THE SHORTFALL CONUNDRUM: A NEW FRAMEWORK FOR ALLOCATING LOSSES IN A MIXED FUND IN AUSTRALIA.

• Date: 01 August 2019
• Author: Chamorro-Courtland, Christian

I Introduction II Tracing A Theories of Tracing B Fictional Tracing Rules III The Basic Pro-Rata Rule A Analysis IV The Original Lowest Intermediate Balance Rule A The Origins of the LIBR B Analysis C The Shortcomings of the LIBR D The Rule in Re Hallett's Estate E The Overdraft Problem and the Distinguishable Fund Theory F Replenishing Trust Funds 1 Which Approach Should Courts Adopt? G Does the Blended Fund Theory Provide a Solution to the Overdraft Problem? V The LIBR-Pro-Rata Hybrid Rule A The Mechanics of the Hybrid Rule 1 Which Version Is Preferable? B Reception of the Hybrid Rule in Australia C Guidelines for Applying the Hybrid Rule VI The Intention-Based Approach A The Intention of the Trustee Is Irrelevant B Actual and Presumed Intention of the Beneficiaries VII The Rule in Clayton's Case A Analysis VIII Authorised versus Unauthorised Withdrawals IX Advice for Beneficiaries X A Framework for Allocating Losses in a Mixed Fund XI Concluding Remarks I Introduction

There is a fervent and ongoing debate in Australia over the best method for distributing trust funds to beneficiaries whose funds have been 'commingled' (1) in an account (ie a 'mixed fund') (2) and have subsequently suffered a shortfall due to fraudulent misappropriation (3) committed by the trustee or as a result of other operational risks. (4) The shortfall conundrum has arisen under the following typical scenario: a trustee ('T') commingles the funds of three beneficiaries ('B1', 'B2, and 'B3') over a period of time in a single trust account. For example, B1 deposits $100 on day 1; B2 deposits $100 on day 2; T misappropriates $100 on day 3; B3 deposits $100 on day 4; T declares bankruptcy on day 5, leaving a shortfall of $100 in the account.

Courts in Australia have struggled to select the appropriate method for allocating the losses among the claimant beneficiaries and distributing the remaining funds. This article provides insolvency administrators and courts with a new practical framework for allocating losses in a shortfall situation in a fair and reliable manner. Adherence to the guidelines in the framework should reduce the number of cases that are litigated by providing an ex ante plan to the beneficiaries of a mixed fund for distributing the remaining trust funds in a shortfall situation upon the bankruptcy of the trustee. The framework also provides courts with practical solutions for the more complex cases that are litigated.

First, this article argues that insolvency administrators and judges should first consider the express or implied intention of the beneficiaries on a caseby-case basis when deciding which method of distribution to apply. (5) The express intention can be determined from the oral or written contractual dealings in the trust documentation between the trustee and the beneficiaries. Alternatively, the implied intention can be ascertained from the previous business dealings between the trustee and the beneficiaries, or if the beneficiaries can demonstrate that the trustee has adhered to a particular custom or practice for holding trust funds.

This article analyses the most common methods that beneficiaries can choose to allocate a shortfall, including: (1) the original lowest intermediate balance rule ('LIBR'); (2) the LIBR-pro-rata hybrid rule ('Hybrid Rule')--either (a) the 'claims' version, or (b) the 'rolling charge' or 'North American' version; (3) the pro-rata approach; (4) the rule in Clayton's Case (6) or first in, first out ('FIFO'). Significantly, this article makes an original contribution to the existing legal literature by developing a new method based on the rule in Clayton's Case that beneficiaries can adopt to allocate a shortfall, which I have called the FIFO-pro-rata hybrid rule.

As a general rule, it is argued that courts in Australia should apply the North American version of the Hybrid Rule in cases where the beneficiaries expressly intended to fully or legally segregate their funds. (7) Courts should also apply the pro-rata approach in cases where the beneficiaries expressly intended to hold their funds as co-owners in an omnibus account, (8) or where they expressly intended to segregate their funds, but tracing has become too complex or costly due to inaccurate or incomplete account records.

Where the express or implied intention of the beneficiaries remains unclear, it is argued that there should be a legal presumption that beneficiaries whose funds are held in a mixed fund intended to segregate their funds from each other and to distribute them using the Hybrid Rule. This presumption is justified as a general rule, since it would be irrational and unfair to presume that the beneficiaries would consent to sharing co-ownership risks with the other beneficiaries in a mixed fund without their prior knowledge or approval. (9)

Second, this article analyses situations where the trustee has wrongfully commingled its own funds in the commingled account with the funds of the beneficiaries. It is argued that there should be a legal presumption that a trustee intended to subordinate its interests to the beneficiaries' interests. Consequently, a trustee will lose its own funds first if there is a shortfall of trust funds in the mixed fund in an insolvency situation. It is also argued that where the trustee replenishes any missing trust funds by depositing its own personal funds into the mixed fund, there should be a legal presumption that the trustee intended to reimburse the trust funds.

Third, this article provides a framework to help insolvency administrators and courts in determining which rule to apply in a shortfall situation. Most of the case law in Australia deals with scenarios where investors have transferred funds to a broker to invest in a scheme (usually a property investment scheme). (10) Other cases deal with scenarios where a lawyer commingles the funds of multiple clients in a single account. As more fraudulent schemes are bound to be uncovered in Australia in the future, this article provides administrators and courts with a reliable framework for allocating losses in order to enhance legal certainty for the beneficiaries and unsecured creditors of an insolvent trustee.

II Tracing

The distribution methods that are analysed in the following sections form a part of the law of tracing:

Tracing is ... neither a claim nor a remedy. It is merely the process by which a claimant demonstrates what has happened to his property, identifies its proceeds and the persons who have handled or received them, and justifies his claim that the proceeds can properly be regarded as representing his property. (11) The orthodox position in many common law jurisdictions is that it is not possible to trace at common law into and out of a mixed fund because the commingled funds lose their identity. (12) Conversely, it is possible to trace into and out of a mixed fund in equity; however, this distinction has been criticised. (13) In order to avoid a lengthy theoretical debate, this article will not distinguish between tracing at common law and tracing at equity.

A Theories of Tracing

Although this article mainly focuses on the practical aspects of allocating shortfalls in a mixed fund, the following section will provide a brief overview of the theoretical debate that is taking place in common law jurisdictions as to the conceptual premise of tracing. Justice Edelman has noted that 'the judiciary has never enunciated the assumptions, or normative premises, upon which the law of tracing has been built'. (14) This has led to an emergence of various theories on the law of tracing.

The 'tracing value' school of thought requires claimants to follow a continuous thread of 'value' from one right to another. Professor Smith has provided the following example:

Consider the simplest case in which the plaintiff's asset is exchanged by a defendant for some other asset, and the plaintiff wants to trace into the new asset. The only connection which the plaintiff has to the new asset is that it was acquired with the old asset. The defendant acquired the value inherent in the new asset with the value inherent in the old asset. That is why we say we trace value: it is the only constant that exists before, through and after the substitution through which we trace. It exists in a different form after the substitution, and that is what can justify a claim to the new asset. (15) However, Dr Cutts has criticised this theory by arguing that the concept of moving and exchanging value through a transaction is unclear and 'theoretically and practically misleading'. (16)

The 'causally linked transactions' school of thought requires the claimants 'to establish a causal link between two or more transactions. It requires that the latter transaction would not have occurred "but for" the earlier defective transaction'. (17) This theory requires a 'transactional link' that forms part of an unbroken chain between the claimant's misappropriated property and the substituted property that is being claimed. (18) However, this theory has been criticised as it does not work in cases where the claimants need to trace backwards. In other words, it does not work where a 'defective transaction occurs after the transaction with the defendant, but a fraudster intends to use the proceeds from the later transaction in the earlier defective transaction'. (19) Cutts has also criticised this orthodox theory because it has become increasingly onerous for a claimant to demonstrate that the chain of transactions remained unbroken, 'not least because a fraudulent fiduciary is unlikely to be forthcoming in their evidence as to the path of misdirected funds. (20) This theory has also been rejected by Evans, who has argued that beneficiaries who are seeking to trace should be freed from the obligation of proving a transactional link. (21)

Cutts has argued under the 'intentional transactions' school of thought that

in order to determine the existence...