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CApITAL And InComEgREgORy Hill

succEssivE intErEsts and

dEficiEnt fiXEd -intErEst

sEcuritiEsthe rules in RE atKInSOn and RE BIRd

By gregory hill

One effect of the Trusts (Capital and Income) Bill, at the time of writing going through Parliament under the special procedure for uncontentious Law Commission bills, will be to disapply the Apportionment Act 1870, and the rules in Howe v Earl of Dartmouth1, Re Earl of Chesterfield’s Trusts2

and Allhusen v Whittell3, in relation to any trust created or arising after the legislation comes into force (including a trust created or arising under an already-existing power), unless a contrary intention appears in any instrument creating the trust, or in any power under which it is created or arises: clause 1(1) and (2)(a)-(d) of the Bill. These changes were recommended by the Law Commission in its report Capital and Income in Trusts: Classification and Apportionment4, and have been widely welcomed: see the House of Lords’ Second Reading Committee debate on 25 April 20125 and the evidence given to the Special Public Bill Committee by trusts practitioners on 11 and 12 July 20126.

The Law Commission’s report and draft Bill also proposed the abolition of the rules in Re Atkinson7 and Re Bird8, which prescribe apportionments between trust capital and income where the realisation of a fixed interest security, such as a mortgage debt or debenture stock, produces a sum which is less than the total amount owing for principal and arrears of interest. Concerns about the possible consequences of abolishing these rules were raised in responses to the Ministry of Justice’s consultation in 2010 on the Law Commission’s draft Bill, and it was decided to retain them because the computations they require are less complex than those under the other rules recommended for abolition, and the necessity for such adjustments arises less often, but if such a situation does arise, the sums at stake are more likely to be large enough to require apportionments to be made in order to produce a fair result as between capital and income beneficiaries.

Re Atkinson and Re Bird are probably among the less well-known of the rules of trust administration, and since they are now not to be abolished, and deficiencies on fixed interest securities, perhaps even including sovereign debt, seem less unlikely today than was thought to be the case even a few years ago, it appears to be appropriate to examine how those rules will work in practice.

Re Atkinson applies where the deficient security was an authorised investment, and requires the amount actually realised (A) to be divided between capital and income in the proportion which the amount due for capital (B) and that due for arrears of interest (C) bear to one another9, but the income beneficiary’s entitlement to the interest actually received is not in any way affected. The relevant formulae, where the investment was authorised, are thus:

Capital = A x B B + C Income = A x C

B + C

If the deficient security was not an authorised investment, Re Bird directs a different calculation: the rights of income and capital beneficiaries are adjusted as if the unauthorised investment had not been made10, by ascertaining what the value (P) of the relevant trust asset would have been, on the effective date of the adjustment, if it had not been converted into the unauthorised investment; what interest (Q) it would have produced for the income beneficiary over the period from conversion to the adjustment date; the amount actually realised (R) from the unauthorised investment; and the interest on it (S) which the income beneficiary actually received. The aggregate of receipts (R+S) is then divided between capital and income beneficiaries in proportion to what they respectively would have received (P:Q) if the unauthorised investment had not been made. The income beneficiary must give credit for interest received (S) but, if not responsible for the wrongful investment, is not liable to refund any of it if the result of the calculation shows

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The Re Bird calculation is the more complicated of the two; the more straightforward Re Atkinson principle

is the one which will normally be applied

that there has been an overpayment. Where the investment was unauthorised, the formulae are thus:

Capital = P P + Q x (R + S) Income = Q

P + Q x (R + S)( ) – S

An example follows, to illustrate the different results of these rules.Nusquamia is a little-known jurisdiction with a chequered

financial history. Professor Maitland analysed the legal and political characteristics of its sovereign debt when there was a default in 190411, and Professor Hart returned to the theme in 195312. Over the next half-century, however, Nusquamia’s political and financial systems have stabilised, on a foundation of consumer-led growth and enthusiastic participation in the global digital economy. Mr Fenton, gentleman, of London and Windsor, has financial connections in the City and political connections at Westminster, and believes Nusquamia is now a land of opportunity. His wife, Ann, has expectations under the will of her grandfather, Elder Page, who died in 2003 leaving his considerable estate in trust for his son, Younger Page, for his lifetime, and subject thereto, and to powers for Younger Page to appoint income to his wife during widowhood and capital among his issue, for Younger Page’s children in equal shares at the age of 25. The trustees are Sir J Falstaff, Rev H Evans and Younger Page’s friend and neighbour Younger Ford, and the will excludes the Trustee Act 2000 s3 and confers on the trustees express power to invest in, inter alia, ‘debt obligations denominated and payable in sterling or euros or United States dollars of any body corporate formed under the law of any jurisdiction’. Mr Fenton suggests to the trustees that they may wish to consider subscribing for a forthcoming sterling debenture stock issue of the leading Nusquamian computer hire-purchase company Nusquamian Binary Gadgets Finance Inc, and after obtaining and carefully considering advice from their solicitors, Silence and Slender LLP, and their brokers, Bardolph, Nym, Pistol & Partners, the trustees sell GBP500,000 (nominal) of Windsor Corporation 3½% loan stock 2050, then standing at 85, and subscribe at par for GBP425,000 NBG Finance 4½% sterling perpetual debenture stock, thereby increasing Younger Page’s income by GBP1,625 per annum, without (as they believe) significantly altering the counterparty risk.

Younger Ford’s father, Elder Ford, died in 2005 leaving a will in very similar terms mutatis mutandis to that of Elder Page (Silence and Slender LLP have acted for both families for many years), appointing Sir J Falstaff, Rev H Evans and Younger Page as trustees, and everyone believes the two wills are exactly the same. However (caution being a Ford family characteristic), Elder Ford’s power of

investment in fact authorises only ‘debt obligations denominated and payable in sterling or euros or United States dollars of any body corporate formed under the law of any jurisdiction within the British Commonwealth the European Economic Community or the United States of America’ (which does not include Nusquamia), and unfortunately the additional words are at the top of page 18 of the will, with the result that when Younger Ford enquires whether NBG Finance stock would also be a suitable investment for his family, no one notices that it is unauthorised, and Elder Ford’s trustees (after taking advice) sell Windsor Corporation stock and subscribe for NBG Finance sterling debenture stock in the same amounts, and at the same prices, as Elder Page’s trustees.

NBG Finance duly pays the interest on its debenture stock for the next five years, but its specialised business of financing home computer acquisitions on hire-purchase shrinks catastrophically as technological developments bring down the price of computer equipment in real terms, so that buyers find they do not need time to pay, and shortly before the due date for the sixth year’s interest payment, the board resolves that NBG Finance is prospectively cash-flow insolvent and can no longer trade, and the company goes into liquidation. Four years later the liquidator pays a first and final dividend of 65p in the pound on the debenture stock.

Elder Page’s trustees receive GBP425,000 x 65% = GBP276,250, A, and since the stock was an authorised investment for their trust fund, under Re Atkinson it is allocated between capital and income rateably in proportion to the capital owing of GBP425,000, B, and the arrears of interest of GBP425,000 x 4½% x 4 years = GBP76,500, C. Applying the authorised investment formulae above:

Capital = A x B B + C = 276,250 x 425,000

501,500 = GBP234,110

Income = A x C B + C = 276,250 x 76,500

501,500 = GBP42,140

Elder Ford’s trustees also receive GBP276,250, R, but since for them the stock was not an authorised investment, Re Bird requires them to divide that sum, plus the interest actually received, in proportion to what the trust asset would have been worth at the time of the adjustment, and the income it would have produced while the unauthorised investment was held, if the latter investment had not been made, with the income beneficiary giving credit for income actually received. On the assumption (equivalent to that made in Re Bird13) that the Windsor Corporation loan stock would have been retained, and the further assumption that when the trustees receive

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CApITAL And InComEgREgORy Hill

their dividend from NBG Finance’s liquidator the Windsor stock stands at 90:

P = GBP500,000 x 90% = GBP450,000Q = GBP500,000 x 3½% x 9 years = GBP157,500R = GBP276,250S = GBP425,000 x 4½% x 5 years = GBP95,625

Taking these values and applying the above formulae for unauthorised investments:

Capital = P P + Q x (R + S) = 450,000

607,500 x 371,875 = GBP275,463

Income = Q P + Q x (R + S)( ) – S

= 157,500607,500

x 371,875 – 95,625( ) = GBP787

On these figures, the Re Bird calculation gives Younger Ford a small further sum by way of income, though much less than Younger Page receives under Re Atkinson. But if NBG Finance had paid one more year’s interest (and the liquidation had been one year shorter), substituting {S1 = GBP114,750} for {S = GBP95,625} in the Re Bird calculation would allocate GBP289,630 to capital, and Younger Ford would have been overpaid by GBP13,380. If he was not responsible for the making of the unauthorised investment, he could not be required to refund, and the result would be simply to allocate to capital the whole of the GBP276,250 received from the liquidation. On the same hypothesis, that NBG Finance had kept going for another year, reworking the Re Atkinson calculation with the substitution of {C1 = GBP57,375} for {C = GBP76,500} would allocate GBP243,612 to capital and GBP32,888 to income.

The Re Bird calculation is the more complicated of the two, and also requires the court to decide what investment would have

been made or retained, what income it would have produced, and what it would have been worth at the effective date of the adjustment, if the unauthorised investment had not been made. In practice these questions may be difficult to answer reliably, for instance if the trustees’ policy throughout was one of active investment, or if the investment which they sold would have matured, producing funds which would have had to be re-invested, before the unauthorised investment was actually realised. But the Elder Ford scenario above, in which a fixed interest security is not an authorised trust investment, is more than somewhat contrived; the Trustee Act 2000 s3, following widely adopted drafting practice, allows a trustee to ‘make any kind of investment that he could make if he were absolutely entitled to the assets of the trust’. It seems, therefore, that the more straightforward Re Atkinson principle is the one which will normally be applied.

The rules in Re Atkinson and Re Bird do no more than allocate between capital and income beneficiaries the loss suffered when a relevant investment turns out to be deficient, and do not affect the question whether any of the beneficiaries, or successor trustees on behalf of all of them, can recover all or any of that loss from the trustees who made that investment. But the beneficiaries together, or successor trustees on their behalf, may make a claim which is partly but not wholly successful, for instance if the investment was authorised and the court holds that its retention did not amount to a breach of the trustees’ duty of care under the Trustee Act 2000 Part I until part of the loss had already been suffered, or if it was unauthorised but the defendant trustees raise and the claimants compromise a defence under an express exoneration clause or under the Trustee Act 1925 s61. In those circumstances, it appears that the rule in Re Atkinson or Re Bird, as the case may be, will govern the allocation between capital and income of the amount recovered.

GREGoRy HiLL TEP IS A BARRISTER AT 10 oLD SquARE, LInCoLn’S Inn, LonDon

1 (1802) 7 ves jun 1372 (1883) 24 ch d 6433 (1867) lr 4 eq 2954 law com no 315, 7 May 2009, Part 65 lords Hansard 25 april 2012 cols Gc291-Gc306, at www.publications.

parliament.uk/pa/ld201212/ldhansrd/text/120425-gc0001.htm#12042543000076 6 www.parliament.uk/business/committees/committees-a-z/other-committees/trusts-

capital-income-bill (at time of writing, unrevised transcripts)7 [1904] 2 ch 160, ca8 [1901] 1 ch 916, Farwell j9 see [1904] 2 ch 160 at 165–166, per vaughan Williams lj; at 167, per

romer lj; and at 169, per cozens-hardy lj (giving the analogy of a contributory mortgage).10 [1901] 1 ch 916 at 91911 ‘Moral Personality and legal Personality’, reprinted in Collected Papers (1911,

ed Fisher), vol iii, p304 at pp318-31912 ‘definition and theory in jurisprudence’ (1954) 70 lqr p37 at pp51-5313 see [1901] 1 ch 916 at 919–920: the trustees had sold GbP10,021 consols to make

the unauthorised investment, and Farwell j directed an apportionment by reference to the dividends which would have been received on that holding down to, and its value at, the death of the income beneficiary.