Misappropriated Trust Property and Liability

How much knowledge should a recipient of misappropriated trust property have before they are imposed with liability?

Introduction

In 1874, Lord Selborne LC formulated the modern law of third party recipient liability. In Barnes v Addy,^[1] his Lordship declared:

“[S]trangers [to a trust] are not to be made [liable]…, unless those agents receive and become chargeable with some part of the trust property…”.^[2]

This liability is known as ‘knowing receipt’. Essentially, knowing receipt defines the personal liability imposed upon a third party recipient of property that has been disposed of in breach of trust.^[3] The third party recipient, once liability is imposed upon him, is obligated to compensate the particular trust in question for any loss caused by his receipt and account for any profits obtained by reason of it.

However, determining the standard required to impose personal liability has not been an easy task. The main issue has been deciding what exact degree of knowledge the recipient should have before they are fixed with liability. This paper will survey the conflicting authorities which attempt to answer this question, concluding that a constructive notice standard of knowledge provides the law’s best standard.

Present standard

The present standard that the law utilises to determine the potential liability of recipients cannot be defined by its clarity. Nourse LJ, in Bank of Credit and Commerce International (Overseas) Ltd v Akindele,^[4] provides the test:

“The recipient’s state of knowledge must be such as to make it unconscionable for him to retain the benefit of his receipt.”^[5]

Whilst his Lordship must be applauded for attempting to consolidate conflicting authority into an inclusive, single test, the protean nature of ‘unconscionable’ renders its use as a standard to objectively assess the personal liability of third part recipients ineffective. Indeed, Lord Nicholls in Royal Brunei Airlines Sdn Bhd v Tan^[6] submitted “if [unconscionability] is to be used in this context… it is essential to be clear on what unconscionable means”, ultimately concluding that “the term is better avoided”^[7]

Lord Nicholls’ comments are not merely of academic interest however, wholly devoid of practical significance. The law in this area is almost exclusively applied in the commercial sphere, as Shine notes:

“[T]o great effect within and alongside the legal framework of financial regulation, insolvency and fraud, with significant practical importance in the recovery of property and provision of remedies to defrauded parties”.^[8]

Accordingly, in order to prevent expensive, protracted litigation and provide wronged claimants with effective recovery, it is imperative that practitioners, courts and financial institutions are certain as to the law which is being applied. Indeed, considering the many thousands of transactions that financial institutions carry out every single day, and therefore the heightened risk of being in receipt of trust property, to “have clarity as to the standards by which conduct … [can] be assessed”^[9] is extremely important.

The Baden scale

In Baden Delvaux and Leuit v Societe Generale pour Favoriser le Development du Commerce et de l’industrie en France SA,^[10] Gibson J classified the different levels of culpable cognisance upon which a third party defendant could be imputed with liability:

1. actual knowledge;
2. wilfully shutting one’s eyes to the obvious;
3. wilfully and recklessly failing to make such inquires as an honest and reasonable man would make;
4. knowledge of circumstances which would indicate the facts to an honest and reasonable man;
5. knowledge of circumstances which would put an honest and reasonable man on inquiry.

Gibson J’s classification of cognisance is arranged in descending degrees of culpability. Whereas levels (i), (ii) and (iii) have been generally understood to indicate the recipient’s actual knowledge of the breach of trust, levels (iv) and (v) have been generally understood to indicate the recipient having constructive notice of the breach of trust. Actual knowledge “is knowledge in [the] subjective sense and embraces those matters which a person … consciously knows”.^[11] Constructive notice, commonly used in direct opposition to actual knowledge, embraces those matters which, in law, a person is treated as knowing even though, in fact, he may not actually know of them.

Actual knowledge

Although criticising Nourse LJ’s test of unconscionability, retention of a fault-based approach to determining third party recipient liability is welcomed. If one is to burden a recipient with the onerous obligations of personal liability, a fault-based standard is preferable to a liability that flows from mere receipt of another’s property; namely, a strict liability. However, whilst supporting a fault-based standard, concern is expressed over a fault-based system of liability determined in relation to the requirement that the recipient has actual knowledge of the breach of trust.

Re Montagu’s Settlement Trusts^[12] is regarded as the leading exposition of viewing liability as based on levels (i), (ii) and (iii) of the Baden scale. In Montagu, in breach of trust, the trustees transferred various chattels belonging to the deceased ninth Duke to the tenth Duke. The tenth Duke subsequently sold many of them. The eleventh Duke, after the tenth Duke’s death, claimed the tenth Duke was personally liable for the value of the chattels he received and sold. Megarry VC, approving Edmund Davies LJ’s ‘want of probity’ threshold in Carl-Zeiss Stiftung v Herbert Smith (a firm) (No.2),^[13] finding in favour of the tenth Duke’s executors, held that in order to impose personal recipient liability, the defendant’s conscience must be “sufficiently affected” .^[14] Accordingly, in rejecting the doctrine of constructive notice, his Lordship provided that before a recipient could be found liable under knowing receipt, there must exist on the recipient’s behalf some form of conscious impropriety.

His Lordship’s judgment, endorsed in Lipkin Gorman v Karpnale Ltd,^[15] received further judicial approval by Hirst J in Allied Arab Bank Ltd v Hajjar,^[16] Knox J in Hillsdown plc v Pensions Ombudsman^[17] and Lord Browne Wilkinson in Westdeutsche Landesbank Girozentrale v Islington LBC.^[18]

Advocates of Montagu would likely centre their support upon the premise that as knowing receipt is about wrongfully occasioning losses to trusts, the only justifiable way one can be held liable as a knowing recipient is if one has actual knowledge of the breach of trust; indeed, the concept of wrongfulness, one may argue, in its very nature, requires one to have, themselves, actual knowledge that their actions are wrongful. Such an approach, based upon an appeal to the recipient’s conscience, is very clearly displayed in Eagle Trust v SBC Securities Ltd.^[19]

However, criticising the actual knowledge approach, requiring one’s conscience to be affected in accordance with levels (i), (ii) and (iii) of Baden before liability can be imposed generates the risk that the beneficiaries’ rights of property will be curtailed, vulnerable to a judicial attitude motivated largely by “‘clean heads’ considerations.”^[20]Concurring with the Montagu line of authority, advocating conscious impropriety, would often leave the claimant-beneficiary without economic redress and the trust consequently uncompensated. If beneficiaries’ interests are to be adequately safeguarded, emphasis within a fault-based understanding of recipient liability must be centred upon property protection and therefore a constructive notice standard equatable to levels (iv) and (v) of Baden. Indeed, Birks, expressly referring to the cases supporting the Montagu position, provides that there effect in equity has been “to make it more difficult for the person properly entitled to reach the ultimate recipient of his funds”.^[21]

Constructive notice

It is argued that constructive notice strikes the ideal balance between protecting the competing rights of both trust property and the recipient. Nelson v Larholt^[22] represents the position as viewing liability based on levels (iv) and (v) of the Baden scale.

In Nelson, an executor of a will fraudulently drew multiple cheques on the deceased’s estate’s bank account in favour of the defendant who received and cashed the cheques in good faith and for value. Denning J, finding in favour of the claimants, held that the defendant must be taken to have known what any reasonable man would have; namely, that “eight successive requests to cash cheques clearly drawn on the bank account of an estate would have placed a reasonable man on enquiry”.^[23] Accordingly, the defendant ought to have known, as the reasonable man would have, of the executor’s want of authority and he was therefore personally liable to compensate the estate for the loss caused by his wrongful receipt of the cheques.

Critics of Denning J’s position may argue that it grants “supremacy to the proprietary interests of a principal at the expense of a recipient with no actual [knowledge] of wrongdoing”.^[24]

Although this point remains pertinent, and must be extensively considered when examining knowing receipt claims, where the facts of a case so strongly point to a defendant’s wrongful third party receipt, questions of largely academic consideration must make way for reality. Of course, practical considerations must not ride roughshod over questions of theory; however, a positive public message would be sent to potential wrongdoers through adopting a law – constructive notice – forbidding third parties escaping recipient liability merely because they received misappropriated trust property bona fide and for value, even though it is clearly apparent, given the factual scenario, that they should have known of their wrongdoing.

Nelson was later approved in Selangor United Rubber Estates Ltd v Cradock (No.3)^[25] and Karak Rubber Co Ltd v Burden (No.2).^[26] Adopting Denning J’s stance, in Karak, Brightman J laid out, correctly, a similar rationale of recipient liability:

“[A] person … is [to be found a knowing recipient] because he has received trust property with … constructive notice that it is trust property transferred in breach of trust, or because … he acquires [constructive] notice subsequent to such receipt.”^[27]

However, Chua has heavily criticised imputing liability upon recipients on the basis of constructive notice. Chua argues holding recipients of trust property, particularly banks and finance houses, liable without possessing culpable cognisance as encapsulated in levels (i) to (iii) of Baden will force them to “to employ extensive [auditing] systems … to insulate ” themselves from the “significant possibility” of being imputed with constructive notice when handling their deposits.^[28] Chua suggests this would “have a crippling effect on the financial sector” due to a “general loss in business efficiency.”^[29]

In criticism of Chua, one must recognise the major, influential role banks and finance houses play in modern societies. Indeed, certain institutions command global power and harbour the ability to shape entire economies. Accordingly, it is suggested that the necessary price they must pay is being subjected to a law – constructive notice – which elevates their customers’ and investors’ property rights above their own, similarly imposing upon them a responsibility to limit the number of deposits they receive that are the result of a breach of trust.

Conclusion

This essay has evaluated the law governing third party recipient liability, in particular, the requisite degree of knowledge which is required before a recipient of trust property can be held personally liable. It has been argued that the actual knowledge standard, encapsulated within levels (i) to (iii) of the Baden scale of culpable cognisance, curtails rights of property, prioritising recipients’ rights above those of the claimant-beneficiary. Accordingly, a constructive notice standard, encapsulated within levels (iv) and (v) of Baden, was supported. In further support of a constructive notice standard, the current ‘unconscionability’ test adopted by the courts to govern knowing receipt was attacked as highly uncertain.

Footnotes

^[1] (1874) LR 9 Ch App 244

^[2] Ibid at 251-252

^[3] A Oakley, ‘Constructive Trusts’ (Sweet and Maxwell 1997, 3^rd ed) 222

^[4] [2000] 4 All ER 221

^[5] Ibid at 235

^[6] [1995] 2 AC 378

^[7] Ibid at 392

^[8] P Shine, ‘ Knowledge, notice, bad faith and dishonesty: conceptual uncertainty in receipt based claims in equitable fraud’ (2013) International Company and Commercial Law Review 293

^[9] N Kiri, ‘Recipient and accessory liability – where do we stand now?’ (2006) Journal of International Banking Law and Regulation 611

^[10] [1983] BCLC 325

^[11] C Harpum, ‘The stranger as Constructive Trustee’ (1986) 102 Law Quarterly Review 114, 121

^[12] [1987] Ch 264

^[13] [1969] 2 Ch 276

^[14] Ibid at 323

^[15] [1991] 2 AC 548

^[16] [1988] 3 WLR 33

^[17] [1997] 1 ALL ER 862

^[18] [1996] AC 669

^[19] [1992] 4 All ER 488

^[20] M Bryan, ‘Cleaning up after breaches of fiduciary duty – The liability of banks and other financial institutions as constructive trustees’ (1995) 7 Bond Law Review 12

^[21] P Birks, ‘Misdirected Funds: restitution from the recipient’ (1989) Lloyd’s Maritime and Commercial Law Quarterly 296

^[22] [1948] 1 KB 339

^[23] A Oakley, ‘Constructive Trusts’ (Sweet and Maxwell 1997, 3rd ed) 230

^[24] J Dietrich and P Ridge, ‘The receipt of what?’: Questions concerning third party recipient liability in equity and unjust enrichment’ (2007) 31 Melbourne University Law Review 48, 54

^[25] [1968] 1 WLR 1555

^[26] [1972] 1 WLR 602

^[27] Ibid at 632

^[28] D Chua, ‘Knowing, Dishonest or Plain Unjust? – A commentary on the past, present and future of knowing receipt’ (2007) 25 Singapore Law Review 53

^[29] Ibid