Sham trusts, the High Court and "Putin's Banker"
03 November 2017
On 11 October 2017, the High Court released its latest judgment in the long running saga between Mezhprom Bank and its liquidator, the Deposit Insurance Agency (the "DIA"), and Russian businessman Mr Sergei Pugachev (also known as "Putin's banker").
The case concerned five discretionary New Zealand trusts, in respect of which the High Court had previously ordered Mr Pugachev to provide disclosure. In a decision which might initially be of concern to individuals and trustees with a connection to or looking to establish a trust in Guernsey, Mr Justice Birss, presiding, ruled that the assets held by the trusts should be available for enforcement (albeit he declined to order relief and adjourned the matter for further submissions).
On the facts of this particular case, Birss J found that at all material times, Mr Pugachev:
"…regarded all the assets in these trusts as belonging to him and intended to retain ultimate control. The point of the trusts was not to cede control of his assets to someone else, it was to hide his control of them. In other words, Mr Pugachev intended to use the trusts as a pretence to mislead other people, by creating the appearance that the property did not belong to him when really it did" (paragraph 424).
This has led some to worry about the susceptibility of offshore structures to onshore actions. Indeed, an article published in the Financial Times on Thursday 12 October 2017 declared that, "the ruling shows a decreasing tolerance in the High Court for opaque offshore accounts that put assets out of the reach of creditors".
The reality, however, is that the sort of claims run successfully by the claimants in this case remain difficult to prove. The key, as ever, is this: what is the true intention of all the relevant players at the time a trust is settled?
It is also worth bearing in mind that Guernsey, in common with other offshore jurisdictions, has "firewall" provisions in its Trusts Law which confer exclusive jurisdiction on the Royal Court of Guernsey over matters concerning Guernsey trusts. Accordingly, even if an English Court were to declare a Guernsey trust to be a sham, potentially this would be of limited impact.
Between 2011 and late 2013, whilst enquiries (and later proceedings) were ongoing in Russia, Mr Pugachev (for the most part via his son, Victor Pugachev) purported to settle assets worth over US $95 million into five discretionary New Zealand trusts, including properties in London, Russia and St Barts. Each of the trust deeds named Mr Pugachev as a discretionary beneficiary and a protector.
Birss J, sitting at the High Court in London, ruled that Mr Pugachev was the true owner of the assets held by the New Zealand trusts (which had come to light during a disclosure exercise and in respect of which further disclosure was later ordered). The judge reached the conclusion that Mr Pugachev's intention in setting up the trusts "was to retain control of the assets but use them as a pretence to mislead third parties by hiding his control" (paragraph 456) and that the assets within the trusts should be available for enforcement.
Mezhprom Bank was founded by Mr Pugachev in 1992 and entered into insolvent liquidation in late 2010. In December 2013, the DIA brought proceedings against Mr Pugachev for the misappropriation of assets prior to the bank's collapse and in April 2015 the Russian Court gave judgment against Mr Pugachev in the sum of around RUR 76 billion (equivalent to around US $1 billion). That judgment is now the subject of an appeal.
By the time the High Court trial began on 4 July 2017, the claimants' lawyers had secured a £1.1 billion freezing order against Mr Pugachev's assets, and Mr Pugachev himself had been committed to two years' imprisonment for contempt of court (a sentence which he escaped as he had already left the country by the time the judgment was pronounced). Only Mr Pugachev's infant children (acting by their mother, Alexandra Tolstoy, as their litigation friend) defended the bank and the DIA's application.
Apparently, the High Court has issued more than 170 orders relating to the DIA's litigation against Mr Pugachev to date.
The claimants argued that the beneficial interest in the assets held by all the trusts belonged to Mr Pugachev, notwithstanding that much of the money or other assets which ultimately went into the trusts was provided by Victor. They sought an order requiring the assets to be vested in the claimants or alternatively in such persons or a receiver as the court deemed fit. The claimants put their case on three bases:
- Firstly, that the trust deeds properly construed and on a proper application of the law, were not effective to divest Mr Pugachev of his beneficial ownership of the assets placed into the trusts. This is referred to in the judgment as the "True Effect of the Trusts" claim (albeit such arrangements are perhaps more commonly referred to as "illusory trusts");
- Secondly, in the alternative to the True Effect of the Trusts claim, the trusts were "shams" because it was the intention of all the parties involved in the creation of the trusts that the assets should continue to belong to Mr Pugachev and therefore they had no effect; and
- Thirdly, in the alternative to the first two claims, the trusts should be set aside under section 423 of the UK Insolvency Act 1986 on the basis that the transfers of the assets into the trusts were carried out with the intention to prejudice the interests of Mr Pugachev's creditors, including the claimants.
These claims were denied by Ms Tolstoy on behalf of her infant children. She (and her parents) gave evidence that Mr Pugachev had told her that the family properties had been bought and placed into trust for her and her children. Mr William Patterson, the New Zealand solicitor who drafted the trust deeds, denied that the trusts were shams and that they were under the complete control of Mr Pugachev.
The court's findings
Assets transferred by Victor
Mr Justice Birss found that "for all these transfers Victor was acting entirely on the instruction of his father and that the beneficial ownership of each asset (money or shares) belonged to Mr Pugachev until the property was transferred into the trusts" (paragraph 205).
- He reached this conclusion on the basis that: there was no evidence that Victor had the means to generate this sort of wealth independently of his father;
- given the provisions of the trust deeds (some of which made no provision for Victor or his children) there was no plausible reason that Victor would wish to transfer his assets into the trusts and
- Victor acted in concert with his father and the associates in his father's family office in London in setting up the trusts, which Birss J considered provided some support for the inference that Victor was simply doing his father's bidding.
The true effect of the trusts claim
The trust deeds conferred wide powers on the Protector and required his consent in a wide variety of circumstances, including the trustees' power of distribution, investment and removal of a Discretionary Beneficiary. Under the trust deeds, the Protector could also remove the trustees "with or without cause" and to act on that removed trustee's behalf to vest the trust property in the new trustee. There were no provisions expressly fettering any of the Protector's powers.
Birss J found (after careful consideration of the terms) that, on a true construction of the trust deeds, the powers conferred on Mr Pugachev as First Protector were personal powers (and therefore not fettered in any way, for instance by fiduciary obligations) "conferred to give the Protector the ability to act in his own best interests" (paragraph 267) and not in the interests of the Discretionary Beneficiaries as a class. He could, for instance, remove a trustee who refused to distribute trust assets to him and replace the trustee with someone who would.
He reached this conclusion because of the extensive nature of the Protector's powers (particularly the power of removal of trustees "with or without cause") combined with the fact that Mr Pugachev, in addition to being the First Protector, was also the settlor of all the trust assets (albeit he was not named as such in the deeds themselves) and one of the named Discretionary Beneficiaries.
Birss J held that provisions about Mr Pugachev's functions as Protector transferring to Victor should the Protector come "Under a Disability", which was defined as to include a disability by operation of law, supported the same conclusion. He found that what this provision did was to allow "Mr Pugachev's effective complete control of the trusts to cease to exist the moment he is compelled to do something he does not want to do, like hand over the assets to a creditor. It is an attempt to make the trust judgment proof and should not be accepted" (paragraph 275).
In conclusion, the Judge found that "on their own terms these trusts do not divest Mr Pugachev of the beneficial ownership he had of the assets transferred into them. In substance the deeds allow Mr Pugachev to retain his beneficial ownership of the assets" (paragraph 278) and that they amounted to "a bare trust for Mr Pugachev" (paragraph 455).
The sham claim
In the event that his interpretation of the first claim was incorrect, Birss J ruled that the trusts were "shams and should not be given effect to" (paragraph 456).
In arriving at this conclusion, the Judge considered that the evidence showed:
– Mr Pugachev is "not a person who would lightly relinquish control of anything", that he is "a person quite willing to lie and put forward false statements deliberately if it would suit his purpose" and that "The circumstances as a whole and Mr Pugachev's character support a credible inference that one of Mr Pugachev's purposes in transferring the property into these trusts was what is euphemistically called "asset protection", in other words to hide them from possible claims, facilitate a plausible denial of ownership, while retaining control in fact" (paragraph 298)
– Mr Pugachev's family by Ms Tolstoy benefitted from use of the assets in the trust but only on his say so and that it was "no part of Mr Pugachev's purpose to divest control in favour of his family as distinct from himself" (paragraph 425); and
– Mr Patterson simply did "Mr Pugachev's bidding" (paragraph 379) and that he had no intention independent of Mr Pugachev (and therefore shared, albeit recklessly, in his "shamming intention") (paragraphs 433-435).
The section 423 claim
The Judge confirmed that the burden of establishing the section 423 claim was on the claimants and that the focus had to be on Mr Pugachev's purpose at the time of the transactions, which must have been to defeat creditors. J Birss stated that, had it been necessary to look into this claim in detail, he would have found that each of the transfers in setting up the trusts satisfied the test in section 423. He stated that this was because, even if the deeds did in fact divest Mr Pugachev of control, his intention was always to use the trusts to mislead other people, who might make a claim in the future. The Judge considered the increased pressure on Mr Pugachev in Russia from 2011 to be a relevant factor in this regard.
This case is an extreme example on its facts and it remains to be seen whether the High Court will be willing to declare that other, less controversial trusts (possibly not involving a Russian oligarch subject to a worldwide freezing order and committed to two years' imprisonment for contempt of court) are shams and should not be given effect to.
Certainly, this judgment contains a useful restatement of the legal principles governing the concepts of "sham" and "illusory" trusts (the section 423 claim having been given relatively short thrift), as well as a useful examination of the scope and nature of a protector's powers and duties and the circumstances in which they may be considered fiduciary or personal in nature (which Birss J gave careful consideration to by reference to the terms of the trust deeds themselves and the circumstances surrounding them).
It is also a stark and timely reminder not only of the sorts of issues trustees should be mindful of when creating and/or administering trusts, but also to look beyond the headlines prevailing in the press to see the reality of a judgment and its actual impact on day to day trust matters. In the meantime it is clear, to misquote Mark Twain, that reports of the death of the trust are greatly exaggerated.
 JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev  EWHC 2426 (Ch)