Why are constructive trusts relevant in bankruptcy?

Estimated reading time: 5 minutes Individual Bankruptcy

Constructive trusts impact on corporate insolvency and bankruptcy by reducing the pool of assets available for distribution to creditors. Here we define constructive trusts, and look at their application in corporate and personal insolvency.

Insolvency practitioner finds a constructive trust

Table of contents:

Constructive trusts are relevant to corporate and personal insolvency: Where a court finds that property held by an insolvent company or a bankrupt individual is held on trust for another party, that property will not be available to the liquidator or bankruptcy trustee for distribution. 

Here we explain what constructive trusts are, and describe how they fit into Australia’s system of corporate and personal insolvency/bankruptcy. 

What is the definition of a constructive trust?

The ‘trust’ is a flexible legal device which allows one person to hold property for the benefit of another person: One person, the trustee, has an obligation to hold and manage the property for the benefit of the other person, the beneficiary. The trust is not a legal entity per se, but represents the relationship in the situation described. 

Trusts can be defined by their context (e.g., a trading trust for Australian businesses, and a family trust for Australian family assets). They can also be defined by their mode of operation. 

An express trust is created through a written trust deed which specifies the trustee, the beneficiary, and the property that is held in trust. 

A constructive trust arises out of the operation of the law, rather than any written document setting out the intention to create a trust. The existence of such a trust is for the determination of the court. As a general principle the court may find that a constructive trust exists where it would be unconscionable to deny another person’s claimed interest in the property. 

A closely related form of trust is the Quistclose trust (it is a matter of academic debate whether this is a constructive trust, an express trust or another form of trust). This trust, named after the case which crystallised it, Barclays Bank v Quistclose Investments Ltd [1968] UKHL, arises where money has been provided for a specific purpose (such as debt) only. If an individual uses it for another purpose, they can be said to be in breach of trust. 

Where a constructive trust is found to exist, it can even affect the interests of secured creditors, such as those who have a registered personal property security interest. 

What is the relevance of constructive trusts for insolvency?

In a corporate insolvency, all ‘property’ of the company goes into the hands of the insolvency professional for potential distribution. But the possibility of a constructive trust raises the question as to which ‘stuff’ held by the company is really its own property. 

If a constructive trust is found, to the benefit of one unsecured creditor, this can substantially reduce the pool available for secured creditors and other unsecured creditors. In making a finding for a constructive trust, the courts will generally consider the impact on other creditors. For example, in Bathurst City Council v PWC Properties Pty Ltd [1998] HCA, it was acknowledged that the court may look to other remedies, as opposed to a constructive trust, stating at paragraph 42”

“An equitable remedy which falls short of the imposition of a trust may assist in avoiding a result whereby the plaintiff gains a beneficial proprietary interest which gives an unfair priority over other equally deserving creditors of the defendant.”

What is the relevance of constructive trust for bankruptcy?

Constructive trusts can be found in cases of personal insolvency and bankruptcy as well (see, for example Re Sabri; Ex parte Brien v Sabri (1996) 137 FLR 165). Though it appears that it has been more common for the courts to find a constructive trust exists in these cases than in the corporate insolvency case (for more on this point, see the insightful analysis from Professor Ying Khai Liew of the University of Melbourne). 

Complicating matters is the fact that bankruptcy is inherently personal: there are a range of romantic/family relationship “transactions” that people might use to claim a trust over certain assets. 

A common form of constructive trust that comes up in personal bankruptcy cases is the ‘Joint Endeavour Constructive Trust’ (JECT). This operates to protect a party which has contributed, alongside other parties, to a joint endeavour, which has subsequntly broken down. Where one party claims to assert ownership in the whole of the property, the court will impose a constructive trust on the assets where it would be unconscionable for the other party to retain title. 

In order for a JECT to be found, the joint endeavour must have been terminated. The courts have found that bankruptcy is one way that this can be terminated. 

In the personal insolvency case, the courts have tended to be less interested in the interests of third parties (such as other creditors), especially where a marriage/de facto relationship is involved, than they are in the corporate insolvency case. Consider, for example, this statement from Justice Atkinson in the Queensland Supreme Court in Clout v Markwell [2001] QSC 91

Although this may be inconvenient for the administration of bankrupt estates, the defendant has not engaged in any behaviour which suggests that her interests should be deferred to that of the judgment creditor. Creditors should be expected in these times to be aware of the possibility of constructive trusts or of equitable interests which may arise when the debtor is married or in a de facto relationship [para 21]. 

Constructive trusts and bankruptcy 

Constructive trusts are relevant in bankruptcy in Australia, as if the court finds that assets of a bankrupt individual were held on trust for a third party, that property will not be part of the pool of assets for distribution to creditors on bankruptcy. 

It is a reality of general commercial practice in Australia that all creditors need to be aware of the possible impact the finding of a constructive trust can have on their claims in corporate insolvency or in bankruptcy.

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