Bankrupt beneficiaries and risks for personal representatives
While testators generally have the freedom to decide how to dispose of their assets in England and Wales, there are limits to this freedom, including when a beneficiary of the estate is declared bankrupt. If the testator dies during the beneficiary’s bankruptcy, the bequest will generally pass to the trustee in bankruptcy for the benefit of the creditors rather than the beneficiary.
Under section 306 of the Insolvency Act 1986 (the “Act”), the assets of the bankrupt beneficiary vest in the bankruptcy trustee upon appointment. Section 283 (1) of the Act provides that (subject to certain provisions) the assets of a bankrupt include “all property owned or vested in the bankrupt at the onset of the bankruptcy”. The definition of property includes personal property rights, such as the beneficiary’s right to have the estate properly administered or their inheritance paid to them upon completion of the administration of the estate.
What happens if a bankrupt is discharged before the distribution of the estate?
In the case of Re Bertha Hemming deceased, Raymond Saul & Co vs. Holden, Ms. Hemming died on July 18, 2003, leaving her property to her son, Mr. Bernard Hemming. Mr. Hemming was declared bankrupt on September 24, 2003. A bankruptcy trustee was appointed on October 14, 2003 and Mr. Hemming’s bankruptcy was discharged on April 1, 2005. The question before the court was whether the estate residual to be distributed after discharge from bankruptcy must be paid to Mr. Hemming or to the bankruptcy trustee.
The court concluded that Mr. Hemming’s right to his mother’s residual estate, including the right to receive the assets comprising this remainder as the administration of the estate is completed, rests with the trustee in bankruptcy. by the application of section 306 of the law and that this right does not accrue to Mr. Hemming on discharge from his bankruptcy until his debts and bankruptcy costs have not been paid. The trustee therefore remained entitled to receive the property representing the residual estate as and when the administration of the estate was completed.
The court felt supported in this conclusion by the problems which would arise in practice if the trustee’s right to the residual succession was not acquired before the succession was complete. She notes that it is a coincidence that the testator dies before a beneficiary is bankrupted, but if the law were such that the creditors of the bankrupt beneficiary could only benefit from the residual bequest if the administration of the estate was completed before the bankrupt was discharged, this could lead to unwanted consequences. For example, a bankruptcy trustee may be required to initiate proceedings to enforce prompt administration of the estate to ensure that it is completed before the bankrupt is discharged. If the bankrupt beneficiary were also the executor, there would be an incentive to delay the administration of the estate.
What happens if the testator dies after the beneficiary goes bankrupt?
If the testator has not yet died at the time of the appointment of the trustee in bankruptcy, the compound right of the beneficiary to have the estate properly administered and to receive his inheritance at the end of administration would not have arisen yet and therefore could not belong to the bankrupt trustee at that time. The beneficiary’s interest in these circumstances is considered to be “property after acquisition”.
Under section 333 of the Act, the bankrupt beneficiary is required to notify the trustee of any post-acquisition property that he has received. The beneficiary must provide such notice within 21 days of becoming aware of the relevant facts in accordance with Rule 10.125 of the Insolvency Rules (England and Wales) 2016 (“IR2016”). This would likely happen within 21 days of the deceased’s death and the beneficiary learning that they have an interest in the estate. If he does not, it is punishable by contempt of court. Property acquired subsequently devolves initially on the beneficiary. However, alternatively, the bankruptcy trustee can take the initiative by serving his own notice on the bankrupt within 42 days of becoming aware of the property after acquisition in accordance with section 307 (1) of the Act, or later, with the court permission. Subsection 307 (3) of the Act confirms that upon service of a notice, the property to which it relates has vested in the trustee as part of the bankrupt’s estate and that the trustee’s title to such property goes back to the earlier date on which the bankrupt acquired the interest (or the property vested in the bankrupt), and not to the later date of service of the notice under section 307. If the Trustee serves or intends to do so under Section 307 within the allotted time, the personal representative (PR) will need to determine whether the distribution should be made to the trustee in bankruptcy rather than to the beneficiary.
What can a bankruptcy trustee do if a PR has transferred assets to the bankrupt beneficiary?
The PRs of an estate have an obligation to ensure that the estate is properly administered and that the assets are distributed to the beneficiaries or legitimate creditors of the deceased’s estate. If they transfer the assets of the estate to a bankrupt beneficiary, they may transfer the assets to the wrong person in violation of their obligations. There is no specific legal protection in the Act for PRs, although there is limited protection for a third party beneficiary of any property acquired afterwards if it is a bona fide purchaser for unannounced value of bankruptcy (see section 307 (4)). If subsection 307 (4) applies, the trustee in bankruptcy is not entitled to any recourse against that third party, whether a notice under section 307 was served before or after the disposition. However, if the defense in subsection 307 (4) does not apply, a trustee in bankruptcy may serve a notice under Rule 10.126 IR2016 on the beneficiary of the estranged property claiming the property for the estate of the bankrupt.
If the beneficiary puts the property out of the reach of the trustee, the trustee, on behalf of the bankrupt’s creditors, can bring an action for damages against the PRs. When PRs have improperly distributed assets to someone who was or is an undischarged bankrupt, it may be difficult to complete a claim for the recovery of those assets due to the restrictions placed on the prosecution of bankrupts by section 285 of the Act. It would therefore be prudent for PRs to avoid this risk by conducting bankruptcy investigation against all beneficiaries before making any distributions. If a beneficiary went bankrupt before the death of the deceased person, they should also ask to see the section 333 notice informing the bankruptcy trustee of any property acquired after the acquisition, and checking with the trustee of bankruptcy if the trustee has served a notice on the bankrupt under subsection 307 (1) or intends to serve such notice before making any distribution of the estate. If the PR is in any doubt as to who is entitled to the estate assets, advice should be obtained before making any distributions.