Cayman Islands: Unit Trusts – Issues, Debates And The Crossing Of Swords – A Cayman Islands Perspective

A unit trust is a form of collective investment scheme, designed to create a pool of assets for investment purposes and usually (but not always) to provide some liquidity to investors by permitting them to redeem their units. Unlike beneficiaries of a private trust, unitholders pay to acquire a beneficial interest in the trust. They subscribe for units by contracting with the trustee, usually by way of a subscription agreement. Moreover, they may be given a measure of liquidity if they are permitted to redeem units on specified dates. In that respect, a unit trust is arguably more akin to a contract. Even in a closed-ended fund where no redemptions are permitted, unitholders may receive periodic distributions reflecting gains on their investment, much as they would if they had invested directly in the stock market or through a corporate hedge fund vehicle. However, in the final analysis, a unit trust is a trust and more a creature of equity, than contract, in that the trustee declares and creates the trust in respect of which it is a fiduciary and not a mere contracting party, and it has ultimate responsibility for managing and administering the trust on the terms of the trust instrument and in accordance with its investment objectives.¹

In this paper, we will look at some of the issues arising in the structuring and operation of unit trusts and see what happens when the trustee and the manager cross swords.

A unit trust is typically established by a declaration of trust by the trustee, although in some cases the trustee may enter into a deed of trust with the investment manager who acts as the promoter of the vehicle and manages (either directly or indirectly) the underlying assets. Investors in the trust acquire their interests by subscribing for units in the trust (or sub-trust as the case may be).

It is collective beneficial ownership, with the result that no one unitholder has any entitlement to any interest or share in any particular part of the trust property.

The terms of the scheme are therefore governed by the trust deed and a number of ancillary agreements.

In the Cayman Islands, a unit trust can be registered as an exempted trust provided that the beneficiaries do not and are not likely to include any person resident or domiciled in the Cayman Islands, other than an object of a charitable trust or power. Such registration entitles the trustee to apply to the government of the Cayman Islands for an undertaking that for a period of up to 50 years, no law which is thereafter enacted imposing any tax or duty on income, capital assets, gains or appreciation, or any estate duty or inheritance tax, shall apply to the trust property or to any income arising under the exempted trust, or the trustees or unitholders thereof.² If, following establishment of the trust, a beneficiary becomes resident or domiciled in the Cayman Islands, the beneficiary in question will be subject to any tax and duty as if the undertaking had not been given. However, this will not, of itself, affect the tax free status of the trust, the trustee or other beneficiaries of the trust.

Structuring Issues

A stand-alone trust can be created for one or more investors, subscribing for one or more classes of units. Certain classes of units may be established at the outset and the trustee invariably has the power under the trust deed to create further classes of units, each with its own rights, preferences, powers, policies and limitations as the trustee may determine, subject to the provisions of the trust deed and any offering document.

The trustee may wish to create additional classes of units from time to time and it is therefore preferable to create the structure with maximum flexibility so that new classes of units can be created without the need to obtain unitholder consent.

The 'umbrella' structure can be a useful device to establish a number of sub-trusts within a single fund structure. There is no formal definition of the term 'sub-trust' in Cayman Islands law. However, it has been described as "…a trust which is independent of, but subordinate in some way to, a head trust.³" Where there is more than one sub-trust, each is subordinate to the head trust but each is distinct from the other. One advantage of this structure is that different sub-trusts can be established for different investment strategies and/or different investors. Another advantage is that there can be one principal constitutive document (the trust deed) with sub-trusts being established in the original trust deed and/or by short–form supplemental deed. It should however be noted that under current Cayman Islands law, there is no statutory segregation of sub-trusts, so careful drafting of the trust deed and ancillary agreements is required at the outset. Post establishment, the scheme must be operated so as to maintain the separate and distinct nature of each sub-trust.

The trust can be constituted with a nominal sum, to be held on trust for charitable purposes. If any sub-trusts are to be established at the same time as the trust is constituted, those sub-trusts should also be properly constituted in the trust deed. There is, on one view no need to constitute the head trust since it merely serves as a framework under which the sub-trusts operate. There is also a view that if each sub-trust is established as a separate and distinct trust, the head trust should not be constituted since this undermines the segregated nature of the structure. In the writer's view, there are certainly practical reasons for constituting the head trust. In particular, the Certificate of Registration as an exempted trust is usually obtained in the name of the head trust (which presupposes that the head trust exists) but upon the retirement/change of a trustee, unless the head trust has been constituted, the trustee cannot retire in respect of it. This can cause difficulties, not to mention confusion with the Registrar of Trusts. One option would be to register each sub-trust as an exempted trust, but this rather defeats the object of having an umbrella structure and introduces an unnecessary level of formality and cost.

The establishment of new sub-trusts is relatively straightforward, subject to the provisions of the trust deed. The initial sub-trust is typically declared in the principal trust deed and subsequent sub-trusts are established when required by the trustee entering into a supplemental deed. Certain managers prefer to have the terms on which the sub-trust will be established set out in a form of notice, sometimes described as a notice of establishment (a "Notice"), the form of which is annexed to the trust deed. The Notice will provide the key provisions found in a term sheet, such as the offering period, the currency in which units in the sub-trust are denominated, the issue price of units in the initial and/or subsequent offering period, subscription, redemption and valuation dates, the management fee and any investment objectives and restrictions referable to the sub-trust. In these circumstances, the trustee will enter into a supplemental declaration of trust to establish a sub-trust on the terms set out in the Notice.

Once the sub-trust is established, care should be taken by the trustee and its delegates to ensure that segregation is maintained. For example, when entering into agreements with third parties with respect to a sub-trust, the trustee should ensure that its liability is limited to the assets of the relevant sub-trust and not simply to 'the trust'. The trustee should also require (by agreement in relevant third-party contracts) that similar provisions be contained in any agreements entered into by the third party in respect of the relevant sub-trust. Consideration should also be given to enabling unitholders of a sub-trust to have the power to remove the trustee in respect of that sub-trust. If so, the trust deed will need to be sufficiently flexible so as to accommodate more than one trustee in the event of the removal/retirement of the trustee and the appointment of a second trustee. However, even with good drafting, there may be practical problems with having two trustees who may have very different commercial practices and may be resistant to acting as one of two trustees within the same structure.

A unit trust may be a master fund and/or feeder fund in a master-feeder structure. It may be one of a number of feeder funds, the assets of which are invested into a master fund. It is important to ensure that the trustee has power to deal with the trust assets in the manner contemplated by the structure. For example, if the trust is a feeder fund, the trustee should have power to suspend calculation of the net asset value of the trust, subscriptions, redemptions and distributions in circumstances where the determination of the net asset value of the master fund, or the redemption or issue of interests in the master fund has been suspended. Consideration should also be given to expanding the provisions dealing with restrictions on transfer of units if as a result of a sale, assignment or other transfer of units, the trustee in respect of the feeder fund or the master fund (as the case may be) could be exposed to a tax liability or other material disadvantage.

Declaration of Trust or Two-Party Deed?

Trustees are becoming increasingly concerned about the level of responsibility imposed on them by the provisions of the trust instrument in circumstances where the true nature of their role is more akin to a custodian trustee who delegates substantially all of its duties to third parties. How can this be addressed and does the type of trust instrument matter?

The current market practice for establishing a trust in the Cayman Islands is by way of a declaration of trust, in which all powers and duties are vested in the trustee. The trustee delegates certain powers and duties to third parties - such as the investment manager and the administrator - through separate agreements.

Two-party deeds (sometimes referred to as a "bi-lateral" deeds) are relatively uncommon, although they have historically been used for feeder funds in the Japanese market, where the master fund is established by declaration of trust and the feeder fund is established by a two-party deed between the trustee and the manager. Typically, in a two-party deed, some of the powers and duties that would traditionally be vested in the trustee are vested in the manager. These powers range from the management of the trust assets to issue and repurchase of units. This can give rise to interesting questions about the true nature of the role of the manager and the extent to which it is, in reality, a trustee.

There are advantages and disadvantages to a trust arrangement using a two-party deed, depending in part on whether you are the trustee or the manager.

From the trustee's standpoint, there may be advantages to a two-party deed where its duties can be limited by the terms of the trust deed. The trust deed can also be drafted so as to place a collar on the exercise of the trustee's discretion. This is particularly important where the manager is driving the underlying transaction and has requested the trustee to accept an appointment on standard terms, with no real expectation of participation or review by the trustee. In circumstances where the manager is wholly responsible for selecting and managing the underlying investments, there is a strong argument that as a mere conduit for the trust property, the trustee has no duty to investigate or advise potential investors about the nature or commercial suitability of the investments.

Indeed, in an English case⁴, where the trust deed provided that the manager was solely responsible for the acquisition, management and realisation of the trust property and that the manager had full power to deal with the property as if it were the beneficial owner, it was held that the trustee had no duty to the subscribers, whether as intending settlors or beneficiaries, once the trust was constituted, to make enquiries or take advice so as to satisfy itself that the property to be acquired for the trust for a purpose described as "speculative" was likely to produce an adequate return.

That is not to say that by making the manager responsible for all investment decisions, the trustee can wholly divest itself of all fiduciary duties towards unitholders. The trustee's powers under the trust deed remain fiduciary and it will retain an irreducible core of fiduciary duties towards unitholders to consider from time to time the exercise of its powers for their benefit.

If the manager is appointed by the trustee pursuant to an investment management agreement ("IMA"), then the manager will owe contractual obligations to the trustee and arguably owes a duty of care towards unitholders⁵. The appointment is usually by delegation of the investment powers and duties that would otherwise fall to the trustee. The delegation itself is important. Unlike an agent (for whom the trustee, as principal, would remain responsible), a delegate assumes the responsibilities of the appointor.

By contrast, under a two-party deed, the manager is a party to the trust deed and is exercising powers under it. As between the trustee and the manager, the parties' respective obligations to the unitholders can be clearly defined, thereby establishing - and possibly limiting - the fiduciary duties. The essence of the fiduciary power is that the person exercising it must always act in the best interests of the beneficiary, plainly a higher standard than a duty to take reasonable care. Under this type of arrangement, the manager will typically assume responsibility for all matters related to the investments and will accordingly owe fiduciary duties towards unitholders to act in their best interests with respect to the exercise of its investment powers. However, the manager may also be responsible for the issue and repurchase of units, thus expanding the remit of its direct responsibilities towards the unitholders.

The essence of a trust is that one person (the trustee) deals with property over which he has control for the benefit of other persons (the unitholders). If a trust deed is drafted in such a way that the manager assumes fundamental responsibilities that would normally fall to the trustee, the manager could be considered a co-trustee. After all, there is no magic in the label 'manager' if, in reality, the manager is a trustee. Is there any way around this? A provision could be included in the trust deed to the effect that the manager is not or is not intended to be a co-trustee. Such a provision would not necessarily persuade a court that the manager is not, as a matter of fact, acting as and assuming the responsibilities of a trustee, but it would underline the parties' intentions and could help to support an argument that the parties acted in good faith. The trustee may also rely upon statutory provisions that relieve it from liability for the acts and defaults of another trustee, provided that no loss is caused as a result of its own wilful default.⁶

The trust deed may provide that the manager will be excused from any liability for its actions, barring fraud and dishonesty; There are two concerns here - First, there are no reported Cayman Islands cases dealing with exoneration clauses in favour of a manager and although exoneration clauses in favour of trustees have been upheld, they are usually narrowly construed.⁷ Second, assuming the exoneration provisions work, they may only assist if the manager has acted innocently, by complying with all of its obligations under the trust deed and acting in good faith. This could be difficult to establish if the manager is held to be a co-trustee and there is uncertainty as to whether in such capacity, it has discharged its obligations.

If a manager breaches an obligation imposed by the IMA, it will be exposed to the risk of a claim from the trustee. However, it is quite possible that the trustee will not have suffered any loss as the trustee will likely be entitled under the terms of the trust deed to be exonerated from any loss. This would not prevent a unitholder who suffered loss from bringing an action against the manager in negligence, but such a claim based on an alleged duty of care arising out of the IMA would be harder to establish than a claim against the manager for a breach of fiduciary duty arising under the provisions of the trust deed. This distinction may be subtle, but it remains to see how it will be played out in practice.

An IMA will normally be governed by the laws of the jurisdiction in which the manager carries on business. If provisions which are normally contained in an IMA are set out in the trust deed instead, unless otherwise expressly provided, all of the manager's obligations will be subject to Cayman Islands law as the governing law of the trust. As a practical matter, a manager may prefer that its obligations are governed by a law with which it is familiar, particularly if the IMAs for other funds that it manages are on the same or similar terms.

It is also worth noting that if the trustee is making a private placement filing in Japan using a two-party deed to which the manager is a party, the manager will invariably become the filing party. As such, the manager may become subject to the regulatory regime in Japan, including the direct scrutiny of the Japanese Financial Supervisory Agency.

There are obviously many issues arising out of the use of two-party deeds that are beyond the scope of this paper. Careful consideration needs to be given to this type of structure, striking a balance between protecting the trustee and the manager, with a view to creating a deed that represents more or less what the parties bargained for.

Whichever type of trust instrument is used, the amendment provisions require careful thought.

The amendment clause is likely to be an important feature of special purpose trusts where the investment objectives are strictly limited and the trustee is not permitted to act otherwise than in accordance with the terms of particular contracts. In these circumstances, it is usually considered undesirable to permit any amendment of the trust deed without the consent of third parties (e.g. the swap counterparty) and unitholders. However, it is advisable for the trustee to be entitled to amend the trust deed in limited circumstances without requiring such consents, if only to correct a manifest error or to conform the trust deed to particular provisions in the offering document. For keys changes, it may be appropriate to require the affirmative vote of a limited number of unitholders or percentage of units outstanding. In an umbrella structure, particular attention should be paid to the amendment provisions to avoid the situation where the trustee is obliged to obtain the consent of all unitholders in all sub-trusts for what may be a relatively minor amendment that only affects unitholders of one sub-trust.

A trustee may incur unlimited personal liability to a contracting party or may become personally liable in tort for the acts or omissions of itself, its employees or delegates in connection with the administration of the trust. Statutory liability may also be incurred, typically for fiscal liabilities.

The general principle is that a trustee is entitled to be indemnified for any costs and expenses it incurs in the course of acting as trustee, provided such costs and expenses are properly incurred in respect of the trust. This is a long standing equitable entitlement, but has been put on a statutory footing in most jurisdictions.⁸ Further, where trustees have rightly carried on business in accordance with the provisions of the trust deed they are entitled to be indemnified out of the trust against any liabilities which they have properly incurred.⁹ However, if a trustee exceeds its powers in incurring a business expense and no benefit is thereby conferred on the unitholders, the trustee is not entitled to be indemnified in respect of such expense.

Trustees may be indemnified out of the trust assets in all circumstances other than fraud¹⁰ or wilful default. Accordingly, it is possible for a trustee to be indemnified in respect of breach of trust or negligence.¹¹

Provisions in the trust instrument that purport to give third parties a "right" of indemnity out of the trust assets may give rise to an equitable obligation on the trustee, but in the absence of direct contractual obligations, third parties may face difficulty in enforcing such an indemnity.

In an umbrella structure, if segregation has in fact been achieved pursuant to the trust deed such that there are distinct funds held on separate trusts, the trustee will generally not be entitled to an indemnity against liabilities incurred in respect of one fund out of the assets of another fund. The rationale for this is that there is no community of interest between the two funds that are effectively held upon different trusts, whether or not they are in the same settlement. Careful drafting is required to ensure that the indemnity clause does not contradict the intention to maintain segregation of assets and liabilities. Thus, it should be clear on the face of the trust deed and other trust documents that the trustee (and any other party entitled to be indemnified out of the assets) should only be entitled to be indemnified for acts and omissions in respect of a particular sub-trust out of the assets of that sub-trust.

The trustee should ensure, when entering into contracts with third parties, that limited recourse language is contained in the relevant contract, so that in the event of a breach of contract, the third party's recourse will be limited to the assets of the trust or the relevant sub-trust (save in the event of the trustee's fraud, wilful default etc.). Failure to do so could expose the trustee to a significantly greater liability than that for which it can be indemnified under the trust deed.

Contractual Issues

In order to constitute a valid contract there must first be two or more separate and definite parties to that contract. This rule is based on the notion that a man may not be both purchaser and vendor to the same transaction and cannot therefore contract with himself alone. Breach of this rule has the effect of making a transaction void. It makes no difference if the person contracting joins in the contract with himself and some other person, whether as covenantor or as covenantee if the obligation on the one side, or, as the case may be the obligation to enforce the contract on the other side, is joint. However, if the covenant is several or joint and several, it is strongly arguable that any of the covenantees could sue alone or all of the covenantees could sue a single covenantor.¹²

An ongoing debate is whether a party can contract with itself albeit in two different capacities. This, it is argued, avoids a breach of the rule. There is some authority in support of this proposition, in the area of commercial law. In the English case of Catherine Lee v Lee's Air Farming¹³ the court found that it was indeed possible for "one person [to] function in dual capacities, and acting in one capacity give orders to himself in another capacity." The court observed that if one person may give himself orders in dual capacities then there is nothing to stop that person from contracting with himself in a different capacity. On the facts, the individual who also owned and controlled the company with whom he contracted, was nevertheless a separate and distinct legal person.

But can the same legal person enter into a contract with itself? Such a contract has been upheld in the context of a commercial "contract" between two offices or departments of the same legal entity, in particular where those offices were for all practical and commercial purposes regarded in the industry as separate entities: "The idea of an individual bargaining with himself at arm's length is a physical, commercial and legal absurdity. But it is not so absurd when one comes to consider an artificial person, who may have more than one directing mind. Nor is it so absurd in the context of organisations, such as trade unions, which have many sections and branches. …"¹⁴

In the context of a commercial trust, trustees frequently act as trustees of different trusts and often act as bankers or administrators in respect of the same or another trust. Why should they not be entitled to contract with themselves if they do so in different capacities, especially if the are contracting in respect of different trusts? Such a contract should create an equitable obligation to the unitholders of the relevant trust on the same terms as the contract and as such be enforceable by the unitholders. It is hoped that this issue will be addressed by the legislature, although this may not end the debate!

The self-dealing rule is based on the proposition that a trustee cannot place himself in a position of conflict, or possible conflict between his duty to the trust and any personal interest or other duty. A breach of the rule has the effect of making a transaction voidable.

The rule has been described thus: "…it is a rule of universal application, that no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting or which possibly may conflict with the interests of those whom he is bound to protect. So strictly is this principle adhered to, that no question is allowed to be raised as to the fairness or unfairness of a contract so entered into." ¹⁵

In a case where trust property is sold in respect of one trust and acquired in respect of another trust with the same trustee, "there is a conflict between the duty of the trustee in his two capacities"¹⁶. As a fiduciary, the trustee owes a duty of loyalty to both groups of beneficiaries. It is not possible for the trustee to use information gained as a result of his trusteeship of one trust, for the benefit of the other¹⁷ It is also a breach of trust if the trustee does not use or disclose all the information within the trustee's knowledge regarding one trust for the benefit of the other trust.

The English Court of Appeal has clearly stated the principle that where a person is bound to disclose to a party material facts, he is not relieved of that obligation because he owes a conflicting duty to his cestui que trust¹⁸. Warrington LJ observed that knowledge by one party of the trustee's conflict of duties is "wholly irrelevant" on the basis that it is not possible to expect the trustee to fulfil his duty to one party over his duty to the other.

Leaving aside the exceptions to the self-dealing rule (see below), it remains unsettled as to whether the rule will apply with full rigor to a transaction between two trusts with the same trustee such that the transaction will be set aside ex debito justitiae at the instance of a unitholder. If the transaction can be shown to be proper and reasonable and that the trustee gained no personal advantage as a result, it is arguable that the transaction should be upheld. There is case law in the United States to the effect that the self dealing rule will only apply to such instances if the transaction is in fact unfair to one of the two trusts.¹⁹

Note that even If the self-dealing rule applies, its consequences may be mitigated by one of the following exceptions:

1. the purchase is made in accordance with a power expressly conferred by the relevant trust instrument; or
2. the purchase is made in circumstances where the trustee has not placed himself in a position of conflict of interest and duty but had been placed in that position by the settlor or the terms of the trust; or
3. the purchase is authorised by statute; or
4. the purchase is made with the concurrence of the beneficiaries, all being of full age and capacity, after a full and proper disclosure has been made to them; or
5. the purchase is made with the sanction of the court.

Accordingly, where the trust instrument expressly excludes the application of the self-dealing rule in contemplation of the trustee transacting with itself, the transaction should not be avoided.

Notwithstanding such an express exclusion, the trustee will still be required to give proper consideration to the interests of all beneficiaries and will not be permitted to have regard only to its own interests.

As noted in Edge and Others v Pensions Ombudsman and Another²⁰: "The rules contemplate that, as trustees, the employee members will from time to time have to exercise discretions in which their duty and interest may conflict. In these circumstances,… no rule of equity that requires them to account for the benefits that an entirely proper exercise of discretionary powers may produce for them."

The debate about the nature of the unit trust and the manager's role is ongoing. As unit trust structures continue to become more complex, trustees must be even more vigilant in focussing on their powers and responsibilities. They must negotiate their indemnities and the limited recourse provisions in their agreements. They must be aware of the issues arising out of their contractual dealings and ensure that the trust deed appropriately excludes the application of the self-dealing rule. When offering securities in foreign jurisdictions, legal advice must always be taken, from appropriately qualified counsel.

The good news is that a trustee of a Cayman Islands trust is always entitled to apply to the Grand Court of the Cayman Islands for an opinion, advice or direction on any question relating to the management or administration of a trust and if the trustee acts on the opinion, advice or direction of the court, it is deemed to have discharged its duties as trustee in respect of the subject matter of the application.²¹