KA No 4 Trustee Limited v Financial Market Authority
Facts of the case
Mark Hotchin was the director of Hanover Finance, United Finance Ltd and Hanover Capital Ltd (which made up Hanover Group). In July 2008, Hanover Group fell into financial problems due to global financial crisis, they had no funds to repay $554 million owed to 36,500 investors. Hanover group tried to stabilise the situation and made a deal with Allied Farmers to swap debentures, notes and bonds for shares.
In March 2011, shares in Allied Farmers worth only a fraction of what they were traded for and that was the end of Hanover Group as well.
In December 2011, the FMA decided to file civil proceedings against Mark Hotchin in public interest. It was done with a view to ultimately freezing sufficient assets of Mark Hotchin to meet any potential civil claims that may be brought forward by aggrieved investors. The claim of FMA was related to false statements made in the company’s prospectus by Mark Hotchin stating company was financially stable although it was not. The FMA alleged that in 2007 and 2008 various prospectuses contained untrue financial statements were signed by Mr Hotchin.
In February 2012, High Court Judge Winkelmann J in her judgement authorised freezing orders with respect to New Zealand assets believed to be associated with Mark Hotchin. It was done to meet any civil claims that may be brought by aggrieved investors.
Mark Hotchin challenged High Court decision in the Court of Appeal.
Structure of discretionary trusts
Structure of both trusts KA 3 and KA 4 are discussed and shown below: (KA stands for Kelly-Ashley )
KA4 trust was created by written deed in 2003 in which Mr. Hotchin declared an intention to create a trust in favour of the discretionary and final beneficiaries. He was not a discretionary beneficiary however the pool of discretionary beneficiary was not closed. He had the power to nominate and remove discretionary beneficiary. He was also not a final beneficiary it was his children. However, he retained the power to appoint and remove trustees, and could also have transferred such powers to any another person.
The trust deed also included a clause prohibiting self-dealing, which states no trustee who is also a beneficiary shall exercise any power in their favour. All or any provision of the trust deed could also be revoked, altered or enlarged. In June 2011, his mother was appointed as joint appointor so the power of appointment and removal of trustee could only been exercised jointly.
KA3 Trust was established by written deed in 1999, the deed was largely similar to KA4 Trust. Mr. Hotchin was one of the discretionary beneficiaries but was not a final beneficiary. However, the pool of beneficiary could have been altered at any time. Similar to KA4 Trust Mr. Hotchin retained the powers to appoint and remove trustees, the trust deed could have been altered or revoked. The deed also contained the same prohibition clause against a trustee benefiting themselves. In June 2011, his mother was appointed as a joint appointor, so from that day onwards Mr. Hotchin and his mother jointly had the power of appointment and removal of trustee .
All assets were owned by trusts, so Mr. Hotchin effectivity owns nothing. However, the FMA wanted to secure Mr. Hotchin assets to repay investors who lost their money due to the collapse of his company. The FMA was attacking on the validity of trust so that it can be declared as a sham trust and all assets held by trust reverted back to the settlor (Mr. Hotchin)
Arguments put forward by both parties
1. Trustees hold assets on behalf of persons associated with Mark Hotchin . His children were “associated persons”, and trustee hold properties on behalf of those associated persons thus s60H(1)(f) of Securities Act 1978 is engaged.
2. KA 4 Trust was a sham. The trust was a sham from inception as Mr. Hotchin was a sole trustee and a settlor. He retained full control on all assets held by KA 4 Trust. Thus, the assets were still considered as his personal assets.
3. Trusts were setup to conceal Mr. Hotchin’s continued enjoyment of the trust property.
a. Structure of the trust deeds gave significant control to the settlor.
b. At the time KA4 Trust was established, Mr. Hotchin was the settlor and sole trustee.
c. Trustee acted purely in the interest of Mr. Hotchin many inter trust transactions showing trustees acted in his favour and under his directions.
d. Particular attention was given to property at 56 Paritai Drive, Orakei, Auckland. Although the property was owned by KA 4 Trust, Mr. Hotchin personally spent $12million on the construction of the house. There were no formal documents relating to this transaction.
1. The trustees said they do not hold property on behalf of discretionary beneficiaries of the trust. Discretionary beneficiary of the trust has no proprietary interest in trust property, but rather only an expectancy to be considered for distributions. Similarly, the fact that the children were final beneficiaries did not give them any present proprietary interest, but rather an interest that was contingent on the survival of the beneficiaries and the existence of trust property at vesting day. Thus, neither of the children could make and enforce a demand for the trust property, and the trust property could not therefore be said to be held on their behalf.
2. The trustees referred to an Australian case, Australian Securities and Investments Commission v Carey (No6) . This case was dealing with s 1323 of the Corporation Act 2001(Australia) which is equivalent to s 60H of the Securities Act 1978. The court said that the beneficiary of a discretionary trust does not have any equitable interest in the trust income or property of the trust .
3. Trustee emphasised that pleading of sham is a pleading of fraud. Therefore, the FMA must provide evidence to establish a case of fraud. In the absence of clear and sufficient evidence this was really a fishing exercise .
Analysis of court decision
Trustees hold property on behalf of whom?
In order to engage s 60G and 60H of Securities Act 1978 the court had to identify whether property in trust held on behalf of associated person or not. There has been no disagreement between both parties that Mr. Hotchin children are associated persons of Mr. Hotchin
In the earlier judgement of the High Court Winkleman J stated neither discretionary beneficiary nor final beneficiary has a beneficial interest in the trust funds .
“A discretionary beneficiary has a “mere expectancy” and a final beneficiary, a residual interest. Neither category of beneficiary can presently compel the distribution of trust funds to them.”
Court of Appeal agreed to this decision. However, the issue before the court was to resolve when discretionary and final beneficiary do not have any right to demand distribution of trust funds, the trustee of such a trust can still be said to hold the trust funds “on behalf of” the beneficiaries for the purpose of 60H (1)(f)
In the High Court judgement Winkelmann J also referred to the purpose of asset preservation provision. She mentioned the Parliament intention behind this section would be to preserve the rights of aggrieved persons. She mentioned, when s 60(1)(f) is interpreted in light of that purpose FMA argument prevails.
The trustee argued assets held by trustee in fiduciary capacity were not covered by section 60H and trust funds were not available to meet creditor’s demand of the relevant person.
The court said if the trustee contention was correct, that would mean that the trustees of a discretionary trust would not hold assets on behalf of anyone for the purpose of s 60H(1)(f) . Nevertheless, the distribution could be made to discretionary beneficiary, which would end up effectively in the control of relevant person. In case of KA4 trust, discretionary beneficiary were Mr. Hotchin’s children and they were associated with Mr. Hotchin (relevant person) i.e. the distribution was under effective control of Mr. Hotchin. Court mentioned that would not have been the intention of the Parliament while setting s 60H of the Securities Act 1978.
“One can envisage a case where the only discretionary beneficiaries or final beneficiaries of a discretionary trust are associated persons of the relevant person, in which case one can be sure that the assets of the trust will end up on in the hands of associated persons of the relevant person sooner or later. In such a case, it is difficult to see why the assets of the trust would not be considered to be held on behalf of the discretionary beneficiary for the purpose of s60H(1)(f). If that is accepted, it is equally difficult to see why the fact that some of the discretionary beneficiary of a trust are not associated persons would change that conclusion”.
The court said, it would be premature to strike out pleading of FMA at his stage rather the matter should proceed to discovery and to a substantive hearing, so that the High Court can make a fully informed assessment.
Is the claim of sham untenable?
In the earlier judgement of High Court, Winkelmann J held there were sufficient particulars to support an arguable case of sham. The trust was set up with Mr. Hotchin as the sole trustee and aspects of how it was operated mainly in relation to Paritai Drive property suggested the trust assets had been allowed to be treated as Mr Hotchin’s. In a similar judgement sham pleading against KA3 was struck out. The settlement of the KA3 Trust involved trustee other than Mr. Hotchin, there were no evidence that those trustees and settlor were intending to setup the trust as a sham. Also, all inter trust transactions of asset transfers and loan transactions were held commercially justified.
Now the question before the court was: is KA4 trust sham?
The FMA argued the seriousness of the case must be analysed and the decision must be taken on this case rather than generalising the situation. The FMA was seeking preservation of assets to preserve the status quo pending the outcome of investigation.
The FMA also pleaded that in the context of parliamentary intentions and legislative scheme, the court should preserve the assets of one likely to be in fault otherwise when it comes to the civil claim the assets may not be available.
Court mentioned, given the nature of claim and earlier judgement of the High Court, the sham argument is reasonably strong.
The essence of FMA argument was Mr. Hotchin formed KA4 Trust to conceal his continued enjoyment held by KA4 Trust and he maintained full and effective control over those assets.
Court mentioned, in a situation where the same person is the settlor and the sole trustee, unilateral intention of the settlor can enlighten whether the trust is sham or not. In the absence of intention, post establishment of trust evidence of action would be required to ascertain settlor intentions in maintaining personal control of the assets.
Introduction of Co-Trustee
The trustee argued that the introduction of an independent professional trustee should put a stop on the assertion of sham argument. FMA alleged that Mr. Hotchin’s apparent beneficial enjoyment and control of assets ostensibly owned by KA4 trust was undisturbed even after the appointment of a co-trustee.
Court said FMA argument was: KA4 Trust was sham from the inception and the post settlement actions support that proposition. FMA was not arguing that a valid trust became sham in the way it was operated (emerging sham). The argument of trustees appeared to be converse of the emerging sham; even though KA4 was sham from inception, but the introduction of an independent trustee converted this into a valid trust.
There was a strong public interest in the preservation of assets where the FMA was investigating suspected breaches of the securities legislation and there was a risk of assets available to meet the potential claims being dissipated.
The Court of Appeal held that Winkelmann J did not make an error in declining the application. It was not sufficient for the orders to be replaced because the nature of any interest Mr. Hotchin had in the Paratai Drive property and the K4 Trust remained unclear.
The court of appeal upheld the decision of the High Court mainly on the notion of heavy public interest in this case. None of the court decision mentioned anywhere that KA 4 trust was a sham. Control held by Mr. Hotchin as a settlor or as a trustee was not sufficient to plead for a sham. It was a case of partial sham where individual transaction was declared sham. A transaction of $12m loan to construct the house was required to be returned to Mr. Hotchin. The FMA was granted caveat in 56 Paritai Drive, Auckland (a property of KA4 Trust).