Trust Property in Insolvency

The real test of a trust comes when the trustee becomes insolvent. If trust property were simply part of the trustee's assets, the beneficiaries would have to queue with his creditors. Indian law, like English law, holds otherwise: property held on trust for others is not available to the trustee's creditors. The Insolvency and Bankruptcy Code, 2016 (IBC) gives this principle express statutory form for companies and individuals. This note explains the principle, its statutory basis, and the practical questions it raises.

1. The Principle

A trustee owns trust property only for the benefit of the beneficiaries (Section 3; Topic 6). His creditors can take what is beneficially his, not what he holds for others. The beneficiaries' right to follow and trace trust property (Sections 63 to 66) operates against the trustee's general creditors, who are neither purchasers for value nor protected by Section 64; indeed Section 64 expressly denies protection to a judgment creditor who attaches and buys trust property.

2. Corporate Insolvency under the IBC

Section 36(4)(a), Insolvency and Bankruptcy Code, 2016 (assets excluded from liquidation estate)

The following shall not be included in the liquidation estate assets and shall not be used for recovery in the liquidation: (a) assets owned by a third party which are in possession of the corporate debtor, including (i) assets held in trust for any third party; (ii) bailment contracts; (iii) all sums due to any workman or employee from the provident fund, the pension fund and the gratuity fund; (iv) other contractual arrangements which do not stipulate transfer of title but only use of the assets; and (v) such other assets as may be notified by the Central Government in consultation with any financial sector regulator.

Liquidation: assets held in trust for third parties, and provident, pension and gratuity funds, are excluded from the liquidation estate.
Corporate insolvency resolution process: the Explanation to Section 18 similarly provides that assets owned by third parties and held by the corporate debtor under trust or contractual arrangements are not part of the assets of which the resolution professional takes control.
Employee funds: tribunals have held that provident, pension and gratuity fund dues of workmen are outside the liquidation estate and must be paid in full, not in the waterfall.

3. Individual Insolvency

For individuals, the IBC's bankruptcy provisions similarly exclude from the bankrupt's estate property held by the bankrupt on trust for any other person. A person who is trustee of a family trust does not lose the trust property to his personal creditors.

4. Proving the Trust

The exclusion protects only property that is actually held on trust and can be identified. Common difficulties:

Issue	Effect
No real trust	An advance payment, deposit or loan that the recipient was free to use as its own creates a debt, not a trust; the payer is an unsecured creditor
Commingling	If trust money is mixed with the debtor's own, the beneficiary must trace it; a charge on the mixed fund is available under Section 66, but if the fund is exhausted the claim may become unsecured
Sham trust	A trust created to shield assets from existing creditors may be set aside as fraudulent (Trusts Act, Section 4; Transfer of Property Act, Section 53; IBC avoidance provisions)
Purpose trusts	Money received for a specified purpose and kept separate may be held on a Quistclose type trust (Topic 51)

Anyone holding money for others should therefore keep it in a separate, designated account with documents showing that it is held in trust.

5. Insolvency of the Beneficiary and of the Author

Insolvent beneficiary: the beneficiary's interest is his property and passes to his insolvency estate, subject to the terms of the trust; a discretionary beneficiary has no fixed interest that creditors can seize, which is one reason discretionary trusts are used for family protection (Topic 54).
Insolvent author: a settlement made to defeat creditors may be avoided (Section 4, Illustration (c); Topic 7), and IBC provisions on preferential, undervalued and fraudulent transactions allow transfers within look-back periods to be reversed.

⚠ Key point

Property held on trust for others is not available to the trustee's creditors. The IBC excludes from the liquidation estate assets held in trust for any third party and provident, pension and gratuity fund dues (Section 36(4)(a)), and from the resolution professional's control assets held under trust (Section 18, Explanation); bankruptcy of individuals similarly excludes property held on trust. The exclusion requires a genuine and identifiable trust; mixed funds need tracing (Section 66), and sham settlements to defeat creditors can be avoided. A beneficiary's interest passes to his own creditors, but a discretionary beneficiary has no fixed interest to seize.

6. Related Topics and Provisions

Nature of the beneficiary's interest (Topic 6)
Following and tracing trust property (Topic 27)