Trading Derivatives With Trustees

Whilst the use of over-the-counter derivatives in the retail savings and pensions markets could hardly be considered innovative, there is a residual reticence amongst trustees and managers of unit trusts and pension funds to commit fully to the use of derivative products, particularly more exotic products, as part of their long-term investment strategies.

  • 25 Jan 2004
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Whilst the use of over-the-counter derivatives in the retail savings and pensions markets could hardly be considered innovative, there is a residual reticence amongst trustees and managers of unit trusts and pension funds to commit fully to the use of derivative products, particularly more exotic products, as part of their long-term investment strategies. This reticence is, apparently, attributable to lack of understanding of derivatives by fund managers and trustees, but is the more pertinent issue the bank counterparties' lack of understanding of trustees? Or more importantly, should it be?

Transacting with trustees raises a host of technical legal issues and problems for both trustees and counterparties. While the issues are discussed in the context of U.K. legislation and English case law, many of these issues and related principles arise in other legal jurisdictions that recognise the trust concept, of which there are over 100.

Contractual Relationships

Superficially, contracting with trustees seems much like contracting with any other party. But here is the root of the problem; the contractual relationship is with the trustee, as principal, and not the fund itself, since a trust has no separate legal personality. This has the generally unexpected and undesirable consequence that the primary obligor is the trustee in a personal capacity. It follows, therefore, that in the absence of a right to have recourse to the trust assets, the counterparty will be compelled to look to the personal assets of the trustee to satisfy the trustee's obligations under the derivative transaction.

In practice, counterparties will instead be relying on the trustee's rights at law, the so-called "trustee's lien" and the right pursuant to Section 31 of the Trustee Act 2000 to have recourse to the trust assets to satisfy claims and expenses properly incurred in the administration of the trust. There may also express rights within the fund documentation itself to supplement the rights. To the extent that the trustee enjoys these rights, a creditor will have a right of subrogation to them (that is, a right to assert the same rights as though it stood "in the shoes" of the trustee) to satisfy its own claim.

The trustee's right of recourse, however, is fragile. In circumstances when a trustee is acting outside the scope of its authority it has a right of reimbursement from the trust assets, leaving a counterparty with a claim in contract against the trustee only: a vulnerable position, compounded by the facts that (1) the trustee itself is unlikely to have sufficient assets to meet any sizeable claim and (2) the personal liability of the trustees is often limited under the International Swaps and Derivatives Association Agreement to the value of the trust fund at the time when the claim is made.

Trustees' Authority

A trustee's authority to deal with the trust assets will derive from specific provisions in the trust deed, the trustees' general power of investment in Section 3 of the Trustee Act 2000 and various other statutory powers. So what exactly should a bank counterparty be looking for? This depends on the nature of "a derivative." It is widely recognised that a derivative transaction is not, intrinsically, an "investment." Even the most complex of structured derivative products can be analysed as a combination of options and forwards , often embedded into other types of financial transactions, such as securities and loans.

A counterparty cannot, therefore, simply rely on a trustee's power to invest in any property . Further, a counterparty would be ill-advised to rely on a general power to enter into contracts given that this may well be limited (expressly or by implication) to entering into contracts in connection with the power to invest; a cross-currency rate swap, for instance, may not be an integral part of, or even ancillary to, the exercise of a power and the exercise of other powers to invest. Given the draconian effect of falling the wrong side of the line, counterparties should accept nothing less than an express power to enter into derivative transactions. Fortunately most modern trust instruments contain the necessary powers.

In its publication CC14: Investment of Charitable Funds (February 2003), the Charity Commission looked specifically at the special case of charitable trusts and the ability of their trustees to enter into derivative transactions. The Charity Commission will authorise the use of derivatives where it is ancillary to the investment process; that is, the intention must be to manage risk and the use of a derivative must be "economically appropriate." To the extent that the use of derivatives could be regarded as speculative or as a trading activity, quite apart from the problems for a counterparty caused by the lack of powers to enter into a contract, favourable tax treatment will be lost by the charity.

Similarly, trust funds which qualify as UCITS (Undertakings for Collective Investment in Transferable Securities) are authorised to enter into derivatives.

In the case of pension funds, despite the wide power of investment in Section 34 of the Pensions Act 1995, pension fund trustees will still be subject to the same concerns as to the scope of their powers as any other trustee. There is also the added complication that the counterparty will usually have dealt with an investment manager who may be acting as agent for a named or unnamed principal or for several different funds.

Even when trustees are authorised to enter into derivative transactions, they will be unable to have recourse to the trust fund while they remain indebted to the trust fund, for example because they have acted imprudently, breached their duties under the Trustee Act 2000 or any fiduciary duties to the beneficiaries, or have committed an entirely unrelated breach of trust. Furthermore, trustee delinquency is a continuing risk for counterparties--the occurrence of any of such events at any time in the future will compromise the trustees' and therefore the counterparty's right of recourse.

The creditor's right of subrogation, being derived from the trustee's right of recourse to the trust fund, will not be exercisable at any time when the trustee itself could not exercise its rights. Assessing credit risk and pricing will, consequently, be inherently difficult when transacting with trustees.

A Banks' Rights

So where does this leave a bank counterparty and what can it do to protect its rights? In its consultation paper on the Rights of Creditors Against Trustees and Trust Funds dated April 1997, the Trust Law Committee considered this question in some detail. The Committee considered, in particular, the possibility of a restitutionary claim in which the creditor, acting in good faith and unaware of the trustee's ultra vires act (that is, act beyond its powers), has enriched the fund. However, whilst the law of restitution is well established in the U.S., its use and development is not favoured by the English courts and would be unlikely to form any substantive basis for a claim by an aggrieved counterparty. Thus, the Committee's discussion, although persuasive, must be viewed cautiously in light of the lack of case law in this area.

The cautious view (although this was challenged (without authority) in June 1999 Report on the 1997 Trust Law Committee's Consultation Paper) is that, in the absence of an express power to grant such a right in the trust investment, a contractual provision whereby the trustee grants to the counterparty a direct unsecured right of recourse to the trust assets will be ineffective. It may, however, be possible to amend the trust deed to give trustees such a power, so that a counterparty would have an equitable interest in the trust assets akin to the trustees' lien, although at a commercial level this may prove unfeasible.

Taking security over the trust assets, provided it is authorised by the trust deed, is another option for the counterparty, although the property may already be subject to prior charges or the trustees could be under contractual restrictions not to charge certain property. Provided that the contract and grant of security is itself intra vires (that is, within the powers of the trustee) the security should then take priority over the rights of beneficiaries.

It may also be possible for the counterparty to become a beneficiary of the trust, giving it a proprietary interest in the fund's assets under the trust instrument. This will not, obviously, be appropriate in the case of charitable or pension trusts, principally for tax reasons.


When contracting with trustees, counterparties should be aware that there remains an element of uncertainty as to whether mandatory close-out netting would be available against trustees. This is because in most legal jurisdictions which permit insolvency set-off "mutuality" of obligation and benefit between the insolvent and the creditor seeking to exercise its right of set-off is required. This means that each party is, in effect, personally liable on what it owes and beneficially entitled (rather than as some sort of representative of a third party) to what it is owed. In the case of a counterparty dealing with a trustee, there is no mutuality of obligation and benefit, on the one hand, between a counterparty and a trustee or, on the other hand, between a counterparty and the trust fund's beneficiaries, since even though the obligation is owed to the trustee the benefit of that obligation belongs to the beneficiaries; The House of Lords decision in British Eagle International Airlines LtdvCompagnie Nationale Air France [1975] 2 All ER 390 confirms that this principle applies under English law in order for mandatory set-off under Rule 4.90 of the Insolvency Rules 1986 to apply.

If the trust fund itself were to become insolvent, a creditor would seek an order from the court under Rule 64.2 of the Civil Procedure Rules that the execution of the trust be carried out under the direction of the court. Despite the lack of mutuality, a court could treat the trust fund as a "quasi-person" for the purposes of contractual set-off, as suggested by the Trust Law Committee, in the 1997 Consultation Paper and the 1999 Report.

There are, of course, always issues that will be particular to the contracting parties and the type and terms of the derivative itself. The powers of the trustees, and the security they can confer will have to be considered in each individual case.


This week's Learning Curve was written byRachel Hughes, associate in the private client department, andEdward Murray, partner in international capital markets atAllen & OveryLondon .

  • 25 Jan 2004

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