Equitable Remedies and Tracing Flashcards
Personal and proprietary remedies
Equitable remedies can be either personal or proprietary in nature.
Personal remedies include monetary remedies such as equitable compensation (awarded in cases
where a breach gives rise to loss) and an account of profits (awarded where a wrongdoer makes a
profit). As we saw in the chapter on ‘Liability of trustees’, equitable compensation may be
awarded where a breach of trust or fiduciary duty results in a loss to the trust fund, while an
account of profits will be more appropriate if the wrongdoer has personally made a profit.
Proprietary remedies involve awarding the claimant a proprietary right. Again, we saw an example
of this in the chapter on ‘The fiduciary relationship’ where we learned that a breach of the noprofit rule gives the claimant a choice between an account of profits and claiming a constructive
trust over the profit.
The option to claim a constructive trust is useful because it gives the claimant the ability to utilise
the following and tracing rules, identifying what the profit has been spent on. These rules can also
be used in cases where trustees have misapplied trust funds. They allow the claimant to trace into
a series of substitute assets and assert a proprietary right over the final proceeds.
1.2.1 Benefits of proprietary claims
The remedy sought at the end of this process might be for a security interest or a beneficial
interest under a trust. Both types of claim ensure that the rights of the beneficiaries are
ringfenced against the insolvency of the trustee. Claims for beneficial ownership of the asset also
enable the beneficiaries to capture the benefit of any increases in value.
Equitable remedies and 15 tracing
So the ability to make a proprietary claim can be very useful. In order to do so, however, it will be
necessary to identify an asset which represents the proceeds of the breach. In the remainder of
this chapter, we consider the following, tracing and claiming rules.
Options when trustees misapply funds
When a trustee misapplies trust property, the beneficiaries have a number of potential options
available to them. Broadly, they may be able to:
(a) Sue the trustee for breach of trust.
(b) Sue a third party who has assisted the breach of trust.
(c) Make a claim against the misapplied property or its traceable proceeds.
(d) Sue a third party who knowingly received the traceable proceeds of the breach.
In the remainder of this chapter we consider the following and tracing processes, and the
proprietary claims that may be made at the end of that process.
Equitable proprietary claims
traceable proceeds.
A proprietary claim has three principal advantages:
(a) It is not affected by the defendant’s bankruptcy or insolvency.
(b) It enables beneficiaries to capture increases in the value of traceable proceeds.
(c) It does not depend on fault: it can be maintained against the defaulting trustee and against
innocent recipients of the trust property or its traceable proceeds.
Following, tracing and claiming underpin equitable proprietary claims. The function of the
following and tracing rules is to locate misapplied trust property and to identify assets which
represent it.
Following: Following is the process of ‘following the same asset as it moves from hand to hand’
(Foskett). It is the process for locating misapplied trust property. Thus, if T misapplies £1,000
(cash) of the trust fund and gifts it to X, and X gifts it to Y, the beneficiaries can follow the
£1,000 from T to X and then to Y.
Tracing: Tracing is the process of ‘identifying a new asset as the substitute for the old’
(Foskett). Generally, one asset is the traceable proceed of another if there is ‘a series of direct
substitutions’ between them (Relfo Ltd (in liquidation) v Varsani [2014] EWCA Civ 360).
Claiming: Claiming is the assertion of a personal or proprietary right in relation to misapplied
trust property or its traceable proceeds (Foskett).
Claiming and types of proprietary claim
If beneficiaries can follow or trace misapplied trust property, they can assert a proprietary
interest in the trust property (or its traceable proceeds). A beneficiary may wish to make claims in
respect of:
* The misapplied trust property
* Assets purchased exclusively with misapplied trust money (or its traceable proceeds)
* Assets purchased with a mixed fund
Once an asset has been identified, it is then necessary to consider the nature of the claim that
can be made in respect of that asset. There are four potential options:
(a) The beneficiary claims beneficial ownership of the asset: This will only be possible in the
simple case where the asset is acquired exclusively with the traceable proceeds of the
breach.
(b) The beneficiary claims beneficial ownership of a share of the asset: This may be possible in
cases where the asset has been acquired using a mixed fund.
(c) The beneficiary claims an equitable lien over the asset: This may be possible in both types of
case. Generally a beneficiary will want to do this where the asset has decreased in value,
meaning that claiming the asset would result in a loss. It effectively turns their personal claim
for breach of trust into a secured claim.
(d) Subrogation: This is a claim that can be made where misapplied trust funds (or their
traceable proceeds) are used to pay off a secured debt. It allows the beneficiary to step into
the shoes of the creditor, treating the beneficiary as if they had loaned the money and
enabling them to take equivalent security to that previously held by the original lender.
The principal defence to an equitable proprietary claim is that of the purchaser of a legal interest
without notice of the trust (also known as a ‘bona fide purchaser for value without notice’).
Purchasers are entitled to deal with trustees as if they are the full legal owner. If the purchaser has
no notice of the trust, they take clean title to the trust property, even if it has been misapplied.
Withdrawals from wrongful mixtures
Tracing is more difficult when misapplied trust money (or its traceable proceed) is mixed with
money derived from other sources. Most tracing cases involve money mixed in bank accounts
and, as a result, the tracing rules have been largely formulated by reference to bank accounts.
But the rules are not limited to money or bank accounts. They also apply to physical mixtures of
fungible goods: Foskett.
There are two principal types of mixed fund.
(a) A mixed fund comprising misapplied trust money and the trustee’s own money (‘a wrongful
mixture’)
(b) A mixed fund comprising misapplied trust money and money derived from one or more
innocent third parties (‘an innocent mixture’)
In cases where the whole of a mixed fund is used to acquire a single asset tracing is reasonably
straightforward. For example:
* T misapplies £1,000 of the trust fund
* T pays the £1,000 into their current bank account which is already credited with £1,000
* T withdraws £2,000 (cash) from the account and uses it to purchase shares
The shares are the traceable proceeds of the trust fund because:
* £1,000 was credited to T’s bank account in exchange for the trust money
* T exchanged the sum credited to the account for £2,000 (cash)
* T exchanged the cash for the shares
Thus, there is a series of direct substitutions between the misapplied trust money and the shares.
Tracing is more difficult in cases where only part of a mixed fund is used in connection with a
particular transaction. Different rules apply to wrongful mixtures and innocent mixtures.
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3.2.1 Withdrawals from wrongful mixtures
The rules applicable to wrongful mixtures can be summarised as follows:
* Basic rule: Where a trustee makes withdrawals from a wrongful mixture, some of which (or
their traceable proceeds) are dissipated, the beneficiary can treat the dissipation as the
trustee’s money and attribute the identifiable funds (or traceable proceeds) to the trust,
regardless of the order in which the withdrawals are made. Dissipation means applying money
in such a way that there is no traceable proceed eg where it is used to pay for a pure service
such as a haircut or a massage.
* Cherry picking: In cases where withdrawals from a wrongful mixture are used to acquire
multiple assets into which a beneficiary could potentially trace:
- In cases where the only contest is between the beneficiary and the trustee, the beneficiary
can attribute the most profitable applications of the mixed fund to the trust money.
- In other cases (eg cases in which the beneficiary is competing with the unsecured creditors
of a bankrupt trustee) the basic rule still applies (ie the beneficiary can attribute any part
of the mixed fund which is dissipated to the trustee) but the beneficiary cannot attribute
the most profitable applications of the fund to the misapplied trust money
Withdrawals from innocent mixtures
Having completed a review of the tracing rules applying to withdrawals from wrongful mixtures, it
is necessary to consider the rules which apply to withdrawals from innocent mixtures.
The two most common examples of innocent mixtures are cases where:
(a) Money from two or more trusts is mixed by a common trustee
(b) An innocent recipient of misapplied trust money mixes it with their own money
This general rule does not apply to withdrawals from an innocent mixture in a current bank
account. Three different approaches have been taken to these cases. They are set out below. In
order to compare them, a common example is used.
Technically, the rule applying to withdrawals from a current bank account is the rule in Clayton’s
Case (1816) 1 Mer 529: Re Diplock. Grant MR stated the rule in these terms (1816) 1 Mer 529, 608: ‘it
is the sum first paid in that is first drawn out’. The rule is commonly described as ‘the first in, first
out’ rule.
Clayton’s case
If Clayton’s Case is applied, the shares are the traceable proceeds of fund A because fund A was
paid into the account first and the shares were purchased with the first £1,000 withdrawn. The
second £1,000 withdrawn from the account (and dissipated) is attributable to fund B. And the sum
credited to the account is the traceable proceed of fund C.
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Thus, the money from trust A and trust C can be traced into the shares and the sum credited to
the account (respectively). But the money from trust B cannot be traced into any assets because
the withdrawal attributed to that money was dissipated.
It is obvious that the rule in Clayton’s Case can produce ‘arbitrary’ results. In the example, the
beneficiary of trust A can, but the beneficiary of trust B cannot, identify a traceable proceed
simply because the money from fund A was paid into the account before the money from fund B
(an entirely fortuitous event). As a result of the arbitrary nature of the rule, in Barlow Clowes
International Ltd (in liquidation) v Vaughan [1992] 4 All ER 22, the Court of Appeal held that the
rule can be disapplied where its application would be:
* Contrary to the intentions of the parties who contributed to the mixture;
* Impracticable (ie too complex or expensive to apply); or
* Unfair
In Barlow Clowes, the court did not apply the rule to investors who had contributed to a common
investment scheme in which all profits and losses were to be shared rateably. The court held that
it would be contrary to the investors’ intentions to apply the rule and to allocate specific
investments to specific investors.
Since Barlow Clowes, the rule in Clayton’s case has been disapplied in every case in which it has
been considered. In Charity Commission for England and Wales v Framjee [2014] EWHC 2507
(Ch), Henderson J noted (at para 49) that the rule ‘may be displaced with relative ease in favour
of a solution which produces a fairer result’.
If the rule in Clayton’s Case is not applied, one of two alternative methods is available.
(a) The pari passu ex post facto method. This involves identifying the amounts contributed to the
account by each individual contributor attributing all the withdrawals from the account
fractionally to all the contributors, regardless of the order in which the payments were made.
This method is called the ‘ex post facto’ method because it is static. It involves a single
calculation after the event.
(b) The rolling charge method. Each individual withdrawal is attributed fractionally to the
contributors to the account immediately before the withdrawal: the fraction attributed to any
specific contributor being equivalent to their fractional contribution to the account
immediately before the withdrawal. This is called the ‘rolling charge’ method because it is
dynamic. It requires the contributors’ fractional contributions to be recalculated every time a
sum is credited to the account. The order in which the payments were made can therefore
affect the amounts attributed to individuals.
As a matter of principle, the rolling charge method should be applied in preference to the ex post
facto method (Barlow Clowes and Shalson). However, if the rolling charge method is too complex
or expensive to apply, the ex post facto method should be applied. To date, there are no examples
of the rolling charge method being applied.
Unmixed funds
Where beneficiaries are able to follow misapplied trust property, they can assert their equitable
proprietary interest in the property: Foskett. The person who holds the property will have to
restore it to the trust fund: Diplock.
Where an asset is purchased exclusively with trust money (or its traceable proceed) the
beneficiary can choose between (Foskett):
* Asserting beneficial ownership of the asset
* Making a personal claim against the trustee for breach of trust and enforcing an equitable lien
on the asset (in other words, the beneficiary becomes a secured creditor)
The beneficiary will normally exercise the option in the most advantageous way. If the traceable
proceeds have increased in value, it will usually be preferable to claim them. If they have
decreased in value, it will usually be preferable to make the personal claim.
Wrongful mixtures
Similarly, where an asset is purchased with misapplied trust money (or its traceable proceeds)
and the trustee’s money the beneficiary can choose between:
(a) Claiming a proportionate share of the asset.
(b) Enforcing a lien upon it to secure his personal claim against the trustee for the amount of the
misapplied money.
The rationale is that, since the trustee is a wrongdoer, their interest must be subordinated to the
beneficiaries’ interest: the trustee cannot claim their interest in the asset until the beneficiaries’
claim has been satisfied in full.
Where beneficiaries claim a proportionate share of an asset which has increased in value, they
capture a corresponding proportion of the increase.
Innocent mixtures
Where an asset is purchased with misapplied trust money (or its traceable proceed) and money
derived from one or more innocent third parties, the beneficiaries can only claim a proportionate
share of the asset: Diplock. The rationale is that innocent parties must be treated equally.
Where the beneficiary’s claim is in competition with the claims of other innocent contributors,
there is no basis upon which any of the claims can be subordinated to any of the others.
Where the fund is deficient, the beneficiary is not entitled to enforce a lien for his
contributions; all must share rateably in the fund.
(Foskett)
The courts have not yet considered whether beneficiaries can assert an equitable lien limited to
the value of their proportionate share in the asset.
Wrongful and innocent mixtures
Where assets are acquired using a mixture of trustee funds and funds from more than one
innocent party the same rules apply as above. As the example below shows, this can result in
situations which feel unfair in comparison to cases involving just one trust. It is, however,
consistent with the broad principle that no innocent parties (including unsecured creditors) should
be preferred over others.
Subrogation
Where misapplied trust money (or its traceable proceed) is dissipated by the payment of a
secured debt, the beneficiaries can be ‘subrogated’ to the rights of the creditor (Boscawen v
Bajwa [1996] 1 WLR 328).
We only consider subrogation in the context of payments used to fully extinguish a secured debt.
We do not consider cases where the money has only been used to reduce the debt, leaving the
original security intact
