Sham Trusts: Illusory or Real?

A sham trust is a trust that, despite appearing legitimate on the surface, is created with the mutual intention of the parties (usually the settlor and trustee) to not be acted upon according to its stated terms. Instead, the true intention is for the settlor to retain control over the trust assets, undermining the basic principles of trust law. Courts are willing to disregard such trusts when it is clear that they were set up to mislead or deceive third parties, such as creditors, tax authorities, or others.

To better understand the legal principles surrounding sham trusts, it's essential to examine relevant case law.

Case Law on Sham Trusts

• Snook v. London and West Riding Investments Ltd [1967] 2 QB 786: This case is foundational in understanding the concept of a "sham" in legal arrangements, including trusts. Lord Diplock explained that a sham is an arrangement where the parties "intend to give the appearance of creating legal rights and obligations different from the actual rights and obligations that they intend to create." In a sham trust, the settlor and trustee appear to create a trust, but in reality, the settlor retains control over the assets, contrary to the legal formalities of the trust. The court held that for a trust to be a sham, both the settlor and trustee must have a common intention to deceive.

In this case, Lord Diplock attempted to give a definition of sham:

[I]t is, I think, necessary to consider what, if any, legal concept is involved in the use of this popular and pejorative word. I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create. But one thing, I think, is clear in legal principle, morality and the authorities (...) that for acts or documents to be a "sham," with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a "shammer" affect the rights of a party whom he deceived.

• A v. A (1997) 1 FLR 361: In this case, the English court held that a trust would be considered a sham if it could be proven that both the settlor and trustee intended that the trust not be a genuine legal arrangement. Here, the court looked at whether the trustee had been allowed to manage the trust assets independently or whether the settlor retained effective control over them. The decision emphasised that the trustee must not simply act as a puppet for the settlor's wishes.
• Rahman v. Chase Bank (CI) Trust Co Ltd [1991] JLR 103: This Jersey case is an example of a trust being declared a sham. The court concluded that the trustee was not acting independently but was following the instructions of the settlor, contrary to the terms of the trust deed. The decision in this case reinforced the notion that if the trustee does not exercise independent control, the trust may be declared a sham.
• Midland Bank Plc v. Wyatt [1995] 1 FLR 696: In this case, Mr. Wyatt purported to create a trust to protect his family home from creditors. However, the court found that the trust was a sham because there was no real intention to create a trust at the time. The trust was not acted upon, and the settlor retained control over the asset, demonstrating that the trust was designed merely to provide a false impression to creditors.
• Re Esteem Settlement [2003] JLR 188: In this case, the Royal Court of Jersey considered the principles behind sham trusts. The court ruled that for a trust to be a sham, the intention of the parties must be that the trust is not genuine. The court also noted that trustees must not act under the control or direction of the settlor. In this case, the trust was found not to be a sham because there was no mutual intention between the settlor and trustees to mislead anyone.

Legal Principles Surrounding Sham Trusts

The following principles are common to most decisions on sham trusts:

1. Common Intention: For a trust to be declared a sham, both the settlor and the trustee must have a mutual intention to deceive third parties by making it appear that a trust exists when it does not. This requirement was made clear in Snook v. London and West Riding Investments Ltd and reaffirmed in cases such as Rahman v. Chase Bank and Re Esteem Settlement.
2. Control by Settlor: One of the key indicators of a sham trust is the degree of control that the settlor continues to exercise over the assets. If the settlor retains control, and the trustee merely acts as an agent or "puppet" of the settlor, courts are more likely to declare the trust a sham. This principle is evident in A v. A and Midland Bank Plc v. Wyatt, where the settlor's ongoing control over the assets was central to the court's decision to disregard the trust.
3. Trustee Independence: A trust can be declared a sham if it is found that the trustee is not acting independently and is merely following the settlor’s instructions, contrary to the trust’s terms. The trustee must manage the trust assets according to the terms of the trust deed, not the wishes of the settlor. This is a key factor in Rahman v. Chase Bank.

Sham Trusts and Asset Protection

Sham trusts are often set up for illegitimate purposes such as avoiding creditors or tax liabilities. Courts have become more vigilant in scrutinising trusts that appear to be created for these purposes. In Midland Bank Plc v. Wyatt, the trust was set up specifically to protect assets from creditors, and the court quickly saw through this intention.

A sham trust is declared when the court finds that the parties involved never intended the trust to operate as a genuine legal entity, but rather as a façade to mislead or defraud third parties. Case law such as Snook v. London and Midland Bank v. Wyatt has clarified that both the settlor and trustee must have a common intention to deceive for a trust to be deemed a sham. Courts will often look at the degree of control retained by the settlor and the independence of the trustee in deciding whether a trust is legitimate. Academic literature reinforces these principles, warning of the risks of using sham trusts for asset protection or tax avoidance, as courts are increasingly adept at detecting and dismantling them.

Not a Sham

To ensure that a trust is not considered a sham, the parties involved (especially the settlor and the trustee) must take certain steps to demonstrate that the trust is genuine and legally effective. A valid trust must follow the established legal requirements and ensure that its structure and administration are in line with the fundamental principles of trust law. Here are key steps to ensure that a trust is not considered a sham:

1. Establish Genuine Intention to Create a Trust

• The settlor must have a clear and genuine intention to create a trust. The settlor should document the purpose of the trust and express their intentions explicitly in the trust deed.
• The trust deed must clearly state that the trustee will manage the assets for the benefit of the beneficiaries and not for the settlor’s personal benefit.
• Avoid situations where the trust is merely a facade to hide the settlor’s continued control over the assets.

In Snook v. London and West Riding Investments Ltd [1967], the court ruled that a sham trust exists when the parties intend to mislead by creating rights and obligations that differ from those stated. To avoid this, make sure the trust’s actual practice aligns with its legal form.

2. Ensure the Trustee Has Full Control Over Trust Assets

• Trustee independence is crucial. Once the assets are transferred into the trust, the trustee must have complete control over them and manage them in accordance with the terms of the trust deed.
• The settlor must relinquish control of the assets and not direct or interfere with the trustee’s management of the trust.
• Trustees must be involved in making decisions regarding the trust assets, and those decisions must be made in the best interests of the beneficiaries, not under the settlor's influence.

‘Sham trusts’ can be twofold: formal shams and administrative shams. It is important to note that the aforementioned categories of shams can overlap. However, the distinction is the following – a formal sham occurs wen the trust instrument allows the settlor a high degree of control. On the other hand, administrative shams occurs when the trust is administered in an improper way. 

In Rahman v. Chase Bank (CI) Trust Co Ltd [1991], the trust was declared a sham because the trustee followed the instructions of the settlor. To avoid this, ensure the trustee has genuine autonomy and is not acting as a "puppet" of the settlor.

In the words of the Royal Court of Jersey:

The trustee was never made the master of the assets. [The settlor] intended to and in fact retained control of the capital and income of the trust fund throughout his lifetime and used the trust and the deed of appointment made under the trust to make the testamentary dispositions.

3. Follow Proper Formalities in Setting up the Trust

• A trust must meet the three certainties as laid out in Knight v. Knight (1840):
  • Certainty of Intention: The settlor must clearly intend to create a trust.
  • Certainty of Subject Matter: The trust assets must be clearly identified and defined.
  • Certainty of Objects: The beneficiaries of the trust must be clearly identifiable.

Following these certainties ensures that the trust meets the basic legal formalities.

4. Document Trustee Independence

• The trustee should keep clear and accurate records of all decisions and actions taken in relation to the trust. This documentation shows that the trustee is acting independently and in accordance with the trust deed.
• All meetings, resolutions, and decisions concerning trust assets should be recorded to show that the trustee has been managing the trust independently of the settlor’s wishes.

Best Practice: Regular meetings between trustees, proper documentation of decisions, and evidence of independent management of trust assets will provide a clear paper trail that can be used to defend the trust’s validity.

5. Avoid Retaining Powers that Compromise the Trust

• The settlor should not retain significant powers over the trust that allow them to control the assets or override the decisions of the trustee.
• While it is permissible for the settlor to include certain reserved powers (such as the ability to appoint or remove trustees or amend the trust deed under limited circumstances), these powers should be carefully drafted to avoid giving the impression that the settlor is effectively still in control of the assets.
• Ensure that any powers retained by the settlor do not undermine the trustee’s independence or the nature of the trust.

In Midland Bank Plc v. Wyatt [1995], the trust was considered a sham because Mr. Wyatt retained effective control over the assets and never intended to allow the trustee to manage the assets independently.

6. Avoid Creating a Trust for Improper Purposes

• If a trust is created for purposes that suggest it is intended to deceive or mislead third parties, such as creditors or tax authorities, it may be more easily declared a sham.
• Ensure that the trust is created for legitimate purposes, such as asset protection, estate planning, or charitable giving, and not simply to shield assets from liabilities in a dishonest manner.

In Midland Bank Plc v. Wyatt, the court found that the trust was created with the intent to deceive creditors, which contributed to its designation as a sham.

7. Engage Independent Legal Advice

• Both the settlor and trustee should seek independent legal advice when creating and administering the trust to ensure that the trust complies with all legal requirements and that there is no perception that the trustee is acting under the settlor's control.
• Having a qualified legal professional draft the trust deed and provide guidance throughout the process can help avoid mistakes that could lead to the trust being challenged as a sham.

Best Practice: Legal advice can help structure the trust correctly and ensure compliance with both common law principles and statutory requirements.

8. Select Independent Trustees

• Appointing independent, professional trustees can reduce the risk of the trust being considered a sham. Independent trustees are less likely to be influenced by the settlor and will be able to make impartial decisions regarding the management of the trust.
• If a family member or close associate is appointed as trustee, there must be clear evidence that they are acting independently and in accordance with their fiduciary duties.

Appointing professional trustees or a trust company can help reinforce the legitimacy of the trust and the separation of control between the settlor and the trust assets.

9. Proper Trust Documentation

• The trust deed must clearly outline the terms and conditions of the trust, including the role of the trustee, the rights and responsibilities of the beneficiaries, and the purpose of the trust.
• Additional documents such as letters of wishes (if used) should not contradict the terms of the trust deed or imply that the settlor is directing the trustee.

10. Respect the Fiduciary Duties of the Trustee

• Trustees must act in accordance with their fiduciary duties to the beneficiaries, including the duty of loyalty, prudence, and impartiality. Trustees must not favour the interests of the settlor over the beneficiaries.
• Regular distributions or management of assets should be aligned with the terms of the trust and the best interests of the beneficiaries.

Conclusion

To avoid having a trust considered a sham, both the settlor and the trustee must act with transparency and genuine intent. By ensuring the trustee is truly independent, relinquishing control over the trust assets, following legal formalities, and creating the trust for legitimate purposes, one can minimise the risk of the trust being invalidated by a court. Proper documentation, legal advice, and trustee conduct are essential in establishing and maintaining the credibility and legality of a trust.

About the Authors

This article has been authored by Dr Franklin Cachia, Director and Lead Consultant and Dr Francesca Anastasi, Legal Advisor. Contact us here or on [email protected] for more information.