Bankrupt beneficiaries and risks for personal representatives

30 September 2021

While testators generally have freedom to decide how to dispose of their assets in England and Wales, there are limits to this freedom, including where a beneficiary of the estate is made bankrupt. If the testator passes away during the course of the beneficiary’s bankruptcy, the legacy will usually pass to the trustee in bankruptcy for the benefit of creditors instead of to the beneficiary.

Under section 306 of the Insolvency Act 1986 (the “Act”) the property of the bankrupt beneficiary vests in the trustee in bankruptcy immediately upon his or her appointment.  Section 283(1) of the Act provides that (subject to certain provisions) a bankrupt's estate comprises, "all property belonging to or vested in the bankrupt at the commencement of the bankruptcy". The definition of property includes personal property rights, such as the right of the beneficiary to have the estate properly administered or their inheritance paid to them on conclusion of the administration of the estate.

What if a bankrupt is discharged before the estate is distributed?

In the case of Re Bertha Hemming Deceased, Raymond Saul & Co v Holden, Mrs Hemming died on 18 July 2003 leaving her estate to her son Mr Bernard Hemming. Mr Hemming was made bankrupt on 24 September 2003. A trustee in bankruptcy was appointed on 14 October 2003 and Mr Hemming’s bankruptcy was discharged on 1 April 2005. The question before the court was whether the residuary estate due to be distributed after the bankruptcy was discharged should be paid to Mr Hemming or the trustee in bankruptcy.

The court found that Mr Hemming's entitlement to his mother's residuary estate, including the right to receive the assets comprising that residue as and when the administration of the estate is complete, vested in the trustee in bankruptcy by the operation of section 306 of the Act and that that right does not re-vest in Mr Hemming on his bankruptcy being discharged unless and until his bankruptcy debts and costs had been paid. The trustee therefore remained entitled to receive the assets representing the residuary estate as and when the administration of the estate was complete.

The court felt supported in this conclusion by the problems that would arise in practice if the trustee’s entitlement to the residuary estate did not vest until the estate was complete.  It noted that it was a matter of chance whether the testator dies before a beneficiary is made bankrupt, but if the law was such that the creditors of the bankrupt beneficiary could only benefit from the residuary legacy if the administration of the estate was completed before the bankrupt was discharged, this could lead to undesirable consequences. For example, a trustee in bankruptcy may be obliged to bring proceedings to compel a speedy administration of the estate in an attempt to ensure that it was completed before the bankrupt was discharged. If the bankrupt beneficiary was also the executor he or she would have an incentive to delay the administration of the estate.

What if the testator dies after the beneficiary has been made bankrupt?

If the testator has not yet died at the time the trustee in bankruptcy is appointed, the beneficiary’s composite right to have the estate properly administered and to receive its inheritance on completion of the administration would not yet have arisen and therefore could not vest in the trustee in bankruptcy at that time. The beneficiary’s right in those circumstances is considered to be ‘after acquired property’.

Under Section 333 of the Act the bankrupt beneficiary is required to give notice to the trustee of any after acquired property it has received. The beneficiary must provide such notice within 21 days of becoming aware of the relevant facts pursuant to Rule 10.125 of The Insolvency (England and Wales) Rules 2016 (“IR2016”). This would presumably be within 21 days of the deceased passing away and the beneficiary becoming aware that they have an interest in the estate. If he or she fails to do so this is punishable as a contempt of court. The after acquired property vests in the beneficiary initially. However, alternatively, the trustee in bankruptcy can take the initiative by serving their own notice on the bankrupt within 42 days of become aware of the after acquired property pursuant to section 307(1) the Act, or later, with permission from the court. Section 307(3) of the Act confirms that on service of a notice, the property to which it relates vests in the trustee as part of the bankrupt’s estate and the trustee’s title to that property is traced back to the earlier date of when the bankrupt acquired the interest (or the property was devolved upon the bankrupt), not on the later date of service of the section 307 notice. If the trustee does serve a section 307 notice or intends to within the time allowed, the personal representative (PRs) will need to consider whether the distribution should be made to the trustee in bankruptcy rather than the beneficiary.

What can a trustee in bankruptcy do if a PR has transferred assets to the bankrupt beneficiary?

PRs of an estate have an obligation to ensure that the estate is properly administered and assets are distributed to the rightful beneficiaries or creditors of the deceased’s estate. If they transfer estate assets to a bankrupt beneficiary they may be transferring the assets to the wrong person in breach of their duties. There is no specific statutory protection in the Act for PRs although there is limited protection for a third party recipient of any after acquired property if they are a bona fide purchaser for value without notice of the bankruptcy (see section 307(4)). If section 307(4) applies, the trustee in bankruptcy is not entitled to any remedy against that third party regardless of whether a section 307 notice has been served before or after the disposition. However, if the section 307(4) defence does not apply, a trustee in bankruptcy can serve notice under rule 10.126 IR2016 upon the recipient of the disposed property claiming the property for the bankrupt’s estate.

If the beneficiary puts the assets beyond the reach of the trustee in bankruptcy, the trustee in bankruptcy, on behalf of the bankrupt's creditors, may bring a claim for compensation against the PRs. Where PRs have wrongly distributed assets to a person who was or is an undischarged bankrupt, it may be difficult to succeed in a claim to recover those assets because of the restrictions placed upon bringing proceedings against bankrupts by section 285 of the Act. It would therefore be prudent for PRs to avoid this risk by carrying out a bankruptcy search against all beneficiaries before making any distributions. If a beneficiary was made bankrupt before the deceased passed away, they should also ask to see the section 333 notice informing the trustee in bankruptcy of any after acquired property, and checking with the trustee in bankruptcy as to whether the trustee has served a notice on the bankrupt under section 307(1) or intends to serve such a notice before making any distribution from 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.

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