October 07 2011
Federal Court of Justice ruling
The treatment of trust agreements in insolvency proceedings is considered to be one of the most controversial topics in German insolvency law. In particular, whenever a trustee becomes insolvent, the fate of the trust is always hotly disputed. Creditors usually argue that all of their assets belong with the insolvency estate, while the trustor usually tries to reclaim what was assigned to the trust in its favour. The key question is whether the trustor has a right of segregation (ie, the right to claim what was contributed to the trust in its favour) or if the trust's assets form part of the trustee's insolvency estate. This conflict is particularly prominent in Germany as there is no legal definition of a 'trust' under either general private law or insolvency law.
In the absence of a statutory rule, German courts and legal scholars have developed certain criteria on whether to grant the trustor a right of segregation. First, contributions to the trust must have been made either by the trustor itself or, in the case of accounts held for the sole purpose of collecting money on behalf of the trustor, by a third party in order to fulfil a trustor's claim against the third party. Second, the purpose of the trust must be restricted to receiving assets in accordance with the contractual trust agreement.
If both these criteria are fulfilled, the connection between the trustor and its assets is considered to be strong enough to outweigh the interests of the (insolvent) trustee's creditors. Even if the trustor's assets are part of the trust's property held by the trustee in the interest of the trustor, the latter will thus be entitled to segregate them from the insolvency estate.
Federal Court of Justice ruling
The difficulty with these seemingly conclusive criteria is that, by definition, only the trustee actually controls the trust and is bound to the will of the trustor only by the contractual trust agreement. If the trustee chooses to act in violation of this agreement, the trustor will be denied the right of segregation in case of the trustee's insolvency by virtue of the abovementioned rules.
Deciding on this particularly contentious issue, on February 10 2011 the Federal Court of Justice clarified what constitutes such a violation.
In the case at hand, the business model of the subsequently insolvent company was based on a Ponzi scheme. Investors were asked to transfer their investments to the company's accounts, which were then used for various purposes, including the payment of phantom profits to existing investors and 'administration fees' to the company itself. When the company became insolvent, the question was whether its behaviour constituted a violation of the contractual trust agreement between itself and the investors, which would deny the latter the right to segregate what was left of their investments from the insolvency estate.
The lower instances had held that the trust agreement was not violated because all transactions had been in formal conformity. It was argued that even if the company misused the investments, this would not have been visible from the outside, as all payments had been given valid denominations. On the surface, the company had thus acted in accordance with the trust agreement, leading to a right of the investors to segregate the amount left on the trust accounts from the company's insolvency estate.
Overruling these earlier decisions, the court held that formal congruence cannot cure a violation in substance. The court argued that it is only the trust agreement which forms the connection between the trustor and its assets. If this agreement is not observed by the trustee, its creditors cannot be required to do so either. Thus, as soon as the trustee violates the trust agreement, the trustor must be denied the right to segregate.
This ruling clarifies the relationship between trustor and trustee under German law. While at first glance it may seem unjust for the trustee to be able to adversely affect the rights of the trustor, this is consistent with the nature of a trust. If a trustor decides to attribute its assets to a trust, it accepts that the only recourse against the trustee will be contractual in nature. As soon as the trustee chooses to violate its obligations under the contractual trust agreement and decides to use the trust assets at its own discretion instead of administering them for the trustor in accordance with the trust arrangements, the assets can no longer be considered to belong to the trustor, which must therefore lose its rights to segregate them in case of insolvency.
For further information on this topic please contact Stefan Sax and Oda Lehmkuhl at Clifford Chance LLP by telephone (+49 69 7199 01), fax (+ 49 69 7199 4000) or email (email@example.com and firstname.lastname@example.org).
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