely on the mere fact that there are third-party discretionary objects who may, at some point in the future, theoretically benefit from the exercise of a discretionary dispositive power. That does not mean that there can never be an attribution of a limited proportion or percentage of the value of a discretionary trust to a spouse under the ‘resource’ approach. However, should respondent spouses or trustees seek such an outcome, they would, in the light of Poon, be well advised to explain (and, where appropriate, evidence) in a rational and consistent manner why and on what basis the trustee would likely feel constrained to refuse a request from the beneficiary spouse for advancement of assets, and why and on what basis in that particular proportion contended for.

  • 1. Kan Lai Kwan also known as Kan Lai Kwan Kay v Poon Lok To Otto formerly known as Pun Lok To Otto and HSBC International Trustee Ltd (17 July 2014, FACV20/2013) (CFA judgment)
  • 2. The judgment as to quantum and costs can be accessed at: bit.ly/poon_cfa
  • 3. TCWF v LKKS [2014] 1 HKLRD 896 (CA)
  • 4. The Financial Times, 17 July 2014
  • 5. South China Morning Post, 18 July 2014, City, page 1
  • 6. See LKW v DD (2010) 13 HKCFAR 537 at §11: ‘It is self-evident that s7 of the MPPO (s7) and s25 of the MCA 1973 (s25) are closely related in content and structure. It is therefore unsurprising that the Hong Kong courts have consistently looked to the English case law for persuasive guidance as to the interpretation and application of s7.’
  • 7. [2005] EWCA Civ 1606; [2006] 1 WLR 1053
  • 8.  [2007] EWCA Civ 503; [2007] 1 FLR 1246
  • 9. [2011] EWCA Civ 617; (2011–2012) 14 ITELR 1
  • 10. Notably: BJ v MJ (Financial Remedy: Overseas Trust) [2011] EWHC 2708 (Fam); [2012] 1 FLR 667 (FD) at 674–675; RK v RK (Financial Resources: Trust Assets) [2011] EWHC 3910 (Fam); [2013] 1 FLR 329 at 344–347, paragraphs [58]–[63]; G v G (Financial Remedies: Short Marriage: Trust Assets) [2012] EWHC 167 (Fam); [2012] 2 FLR 48 (FD) at 67–71; B v S (Financial Remedy: Marital Property Regime) [2012] EWHC 265 (Fam); [2012] 2 FLR 502 at 520 paragraph [46]; DR v GR and others (Financial Remedy: Variation of Overseas Trust) [2013] EWHC 1196 (Fam) at paragraphs 45–47
  • 11.  CFA judgment, §44 and §62
  • 12. [2007] EWCA Civ 503; [2007] 1 FLR 1246
  • 13. CFA judgment, §16
  • 14. PLTO v KLK [2013] 2 HKLRD 1089 (CA), §41
  • 15.  CFA judgment, §42
  • 16.  CFA judgment, §41
  • 17. PLTO v KLK, §§28-33; CFA judgment, §45
  • 18. PLTO v KLK, §41; CFA judgment, §45
  • 19.  CFA judgment, §43
  • 20.  (2008) 238 CLR 366 at §125 (footnotes omitted); [2008] HCA 56
  • 21.  CFA judgment, §44
  • 22. CFA judgment, §44 and §62
  • 23. Lewin on Trusts (18th edn, Sweet & Maxwell, 2008) at 29–164; cited in PLTO v KLK at §40
  • 24. a. b. CFA judgment, §60
  • 25. CFA judgment, §60 
  • 26. CFA judgment, §65
  • 27. CFA judgment, §75
  • 28. CFA judgment, §74
  • 29. CFA judgment, §79
  • 30. CFA judgment, §81
  • 31. CFA judgment, §83
  • 32. CFA judgment, §52
  • 33. CFA judgment, §53
  • 34. CFA judgment, §88
  • 35. ‘An unconscionable time a-dying: reports from a traveller in a foreign country’, Trusts & Trustees, 17:9 (2011), 809, page 811
  • 36. Charman v Charman (No.4) at 1271, paragraph [57]
  • 37. Section 7(1)(a) MPPO
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Andrew Lynn

Andrew Lynn TEP is a Barrister at Gilt Chambers, Hong Kong.

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