Insolvency and the Remedial Constructive Trust

One of the fundamental principles of English insolvency law is that any remaining assets in a liquidation will be distributed pari passu amongst the unsecured creditors. In most cases, however, the unsecured creditors stand to gain very little when it comes to their turn and understandably look for ways to improve their position. Last year the Court of Appeal was asked to impose a remedial constructive trust over the proceeds of sale of assets situate in the Turkish Republic of Northern Cyprus by parties claiming to be the original Greek Cypriot owners of the assets prior to the Turkish Intervention in 1972. In effect, the Court was being asked to create de novo an equitable interest over these assets and thereby re-order the priorities amongst creditors. This article considers the current position of the remedial constructive trust in English insolvency law in light of the Court of Appeal decision in Re Polly Peck International plc (In Administration) (No 2) (1998).

Introduction

Before getting into the facts of the case it is important to distinguish a remedial constructive trust from an institutional constructive trust. In essence, an institutional constructive trust arises by operation of law as from the date of the circumstances which give rise to it: the function of the Court is merely to recognise the trust and declare that it exists. A remedial constructive trust is not declared by the Court, it is imposed as a judicial remedy and only exists from the date of its imposition. The extent to which the remedial constructive trust operates retrospectively to the prejudice of third parties lies at the discretion of the Court and this discretion is, understandably, one that the Court exercises with considerable caution.

It is also worth noting at the outset that the concept and application of remedial constructive trusts are relatively commonplace in jurisdictions such as Canada and New Zealand but they are more often relied upon in matrimonial disputes rather than in an insolvency context.

The Facts

Polly Peck is insolvent and has been in administration since October 1990. Prior to administration, Polly Peck was a holding company for a world wide group of over 200 direct and indirect subsidiary companies. In March 1995, the administrators of Polly Peck sold the shares of certain subsidiaries which had occupied properties in the Turkish occupied area of Northern Cyprus ("TRNC"). These properties were expropriated after the intervention of the Turkish army in Northern Cyprus in 1974 and since then had been leased to the Polly Peck subsidiaries.

The applicants were Greek Cypriots who claimed to have owned the properties occupied by the Polly Peck subsidiaries prior to 1974. They sought leave under s.11(3) Insolvency Act 1986 to commence proceedings against Polly Peck and the administrators for the proceeds of sale which, the applicants claimed, represented the profits of wrongful occupation and exploitation of the properties by the Polly Peck subsidiaries. The proceeds of sale were held in a separate account (subject to an undertaking) until the case was decided.

Mr Justice Rattee at first instance granted the applicants leave to commence proceedings against Polly Peck on the ground that their statement of claim did achieve the threshold of disclosing a seriously arguable case. He concluded that there was a seriously arguable case that the applicants remained at all material times entitled to possession of their property; that Polly Peck knew that its subsidiaries were exploiting those properties; that Polly Peck actively encouraged such exploitation; that it had benefited from the exploitation and should be bound to disgorge such profit; and that the court should impose a remedial constructive trust on so much of the proceeds of sale as represents such profit. Polly Peck and its administrators appealed.

Issues on appeal

Polly Peck and the administrators argued that the proposed action by the Greek Cypriot applicants was bound to fail on two grounds. First, the English courts had no jurisdiction to entertain the proposed action because it related to the determination of title to, or the right to possession of, immovable properties situate outside England. Second, the applicants’ claim to be entitled to a remedial constructive trust was misconceived and failed to disclose any seriously arguable case against Polly Peck or the administrators.

On the first ground of appeal, the court agreed with the judge at first instance that the court would have jurisdiction to entertain the proposed action as the proposed proceedings were not principally concerned with the question of title to, or the right to possession of, foreign land. The appeal therefore turned on the Court’s acceptance of the applicant’s entitlement to a remedial constructive trust over the proceeds of sale.

The Decision

The Court recognised that if a remedial constructive trust was imposed, the proceeds of sale in the hands of the administrator would cease to be an asset absolutely and beneficially owned by Polly Peck and would be excluded from pari passu distribution among the unsecured creditors.

The Court refused to accept this and held that the applicants’ claim did not raise any serious question to be tried. Whilst the Court accepted that the applicants had rights against Polly Peck, it held that those rights were not proprietary in nature.

Mummery LJ was of the view that the administrators were bound to distribute the assets of Polly Peck among the creditors in accordance with the statutory scheme of fair distribution sanctioned by Parliament. If an asset is the absolute beneficial property of a company, there is no general power in an administrator (nor a liquidator) to amend or modify the statutory scheme so as to transfer that asset or to declare it to be held for the benefit of another person. To grant a remedial constructive trust to the applicants in respect of the proceeds of sale would have the effect of conferring a priority not accorded by the provisions of the statutory insolvency scheme. As Mummery LJ eloquently put it in responding to a submission by the applicants’ Counsel that the law (specifically trust law) moves:

"That is true. But it cannot be legitimately moved by judicial decision down a road signed "No Entry" by Parliament. The insolvency road is blocked off to remedial constructive trusts, at least when judge-driven in a vehicle of discretion."

Nourse LJ added some further observations of his own. Due to the lack of earlier authority, His Lordship based his judgement on the principle that you cannot grant a proprietary right to a person who has not had one beforehand, without taking some proprietary right away from another. No English court has ever had the power to do that, except with the authority of Parliament. On this basis, His Lordship held that the applicants’ claim would not be seriously arguable even if Polly Peck was solvent as it is not that you need an Act of Parliament to prohibit a variation of proprietary rights, you need one to permit it.

The appeal by the administrators and Polly Peck was allowed and the application by the applicants for leave to appeal to the House of Lords was refused.

Conclusion

Whilst the Court of Appeal appeared fairly resolute in its refusal to impose a remedial constructive trust in this case, it would seem premature to assume that this is an end to the matter.

One possible hint that the remedial constructive trust is not completely excluded in English law can be found in the judgment of Lord Browne-Wilkinson in Westdeutsche Landesbank Girozentrale v Islington LBC [1996] AC 669 in which he states:

"The court by way of remedy might impose a constructive trust on a defendant who knowingly retains property of which the plaintiff has been unjustly deprived. Since the remedy can be tailored to the circumstances of the particular case, innocent third parties would not be prejudiced and restitutionary defences, such as change of position, are capable of being given effect."

The courts are understandably reluctant to tread on the toes of the legislature by creating a proprietary interest which circumvents established statutory rules of distribution. Until the point is decided at the highest level, it can probably be assumed that the argument will surface again as the Polly Peck case does not rule out future judicial recognition of remedial constructive trusts if factors exist that make it ‘just’ for the courts to grant proprietary relief. As far as insolvency practitioners are concerned, however, English law is currently unlikely to recognise remedial constructive trusts in an insolvency context.

This article was first published by Monitor Press in Corporate Briefing.