Smoke and Mirrors: Shams and Illusory Trusts in Divorce Proceedings

The existence of so-called ‘sham’ or ‘illusory’ trusts in divorce proceedings often leads to complex and intellectually engaging work for family and chancery lawyers. Identifying such trusts can significantly impact the value of the matrimonial pot and the eventual financial distribution. Remedies are typically pursued through interim applications under s 37 Matrimonial Causes Act 1973 (MCA 1973) and/or s 423 Insolvency Act 1986 (IA 1986).

This article explores the legal principles for identifying sham and illusory trusts and offers practical advice for practitioners on strategy and evidentiary steps.

Back to basics: key players in a trust

As with all trust arrangements, the following roles are central:

(1) Settlor: the party who entrusts the property.

(2) Trustee: the party to whom the property is entrusted.

(3) Beneficiary: the intended recipient of the property.

(4) Protector: a person(s) appointed to monitor, oversee or exercise a degree of control over the trust by the trustees.

Further, financial remedy practitioners ought to be aware of the three certainties for the creation of a valid trust, namely:

(1) certainty as to the intention of the settlor to create a trust (also known as certainty of words), the trust property being intended to be kept separate from other property of the trustee;

(2) certainty as to the subject matter to which the trust is to attach;

(3) certainty as to the ‘objects’ (or more simply, persons) who are intended to benefit.

The difference between a ‘sham’ and an ‘illusory trust’

Sham

‘Sham’ is a concept of general application; it is not specific to the law of trusts. The canonical definition was provided by Diplock LJ in Snook v London and West Riding Investments Ltd [1967] 2 QB 786 at 802:

‘I apprehend that, if [this popular and pejorative word] has any meaning in law, it means acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the Court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create…

… For acts or documents to be a “sham”, with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating.’

The essential ingredient for identifying such a sham is the parties’ intention to mislead and this ought to be a ‘common intention’ between the settlor and trustee. This is crucial, as whatever a settlor might have intended when a trust was created, and whatever may have happened since, a trust would not be a sham if either the original or subsequently appointed trustees had not been party to it at the time of their appointment.[[1]]

Illusory trust

As for illusory trusts, one definition can be: ‘used to describe a purported trust the terms of which provide that the property must be held for beneficiaries but simultaneously allocate so many powers to the settlor that the arrangement cannot take effect as a trust in [the beneficiaries’] favour because they have no meaningful rights in respect of it’.[[2]]

Essentially, the key ingredient in establishing whether a trust is illusory is how much control and/or powers a settlor retains under the trust, so that the beneficiaries may be seen to be prejudiced. Namely, there is an ‘illusion’ of a valid trust but in actual fact the settlor is simply reserving powers to him- or herself.

In family cases, this often arises when one party claims trust-held assets should be included in the matrimonial pot, depending on the roles of the parties – settlor, beneficiary or trustee.

The distinction between sham and illusory is somewhat sophisticated, but the latter often requires less of a focus on ‘fraudulent’ or dishonest behaviour of a party and more whether the terms of the trust allow the trustee to stray beyond the powers afforded within the bounds of a valid trust.

As pithily defined by Grahame Young, a barrister at Francis Burt Chambers, Perth, Australia in his breakdown of New Zealand Supreme Court case Clayton v Clayton [2016] NZSC 29:[[3]]

‘A sham trust is one where as a matter of construction the terms of the document would establish a valid trust, but the intention of the relevant parties is that they will not be bound by those terms but hold the property for or at the direction of the settlor.

An illusory trust is one where the intention of the parties is that they will be bound by the terms of the document, but as a matter of construction those terms do not establish a valid trust.’

Note, however, that the terminology is not without criticism – both the Supreme Court justices in Clayton and Birss J in a later UK case Mezhdunarodniy Bank v Pugachev [2017] EWHC 2426 (Ch) questioned the utility of the term ‘illusory’.

Who bears the burden of establishing such a document/trust and to what standard?

For both issues, the burden of establishing that a document is a sham or illusory – i.e. that it was executed with the common intention of misleading third parties as to the rights and obligations (if any) which the parties thereto actually wished to create – rests on the party making that allegation: National Westminster Bank plc v Jones [2001] 1 BCLC 98 per Neuberger J at [68].

This is why particular care ought to be taken in investigating matters before the making of an application – the burden is a high one to prove for the applicant.

As clarified by Mostyn J in the case of Bhura v Bhura [2014] EWHC 727 (Fam) at [9], whilst the standard of proof is set at the balance of probabilities, clear evidence is required to satisfy such a test. He stated:

‘Because a degree of dishonesty is involved in a sham there is a very strong presumption that parties intend to be bound by the provisions of agreements into which they enter, and intend the agreements they enter into to take effect. However, this does not elevate the standard of proof, which is set at the balance of probability. Nonetheless the test is a stiff one and there is a requirement of very clear evidence given the seriousness of the allegation.’

Care must be considered before raising such allegations of sham documents in financial remedy proceedings for the above reason, and there are numerous examples where the case has not been made out, such as in A v A [2007] EWHC 99 (Fam) and ND v SD (Financial Remedies: Trust: Beneficial Ownership) [2017] EWHC 1507 (Fam), where Roberts J set out the importance of distinguishing between motive and intention. At [67] he clarified that even an artificial transaction which was put in place for the purpose of asset protection would not necessarily be cast aside as a sham if all the parties to the transaction genuinely intended the agreements incorporated into the document in which they appeared to take effect.

See also the approach taken in Joy v Joy-Morancho & Ors (No 3) [2015] EWHC 2507 (Fam), where W’s legal team had chosen not to run the case on a sham trust basis for fear of failing to meet the stringent test; however, Sir Peter Singer (sitting as a Judge of the High Court) instead found that the case collusively advanced by the husband was a ‘rotten edifice founded on concealment and misrepresentation and therefore a sham, a charade, bogus, spurious and contrived. It could further be described as fraud’.

What evidentiary steps ought to be taken to establish the existence of such a trust?

Sham

As helpfully set out by Rajah J in Islam v Islam & Ors [2024] EWHC 1082 (Ch) at [140]:

‘Determining whether the parties have a shamming intention is not a question of construction of the impugned document, but a matter on which extrinsic evidence is admissible to prove or disprove the existence of the requisite subjective intention.’

The court is not restricted therefore simply to the document but will be looking at all available evidence to determine the state of mind of the parties and to determine what their intentions were at the time.

Such evidence could include:

other documents supporting the ‘sham document’, e.g. in the instance of transfer of shares, any communications to other shareholders about such a transfer;
minutes of meetings (be it commercial or familial context);
accounts of witnesses present at the time of such a document being created.

Practitioners will want to take particular notice of the following, as potential ‘warning signs’ of a sham document:

amendments to or creation of trust documentation either during proceedings or just prior to issuing;
timing of transactions taking place just before proceedings;
any agreements/amendments being created in secret without the opposing spouse’s knowledge;
unusual haste in creating a trust document, particularly if done without the benefit of legal advice;

Illusory trust

The focus here is on the control retained by the settlor and how the trust was administered in practice. Practitioners should examine:

trustee discretion (or lack thereof);
past transactions under the trust (e.g. asset purchases, appointments);
any deviation from the trust’s formal structure.

What are the consequences of identifying such a trust?

Sham

Essentially, a sham is a void instrument, as it is predicated on the basis of fraud. However, the consequences that flow from this vary, as stated by Rajah J in Islam, concluding that ‘a document, agreement or provision is a sham or pretence does not make it void, or of no effect, for all purposes … the Court has some ?exibility as to what the consequences should be … because where there is a sham the illegality principle is engaged’ (at [144] and [219]).

On this point, practitioners ought to be mindful about the potential implications of the principles in Patel v Mirza [2016] UKSC 42 where illegality is engaged, especially if your client is attempting to rely on the document that is found to be a sham. Namely, ‘no court will lend its aid to a man who founds his cause of action upon an immoral or an illegal act’, as the court will generally not allow a party to profit from their wrongdoing. However, the court will also need to address public policy issues and whether overall it would be disproportionate to refuse relief of the party, weighing up the seriousness of their conduct.

Given the nature of shams, a client’s credibility is always going to be called into question, and it can have a devastating impact on their financial remedy claim – either by way of overall distribution or, more likely, in cost consequences.

Ultimately, in the context of financial remedy proceedings, the main practical consequence of the court finding a sham and the trust being void is that the property will be made available to third parties, for example creditors and spouses.

Illusory trust

An illusory trust is typically re-characterised as a bare trust. The supposed trustee becomes a nominee, and the beneficiary obtains an immediate and absolute right to the assets.

In a divorce, if the husband or wife is the sole beneficiary, the trust assets may be treated as matrimonial property and become available for distribution.

Potential applications

MCA 1973, s 37

It may be possible to set aside a disposition of an asset into trust if the court is satisfied that the disposition was made with the intention of defeating the other party’s claims for financial relief on divorce/dissolution pursuant to MCA 1973, s 37(2).

Further, s 37(5)(a) MCA 1973/Sch 5, Pt 14, para 75(4)(a) Civil Partnership Act 2004 creates a presumption that any disposition made within the 3 years preceding the application for financial relief was made with the intention to defeat the other party’s claims, if the disposition would in fact have that consequence. Such a disposition is termed ‘reviewable’ and the court may be asked to review the disposition and, if justified, set it aside. Such an application may be made before or after an order has been made by the court in the main financial proceedings. The third party to whom the disposition has been made will have to be joined as a party to the proceedings.

A freezing injunction may also be obtained under s 37(2)(a) MCA 1973 for an avoidance of disposition order within financial remedy proceedings to prevent a reviewable disposition or other dealing with property, where the court is satisfied that it is about to be made, or that property may be transferred out of the jurisdiction, with the intention of defeating a claim for financial relief. Practitioners may also wish to make a separate application to the High Court (Family Division) under s 37 Senior Courts Act 1981 for a Mareva freezing injunction to be granted, which will prevent a respondent from dealing with the whole or part of their assets (i.e. by moving assets abroad or dissipating them) while legal proceedings are ongoing.

As an aside, it is worth noting that such a freezing injunction may also be granted by the English court in support of matrimonial proceedings taking place elsewhere, pursuant to s 25 Civil Jurisdiction and Judgments Act 1982. In such an application the court will consider three factors:

(1) Whether the making of an order would interfere with the management of the case in the primary court.

(2) Whether there is a danger that such an order would give rise to inconsistent orders.

(3) Whether at the time the order is sought there is likely to be a potential conflict as to jurisdiction.

IA 1986, s 423

An application of this nature is often plead in the alternative to the above. It enables a trust document to be set aside on the basis that the transfers of the assets into the trusts (known as transaction at an undervalue (TUV)) were carried out with the intention to prejudice the interests of a party’s creditors.

Essentially, a party enters into a TUV with another where:

they make a gift or receive no consideration for the transaction;
the consideration for the transaction is marriage or the formation of a civil partnership;
the consideration for the transaction, in money or money’s worth, is significantly less than the value, in money or money’s worth, of the consideration provided by it.

An order shall only be made if the court is also satisfied that the TUV was entered into for the purpose of:

putting assets beyond the reach of a person who is making a financial remedies claim against them; or
otherwise prejudicing the interests of such a person in relation to the claim they make.

Despite this being an Insolvency Act provision, it happily does not require substantive formal insolvency proceedings and can be applied for in the family courts (although please note most applications of this nature would be required to be made in the High Court (Family Division)).

In terms of relief, the courts have wide discretion ‘and may make such order as it thinks fit’ so long as the order seeks both to:

restore the position to what it would have been if the transaction had not been entered into; and
protect the interests of victims of the transaction.

While the court’s discretion is necessarily wide, s 425 IA 1986 sets out a list of some possible remedies which can be useful for practitioners to cite when making their applications and drafting their orders.

The most commonly used remedy is for the transaction to simply be undone, by transferring the property back to the transferor.

Practical guidance for practitioners

When faced with the potential existence of either a sham document or an illusory trust, great care must be taken in pleading this/making the above applications.

In either case, the applicant is usually alleging an element of fraud and as such the evidential threshold is high. Further, there are high cost consequences of an unsuccessful application as:

(1) preliminary hearings of this nature fall outside the ‘no order to costs’ regime; and

(2) an unsuccessful application is likely to result in an order for indemnity costs.

As such, here are some questions to consider before advising your client to embark on a potentially costly exercise:

Value and proportionality: Are the trust assets material to the overall claim?
Liquidity: Will these assets actually produce a financial benefit? For example, if dealing with a transfer of shares in a small family-run business owned with three other directors – what’s the likelihood of the applicant actually receiving said funds?
Jurisdiction and enforcement: Can any resulting order be enforced abroad?
Alternative approaches: Could dissipation arguments (e.g. add-back) be more suitable?
Pleadings and procedure: Is the case sufficiently prepared for formal points of claim, defence and witness evidence?
Third-party involvement: Are offshore trustees or other beneficiaries necessary parties? Will they submit to the jurisdiction?

Conclusion

Claims involving sham or illusory trusts can be pivotal in financial remedy proceedings, but they require careful handling due to their complexity and the high burden of proof involved. When approached strategically, with thorough investigation and clear evidence, these claims can significantly impact the outcome of a divorce or dissolution, potentially unlocking assets that may otherwise remain out of reach for clients.

However, practitioners must remain mindful of the risks – particularly the potential for substantial costs and credibility damage if an application fails. By ensuring a proportionate approach, clear pleadings, and an understanding of the practical implications, legal professionals can effectively navigate these intricate issues and safeguard their client’s interests.

[[1]]: ⁠A v A [2007] EWHC 99 (Fam), Munby J. This case provides a comprehensive breakdown of the interaction between ‘shams’ in a family context and is a recommended starting point for family practitioners looking for guidance in this area.⁠

[[2]]: ⁠Underhill and Hayton – Law of Trusts and Trustees (Lexis Nexis, 20th edn, 2022) at 8.1.⁠

[[3]]: ⁠G Young, ‘Sham and illusory trusts – lessons from Clayton v Clayton’ (2018) 24 (2) Trusts & Trustees 194.⁠