Minimising unit trust risk

Investing in a unit trust to hold certain assets can be beneficial, but adds a layer of complexity to an SMSF portfolio. Shaun Backhaus and Daniel Butler explore the benefits of putting a unitholders’ agreement in place to minimise the risks associated with these arrangements.

Unit trusts are a common investment structure and can provide a simple way for parties to co-invest in property or business together. In particular, investing via a unit trust is a popular way for SMSFs to invest in real estate, including to develop property.

While the terms of a unit trust deed typically cover a number of important points, there are many other critical points that can be covered in a variation to the deed or in a unitholders’ agreement to provide greater certainty, minimise risks and to assist avoiding costly disputes.

This article outlines what unitholders’ agreements should typically contain and why they should be considered where there is more than one unitholder, including a related party.

Should the trust deed be varied before entering into a unitholders’ agreement?

Typically yes. This is because many deeds may have been prepared years ago and do not reflect the range of trust, taxation and other developments from the date they were originally prepared. Moreover, many deeds supplied in recent times are not at a satisfactory standard of quality, especially if not supplied by a reputable law firm practising in the area.

Accordingly, there is sound reason to carefully examine a unit trust deed to make sure it is appropriate before embarking on preparing a unitholders’ agreement. A note of caution, however, care is needed in making any variation to a trust deed for fear of ‘resettling’ the trust (a ‘resettlement’ is broadly for tax purposes the creation of a new trust and a transfer of property from the old trust to the new trust) and giving rise to tax and duty problems. Expert advice from a lawyer with tax and duty experience in the relevant jurisdiction is recommended to make sure variations do not attract unwanted tax liabilities.

What should be included in the unitholders’ agreement?

A unitholders’ agreement is dependent on the quality of the drafting in the unit trust deed and on how well the agreement is drafted. Such an agreement should cover the key points in the relationship between the unitholders not covered by the unit trust deed and also the key risks and rights each unitholder may have in certain scenarios.

Types of provisions to consider

We now briefly examine various types of provisions and issues that should be considered in preparing a unitholders’ agreement.

How units can be offered by sale and to whom?

Some unit trust deeds include provisions requiring a unitholder intending to dispose of their units, that is a vendor, to offer their units in the first instance to other unitholders in proportion to the other, or purchasing, unitholders’ holdings.

Initially, the vendor might offer their units at the value notified by them based on their market value, which may be at an inflated or deflated price. There may be provisions allowing the purchasing unitholders to dispute the vendor’s market value and request an independent valuation of the units.

Special provisions can be inserted in a unitholders’ agreement to include the process agreed between the unitholders. For example, where there is an individual unitholder who dies, rather than their units transferring to their executors upon their death to form part of their deceased estate (which the other unitholders do not get along with, et cetera), the other unitholders could be provided with the right to purchase those units subject to the specified valuation process set out in the unitholders’ agreement.

Similarly, where the unitholder is a company or trustee of a trust and the key person(s) in respect of that company or trust dies or loses capacity, this may be a trigger event allowing the other unitholders to undertake a compulsory purchase of the units held by that company or trust.

Where an SMSF is a unitholder, care is needed so a contravention of the Superannuation Industry (Supervision) (SIS) Act 1993 does not occur. For example, where there is a 50/50 arrangement between two unrelated SMSF unitholders and the key person of one of the SMSF unitholders dies and the other 50 per cent SMSF unitholder obtains the right to purchase the deceased SMSF’s units, then the in-house asset rule in part 8 of the SIS Act would be contravened.

In this situation, for the purchase to proceed, the first step for the SMSF related to the key person who is still alive would be to dispose of their entire unitholding in that unit trust. Note that if that SMSF did not dispose of its 50 per cent before a related party outside the SMSF acquires a greater amount of units, then an immediate contravention of the in-house asset rules occurs.

When should a unitholder be forced to sell their units?

The unitholders’ agreement can specify a range of limitations or prohibitions, which, if contravened, give rise to a compulsory purchase of the defaulting unitholder’s units. For example, unitholders, especially when one or more SMSFs are involved, should prohibit all unitholders from placing their units to any security or charge, for example, some lenders may want to register a charge under the Personal Property Securities (PPS) Act 2009 in respect of a unitholder’s unit certificates. Thus, if a unitholder did pledge their units for security in respect of a mortgage or charge, this event could give rise to a compulsory purchase trigger under a unitholders’ agreement.

For example, if unitholder ABC Pty Ltd of the ATF ABC Family Trust sought to raise some finance and provided their unit certificates subject to a PPS Act charge and the unitholders’ agreement specified that no unitholder can charge their units, this would allow the other unitholders to compulsorily purchase these units. Note, a unitholder that places their units to some form of security or charge increases the risk of other unitholders and the trustee of the unit trust may also become embroiled in a legal dispute seeking to resolve any issues that arise from the enforcement of the charge, et cetera.

The agreement may also list other criteria for when a compulsorily buyout would be invoked, such as on the change of control of a unitholder, where the unitholder becomes insolvent or rendered bankrupt, or where the unitholder breaches any of its obligations under the trust deed or unitholders’ agreement and fails to rectify within a specified timeframe.

What decisions require a greater than majority vote?

There are typically a range of decisions unitholders want to be subject to a vote that is higher than the usual 50 per cent threshold to pass a unitholders’ resolution. Typically, at least a 75 per cent, that is a special resolution, threshold is relied upon and certain decisions are set to a 100 per cent, or a unanimous resolution, threshold. Broadly, the unitholders need to consider what the key decisions are that should be subject to a higher threshold and set them out in the unitholders’ agreement; typically in an annexure to the agreement so the agreement is not bogged down with this detail. For example:

• a special resolution may be required to invest more than $100,000 on improvements to a property, or

• a unanimous resolution may be required to decide to purchase or decide to dispose of a property. In recent times where there are numerous unrelated unitholders involved, there is a trend to include a provision that requires the property to be sold in say five to seven years’ time unless a special resolution is passed to retain the property. Tax advice should be obtained before inserting such a provision as this may suggest the investment is not for long-term capital appreciation, but rather an asset held on revenue account where any capital appreciation might be assessed as normal income.

Other restrictions in respect of superannuation law

There are a range of safeguarding provisions we like to insert into a unitholders’ agreement to minimise the risk of contravening the SIS Act and SIS Regulations 1994.

These provisions need input from the client and the lawyer preparing the agreement to make sure the provisions are suitable for the parties. Several such provisions usually include:

• that suitable wording is included to limit an SMSF and its related parties from acquiring more than a 50 per cent stake in the unit trust or a controlling interest unless approved by a special process. This is designed to minimise the risk of an in-house asset contravention as a ‘relatedtrust’ relationship can easily arise under section 70E(2) of the SIS Act, and

• appropriate provisions to confirm each SMSF trustee has undertaken appropriate due diligence, investigations and checks and has had ample opportunity to obtain professional advice before investing in the unit trust and entering into the agreement. These provisions would also confirm the investor will not contravene the SIS Act or the SIS Regulations and has responsibility for their ongoing compliance with the super rules. Moreover, if any provision in the unitholders’ agreement was ever considered to breach or constitute a SIS Act or SIS Regulations contravention, then the relevant provision in the unitholders’ agreement is to be read down to the extent of inconsistency with the SIS Act and SIS Regulations.

What can go wrong?

There are many things that can happen to a unitholder, or the person controlling a unitholder entity, that can cause problems for other unitholders. These include such things as a unitholder or their controllers or associates:

• dying or losing capacity,

• becoming bankrupt, insolvent or being placed into liquidation or under administration,

• being sued or otherwise caught up in litigation,

• getting divorced or experiencing other familial or personal issues, or

• simply wanting to divest their unitholding.

While an investor may initially know and get along with all of their fellow unitholders, these events can result in another unknown person or entity becoming a unitholder, or controlling a unitholder entity, which may not be a desirable outcome for the remaining unitholders. Naturally, having appropriate compulsory purchase triggers in the unitholders’ agreement to cover the key risks for those involved is recommended.

Further, the unitholders may be involved in a time-consuming dispute and require some mechanism for one or more unitholders to resolve the issue. To minimise any dispute, appropriate alternative dispute resolution (ADR) provisions should be included to minimise the involvement of the courts until the ADR provisions have been exhausted, for example, the parties seek to resolve first and if after five business days there is still a dispute, the parties involve a mediator before commencing legal action. Appropriate ADR provisions may result in hundreds of thousands of dollars not being charged in a drawn-out legal battle and having a unitholders’ agreement to just include these provisions can justify the investment in obtaining one.

The process of discussing and agreeing on what should be included and what not to include in a unitholders’ agreement is usually a great way to understand what is in the minds of the prospective investors and what goals and risks they consider important in respect of the relationship. Furthermore, it is much easier to discuss these upfront compared to after a falling out when the parties are only corresponding between their lawyers.

Conclusion

A proper review and fixing up of a unit trust, and putting in place a unitholders’ agreement, is a prudent way to ensure greater certainty and minimise the opportunity for future disputes. In particular, the parties’ rights and obligations in respect of various matters included in a unitholders’ agreement should be clear from the commencement of the relationship. Such an agreement can ensure any default events or disputes are dealt with more effectively.