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The Law of Tracing
The law of tracing is possibly one of the most complex legal topics, which many have struggled to reconcile with age-old legal principles. Broadly speaking, it addresses the question of when rights held in an asset can be asserted in another asset despite changes in form or attempts to conceal the initial asset. The scope of this insight is divided into the following key topics:
What is tracing?
An employee embezzles funds from his employer using the money to buy company shares. When the facts come out, the question arises, can the employer say that the shares belong to it?
To further complicate matters, what if the employee in question has given the shares away to an unknowing charity? Or what if the employee is bankrupt so that his creditors have an interest in retaining and/or maximising the value of the employees’ assets. To answer these questions requires an understanding of the law of tracing.
The fundamental idea behind the law of tracing is that sometimes, for certain legal purposes, one asset stands in the place of another. A claim which could have been made in relation to the original asset is allowed in relation to the new asset.
Accordingly, tracing identifies a new object or asset as the potential subject matter of a claim, on the basis that it is the substitute for the original item which was itself the subject matter of a claim.
Lawyers will frequently refer to tracing as a remedy however that is not strictly accurate, as Lord Millet explained in the seminal case of Foskett v McKeown [2001] 1 AC 102, tracing was neither a claim nor a remedy.
[tracing] is the process of identifying a new asset as the substitute for the old…the claimant claims the new asset because it was acquired in whole or in part with the original asset.
What is the difference between tracing and following?
Following is normally quite simple, involving the physical location of a tangible asset. For example, if a thief steals a diamond, he takes possession of a tangible item. That possession may subsequently transfer to a number of different people. The physical exercise of locating that item is termed following.
Conversely, tracing is to do with substitution. Tracing identifies a new item as the potential subject matter of a claim on the basis that it is the substitute for an original thing which was itself the subject matter of a claim. The new thing, as a substitute, stands in the place of the old thing and therefore can be subject to the same claims.
By way of an example, tracing focuses on the same person where that person acquires a new item. Following tends to focus on whether a new person has acquired the same thing.
Take the situation where a thief steals the diamond and swaps it for a ruby, which he then gives to his brother. The original owner of the diamond may wish to make a claim in relation to the diamond. If he does, he may need to follow it. If a third person acquired the diamond from the thief, the original owner of the diamond may (subject to the given law and facts) have a claim to the diamond as against the third person. The original owner of the diamond does not need to trace in those circumstances.
If, however, the original owner wishes to bring a claim against the brother of the thief then he must trace through the substitution of the ruby for the diamond. Then the original owner will have to follow the ruby to its receipt by the brother.
How do you trace property or assets?
As it has been explained in the preceding paragraphs, during the tracing process one does not trace the asset but traces value because the only connection the claimant will have with the new asset is that it was acquired with the original asset, hence value is traced due to the fact that it is the only constant.
In practice, it is a slightly more difficult than the above summary as tracing may take place at common law or in equity which is frequently the subject of great debate and beyond the scope of this insight.
Common law and equitable tracing
As long as the distinction between tracing at common law and tracing in equity persists, common law tracing cannot be used to identify assets to be the subject of an equitable claim and equitable tracing cannot be used identify assets to be the subject of a common-law claim.
The significance of this shortcoming is noteworthy because a common law claim is a personal claim against a person holding, or a person who has held, the asset that is traced, whereas a proprietary claim in equity is a claim against the property currently held by the defendant. The latter is unaffected by the defendant’s personal insolvency.
What are clean and mixed substitutio
ns?
Clean substitutions
Tracing in its raw and cleanest form is through clean substitutions which in essence means that all of the value that went into the substitution is the value being traced.
The only difficulty that will come would be if intention cannot be evidenced. For example, if a thief steals £1,000 and uses the money to buy a ruby then we can trace the ownership of the banknotes into the thief’s ownership of the ruby.
However, if the thief places the money into a safety deposit box and relying on this new wealth he purchases a ruby for £1,000, paying for it with a bank transfer from his savings account. A month later, he withdraws the money from his safety deposit box and pays his rent. The question arises can I trace into the thief’s ownership of the ruby. Unfortunately, the answer is no because the process of tracing depends on proving that some value was acquired with some other value. Accordingly, we can trace into the month’s rent.
Mixed substitutions
The basic premise of a mixed substitution is one person’s value is indistinguishably mixed with another’s in the new asset.
However, at common law, the claimant might be able to trace the value of his original property through ‘clean substitutions’ (see above), this does not apply to mixed substitutions. In essence, the property may be traced at common law to the point that it remains in an identifiable form so the claimant at every stage of the tracing process is able to say: ‘that belongs to me’. It is also important to note that although it must remain in an identifiable form, it does not matter that its legal or factual form has changed from say a diamond to a ruby or from coins to notes (see Taylor v Plumer (1815) 3 M & S 562).
Notwithstanding the strictures of the common law, not all is lost, as equity has no such limitations. In the 1879 case Re Hallett’s Estate (1879) LR 13 Ch D 696, the Court of Appeal upheld a decision to allow a trust beneficiary to trace its money into an account where it had been mixed with the trustee’s own money.
This seismic shift in the approach of the courts was comically referenced by Lord Atkin LJ in Banque Belge pour L’Entranger v Hanbrouck:
if in 1815 the common law halted outside the bankers’ door, by 1879 equity had had the courage to lift the latch, walk in and examine the books.
As the principle stands equitable tracing is not defeated by the irretrievable mixing of property. Equity adopts a “more metaphysical approach” by recognising the value of the claimant’s rights by a continuing equitable interest in the mixture (Re Diplock [1948] Ch 465 CA at 520).
Nevertheless, for all of the obvious advantages of equitable tracing over common law tracing, tracing in equity is subject to one significant limitation: equitable tracing depends on upon proof that the claimant’s property or asset has at some stage in the tracing process been held by somebody subject to a fiduciary relationship.
Equitable tracing: the need for a fiduciary relationship
This insight is not going to consider the judicial and academic criticism of the requirement for a fiduciary relationship which appears to have no logical justification and its requirement “depends on authority rather than principle” (see Agip (Africa) Ltd v Jackson[1990] Ch 265 at 290A).
The initial fiduciary relationship to start the tracing process can be satisfied if one of the following should exist and/or in certain cases be imposed retrospectively:
By way of an express trust.
Where property is held by “quasi-trustees” who administer it for the benefit of others in a fiduciary capacity, for example, executors, agents and company directors.
Trusts that arise by operation of the law, namely: (i) constructive trusts; and (ii) resulting trusts.
By way of an equitable charge.
The courts have in certain cases relaxed the fiduciary relationship requirement. Chase Manhattan Bank v Israel-British Bank (London) Ltd [1981] 1 Ch 105 is the authority for the proposition that equitable tracing is permissible even when the fiduciary obligation does not arise until the moment at which the claimant’s property passes into the defendant’s hands. However, Lord Mustill in Re Goldcorp Exchange Ltd [1995] 1 AC 74 urged greater restraint in the discovery of fiduciary relationships.
What are the remedies?
Having considered the nature of the tracing process, it is important to consider the types of remedy, which are available.
The two principle remedies are; the charge and the constructive trust, although the resulting trusts, equitable compensation, lien and subrogation are also possible.
The remedial process is relatively simple:
The tracing process is undertaken in accordance with the principles considered in the foregoing paragraphs; and,
Having identified the asset which is to be the subject matter of the claim, the claimant will seek to impose a trust or some other equitable remedy over that asset. As a matter of law, there is no one remedy that should be applied, instead, the courts appear to be prepared to impose whichever remedy seems to be most appropriate in the circumstances and whichever remedy provides the most convenient solution. The onus is on the claimant to claim the remedy which is most appropriate in the given situation.
Accordingly, we will consider each of the main remedies below:
Equitable Charge
A charge will only arise in equity and not in law. It will entitle the claimant to seize the property and seek a court order to sell it if the defendant does not pay the claimant the sums owed under the charge.
The benefit of a charge rather than the constructive trust, as considered below, is the former grants a property right which will be enforceable in the event of insolvency however under a charge, the claimant will only be entitled to recover the amount of the debt and not take absolute title to the asset, therefore, the claimant will not benefit from any increase in the value of the asset.
A Lien
A lien will entitle the claimant to take possession of the asset and retain the asset until the defendant pays the claimant the amounts that are owed. In the above example where the traced asset is a ruby which is not expected to increase much in value, then the claimant may prefer to take a lien over the precious stone, until such time that he has settled the claim with the defendant.
A Constructive Trust
A constructive trust is likely to be sought in situations in which the asset is intrinsically valuable. The constructive trust entitles the claimant to an equitable proprietary interest in the traced asset. In theory, such a constructive trust could be constructed so that any third party with rights in the traced asset would hold the equitable interest in that property in common with the claimant; more usually a constructive trust will be claimed so that the claimant can become the absolute beneficial owner of the property so that he can acquire any future increase in value in that property
Where the asset subject to the tracing claim is capable of being separated from other property so that it could form the subject matter of a trust, a constructive trust may be the most appropriate remedy. Conversely, if the asset were not segregated, then it would be impossible to impose a trust over that asset because the subject matter of that trust would not be separately identifiable.
Subrogation
Subrogation is a well-accepted doctrine that allows the claimant to assume the rights of a third party as against the defendant. Hence the claimant will be considered to stand in the shoes of the third party and is ‘subrogated’ to the rights of that third party.
In application to the law of tracing the most concise statement was put forward by Lord Clarke in Bank of Cyprus UK Ltd v Menelaou [2015] UKSC 66:
Where A’s money is used to pay off the claim of B, who is a secured creditor, A is entitled to be regarded in equity as having had an assignment to him of B’s rights as a secured creditor. […] It finds one of its chief uses in the situation where one person advances money on the understanding that he is to have certain security for the money he has advanced, and, for one reason or another, he does not receive the promised security. In such a case he is nevertheless to be subrogated to the rights of any other person who at the relevant time had any security over the same property and whose debts have been discharged, in whole or in part, by the money so provided by him.
Accordingly, in the context of subrogation, tracing is not about identifying a particular asset in the hands of the defendant as belonging to the claimant but rather as providing the necessary link with the payments made to discharge the relevant security interest (see Lord Carnworth [2015] UKSC 66 at [128]).
If you want to discuss any of the issues raised herein please do not hesitate to contact a member of our team to discuss any matters relating to your business.
Sources and further reading
‘The Law of Tracing’ (1st Ed) Lionel D. Smith
‘The Law of Tracing in Commercial Transaction’ (1st Ed) Magda Raczynska
Trust and Equity (6th Ed) Gary Watt
‘Unjust Enrichment, Proprietary Subrogation and Unsatisfactory Explanations’ Jessica Palmer (2016) 28 SACLJ
‘Choosing remedies in tracing claims’ Alastair Hudson (http://www.alastairhudson.com/trustslaw/Remediestracing.pdf)
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