Written by Partner Marc Kemp and Senior Associate Eve Regnard
Those of us who work daily with commercial trusts understand that limitation of liability clauses are critical. They are the mechanism that allows commercial trusts to operate the way they do – as separate economic entities without separate legal personality. Without consistent use of an effective limitation of liability clause, the trustee of a commercial trust would be exposed to personal loss and the risk of insolvency, not to mention exposing the assets of other trusts to improper claims. For a counterparty, a limitation of liability clause that over-protects the trustee can leave it without recourse in unexpected circumstances.
Getting a limitation of liability clause right can be challenging. Given the importance of the clause, negotiations can be tough. The drafting is abstract and broad, as it needs to cater for a universe of possible scenarios that might arise. Often the parties are tussling over language and concepts that are untested at best, and at worst unclear or contradictory.
So we all sat up and paid attention when a rare decision on the practical application of such a clause was handed down in ALYK (H.K.) Limited v Caprock Commodities Trading Pty Limited and China Construction Bank Corporation  NSWSC 764. As we considered the issues raised by the Caprock case, we found ourselves reliving many other issues we have dealt with in this space. In this article we hope to share that thinking with you, and to give you some drafting tips which may help avoid some of the pitfalls in this area.
The facts before the court
In the Caprock case the limitation of liability clause before the court was not very sophisticated. It simply read:
[Trustee] enters into this contract and acts and incurs liabilities solely in its capacity as trustee of [the fund] under the trust deed dated on or about the date of [the contract] and its liability is limited to the assets of [the fund].
Following arbitration of a contractual dispute, the arbitrator required the trustee to pay the counterparty an award of $2 million, plus substantial costs. The amount exceeded the assets of the fund, and the court was required to decide how much the trustee should be required to pay in a judgment enforcing the arbitral award.
The trustee had made several significant payments to related parties out of the fund immediately before terminating the contract, which had the effect of reducing the assets of the fund by over $800,000.
While the clause before the court was simplistic, the decision has potentially significant implications even for the fulsome clauses that we normally see. The following key issues were dealt with:
- When do you calculate the cap on the trustee's liability?
The Court had to decide when the assets of the fund should be calculated to determine the dollar value of the trustee's liability cap. The parties argued for various outcomes:
- the date that the liability arose (when assets were $819,883.16);
- the date of the arbitral award (when assets were $538,261); or
- the date of the judgment (24 July 2015) (unchanged at $538,261)
Justice Black disagreed with all of these suggestions, and decided that the calculation is to be made when the trustee seeks to exercise its right of indemnity out of the fund. Seeing as the trustee had taken no action to do so, the liability would be calculated on the date of the judgment (ie 24 July 2015).
Clearly the action (or inaction) of the trustee can significantly affect the amount available to a counterparty to remedy a breach by the trustee, as the assets of the fund would fluctuate over time.
- Can the trustee pay out assets of the fund to avoid paying them to the creditor?
The biggest fluctuation in the trust's assets in this case occurred when the trustee made a number of related party payments immediately before crystallising liability under the contract. The counterparty initially raised these payments as relevant to the outcome, but then dropped the request that the related party payments be taken into account. In his reasons, Justice Black said that, if the point had been pressed, he would not have treated the $800,000 as assets of the fund after they had been paid out. If the parties had wanted to limit payments out of the fund, the contract would have said so.
The trust the subject of the Caprock case was not a registered managed investment scheme. If it had been, the outcome may have differed. Registered schemes are restricted from entering into transactions with its related parties that are not (for example) at arm's length or which do not have unitholder approval.
- Is the trustee's liability capped at the gross or the net assets of the fund?
From the trustee's perspective, perhaps the most significant outcome was that the limitation was applied to the gross assets of the fund. The trustee conceded this point given the wording of the clause, and Justice Black said he agreed, and would have ruled accordingly if needed. Any shortfall between the gross value of the assets and the net amount the trustee could raise when realising those assets (eg, after paying off finance liabilities) would be borne by the trustee. Over the years we have seen many clauses that could have the same outcome.
- Will a judgment against the trustee be limited to 'its trustee capacity'?
The court refused the trustee's request that judgment against it be made 'in its capacity as trustee of the fund'. In effect, the trustee was seeking an additional limitation on its liability so that it would not have to use personal assets (or assets of another fund) to meet the judgment. Justice Black explained that the 'capacity' of the trustee is not a distinction recognised by the law. Liability to satisfy a judgment debt is personal.
We often see limitation clauses that preclude legal action against the trustee 'in any capacity other than as trustee of the fund'. This restriction doesn't add anything to the substantive limitations in the clause.
The Caprock case highlights just a few of the practical problems for trustees and counterparties dealing with limitation of liability clauses. We think that the following questions are equally significant, and not necessarily well solved by the typical clauses used in the market:
- Most limitation clauses cap the trustee's liability by reference to the trustee's right of indemnity out of the assets of the fund. This imports into the clause all of the equitable bars to the trustee's access to that indemnity. Instead, if the clause is drafted well, the trustee (and not the counterparty) would bear the risk that its indemnity is impaired through its fault, but if this is not done effectively the counterparty can lose its rights if the trustee has acted improperly. Most limitation clauses set out appropriate carve outs to the limitation to ensure that this is the case.
- If the trustee's impropriety does reduce its access to the assets of the fund, and therefore expose it to personal liability under a carve out to the limitation of liability, there is a risk that its personal liability would not be proportional to the wrong – for example, it could open the trustee to a $5 million personal claim in relation to a $2 million fund in circumstances where the wrong committed by the trustee has not decreased the trust assets. Some trustees seek to protect against this risk by including an additional cap on their personal liability should their indemnity out of trust assets be impaired (often also quantified as the assets of the fund). Counterparties tend to resist this, given that the trustee's misconduct could decrease the trust assets, and in those circumstances it is hard to argue that the trustee should be excused.
- Many clauses do not adequately deal with simultaneous claims by multiple creditors. If the cap is set by reference to the assets of the fund on a gross basis, the claims may in aggregate exceed the assets of the fund.
- Most clauses do not address the trustee's costs relating to any dispute (including costs orders), nor the cost of realising assets to meet the liability, again potentially leaving the trustee to pay those costs personally.
- Some clauses seek to solve for (iii) and (iv) by referring to the amount for which the trustee is 'actually indemnified'. This creates a circularity that counterparties find difficult to accept. What if the trustee simply doesn't exercise its right of indemnity – is its liability reduced to nil? If the liability doesn't arise until it is indemnified, is there anything to be indemnified at all?
- Some clauses are so broad in their protection of the trustee that it becomes unclear whether the trustee is liable for anything. This could in fact create a risk for the trustee, that the clause is struck out or read down to the trustee's detriment.
- A trustee may have an effective limitation of liability in terms of the amount of a cap, but still be exposed to an insolvency risk (a risk that it cannot meet its debts as they fall due) by reason of the illiquidity of the assets of the fund. Even a $1 billion fund may be unable to meet a $1 million liability if the Trustee doesn't have timely access to that cash.
- Some trustees seek to include in their limitation a statement that the trustee has no liability if they cease to be the trustee of the fund. In the absence of a clear pre-condition for a replacement trustee that assumes relevant liabilities, such a clause would leave a counterparty completely exposed.
- Authorities are not clear on whether the trustee's negligence is caught by limitation clauses if not expressly referred to.
These questions, and others, are receiving heightened attention as greater numbers of offshore counterparties enter the Australian market in various capacities. Extensive use of commercial trusts, and their limitation of liability clauses, are somewhat unique to Australia and many offshore counterparties find them unduly broad.
Many of the complexities described in this note have been considered and addressed in a model limitation clause jointly drafted by our Senior Finance Counsel Diccon Loxton and published in Trustees' limitation of liability: Myths, mysteries and a model clause by Loxton and D'Angelo (2013) 41 ABLR 142. That article considers the perspective of finance security trustees, but its wisdom is equally applicable to commercial trustees and their counterparties, and it was cited with approval in the Caprock case.
A core difference between the model clause and those we commonly see is that the measure of the cap on the trustee's liability is whether the liability 'can be satisfied out of trust assets'. This formulation deliberately encompasses both the legal and practical access the trustee has to the assets, avoiding specific reference to the right of indemnity and the possible problems that presents.
From the trustee's perspective, the clause clearly sets out what actions the counterparty can and cannot take vis a vis the trustee. Importantly, it prohibits the counterparty from seeking to have the trustee placed in any form of insolvency administration. It also states that where certain permitted actions give rise to liability, that liability is also limited by the clause. For example, liability to pay a costs order or to meet the costs of liquidating trust assets would itself come within the liability cap.
In seeking to balance the legitimate expectations of both trustees and their creditors the model clause has much to recommend it, and would be a good starting point for a lawyer lucky enough to start with a blank canvas to write on.