Equitable remedies and tracing - Comparison between common law and equitable tracing

Learning Outcomes

This article explores the process of tracing property, comparing the approaches at common law and in equity. It details the prerequisites for equitable tracing, the rules applied when funds are mixed, and the defences that may defeat a tracing claim. Your understanding of these principles will enable you to identify the correct legal rules applicable to tracing scenarios in SQE1 multiple-choice questions and apply them effectively.

SQE1 Syllabus

For SQE1, you are required to understand the principles of tracing both at common law and in equity, particularly in the context of trusts and breach of fiduciary duty. You need to be able to apply these rules to practical scenarios.

As you work through this article, remember to pay particular attention in your revision to:

• The distinction between tracing at common law and tracing in equity, including their respective limitations.
• The requirements for equitable tracing, namely a fiduciary relationship and an equitable proprietary interest.
• The rules applicable when tracing into mixed funds, including funds mixed by a trustee with their own money (Re Hallett’s Estate, Re Oatway), and funds mixed belonging to two trusts or an innocent volunteer (Clayton’s Case, pari passu sharing).
• The circumstances where the right to trace may be lost, including dissipation and transfer to a bona fide purchaser for value without notice (BFPFVWN).
• Defences available against an equitable tracing claim, such as change of position.
• The link between successful tracing and the availability of proprietary remedies.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which form of tracing is generally unable to proceed once money is mixed in a bank account?
   1. Equitable tracing
   2. Common law tracing
   3. Both forms
   4. Neither form
2. A trustee mixes £5,000 of trust funds with £5,000 of their own money in an account. They then withdraw £5,000 and buy shares, which later increase in value. The remaining £5,000 is dissipated. Which principle allows the beneficiaries to claim the shares?
   1. Re Hallett's Estate
   2. Re Oatway
   3. Clayton's Case
   4. Lowest intermediate balance rule
3. What defence allows an innocent recipient of misapplied trust property to resist a proprietary claim if they have acted in good faith to their detriment based on the receipt?
   1. Bona fide purchaser for value without notice
   2. Laches
   3. Dissipation
   4. Change of position

Introduction

When property is misappropriated or misapplied, particularly in breach of trust or fiduciary duty, the rightful owner or beneficiary will want to recover it or its value. The legal process of identifying the property as it changes hands or form is known as tracing. It is important to distinguish tracing from the remedies available once property is identified; tracing itself is merely an evidential process. English law offers two distinct tracing mechanisms: common law tracing and equitable tracing. Understanding their differences, requirements, and limitations is essential for advising clients and succeeding in the SQE1 assessment. Equitable tracing, in particular, provides valuable tools for recovery where funds become mixed, a common issue in trust disputes.

Key Term: Tracing The process of identifying a new asset as the substitute for an old one. It enables the claimant to identify their property or its value in the hands of another.

Common Law Tracing

Tracing at common law is based on the claimant asserting their legal title to the original property. It involves following the specific asset from person to person.

Key Term: Following The process of pursuing the same asset as it moves from hand to hand. This is the primary mechanism available at common law.

The major constraint of common law tracing is its inability to function effectively once the claimant's property loses its specific identity through mixing with other property of the same kind. This is particularly true for money. If £100 cash is mixed with other cash, or paid into an active bank account containing other funds, the common law typically regards its identity as lost, and tracing ceases. This significantly limits its utility in many commercial and trust scenarios.

Worked Example 1.1

A client entrusts a unique painting to an agent for sale. The agent sells the painting for £5,000 cash and places this specific cash in a separate, labelled envelope. Before the agent can pass the money to the client, the agent becomes bankrupt. Can the client recover the £5,000 cash using common law tracing?

Answer: Yes. At common law, the client can follow the painting to the purchaser (though the purchaser might have a defence). Importantly, the client can also trace the value into the specific £5,000 cash, as it is the identifiable, unmixed proceeds of their property, kept separate by the agent.

Related Topic: Bankruptcy / Insolvency 🔗

Establishing a proprietary claim through tracing can give a claimant priority over general creditors in an insolvency situation.

Equitable Tracing

Equity developed more sophisticated tracing rules, primarily to provide remedies for beneficiaries whose trust property had been misapplied, especially when mixed with other funds.

Prerequisites for Equitable Tracing

Generally, two conditions must be met for a claimant to trace in equity:

1. Fiduciary Relationship: There must be a pre-existing fiduciary relationship between the claimant and the party who misapplied the property (e.g., trustee-beneficiary, director-company). This establishes the basis for equity's jurisdiction. The courts have sometimes found such a relationship arises from the very act of misappropriation itself.
2. Equitable Proprietary Interest: The claimant must demonstrate they held an equitable proprietary interest in the original property (e.g., the beneficiary's interest under a trust).

Key Term: Fiduciary Relationship A relationship where one party (fiduciary) owes duties of loyalty and good faith to another (principal/beneficiary), such as a trustee to a beneficiary.

Key Term: Equitable Proprietary Interest An ownership interest in property recognised in equity, separate from the legal title, held for example by a trust beneficiary.

Advantages over Common Law

The principal advantage of equitable tracing is its ability to follow the value of the claimant's property even when it has been mixed with other property, including money in a bank account, or used to acquire a new asset. Equity focuses on the value, not the specific physical item.

Tracing into Mixed Funds

Equity applies different rules depending on whose money has been mixed.

Trustee Mixes Trust Funds with Own Funds

When a trustee (or other fiduciary acting wrongly) mixes trust money with their own personal funds in an account, equity applies presumptions against the wrongdoing trustee to protect the beneficiary:

1. Presumption of Honesty / Trustee Spends Own Money First (Re Hallett’s Estate): If the trustee withdraws money from the mixed account and dissipates it (spends it untraceably), they are presumed to have spent their own money first. The remaining balance, up to the amount of the trust money originally deposited, is presumed to belong to the trust.
2. Beneficiary's Right to Trace into Investments (Re Oatway): If the trustee withdraws money from the mixed account to purchase an asset (e.g., shares) and dissipates the rest, the beneficiary can trace their funds into the purchased asset. This prevents the trustee from claiming the profitable investment was made with their own money while the trust money was dissipated. The beneficiaries effectively get the 'first choice' to follow their money into the most advantageous outcome.
3. Lowest Intermediate Balance Rule (Roscoe v Winder): The trust's claim against the mixed bank account is limited to the lowest balance the account reached after the trust money was deposited but before any subsequent personal deposits by the trustee. Later deposits of the trustee's own money are not treated as repaying the trust unless this was clearly intended.

Key Term: Dissipation The spending or use of funds in such a way that no asset or value remains which can be identified or claimed (e.g., spending on a holiday, general living expenses, or settling unsecured debts).

Key Term: Mixed Fund A fund (e.g., a bank account) containing assets or money from more than one source, where the original components are no longer separately identifiable.

Key Term: Re Hallett's Estate presumption The equitable presumption that where a trustee mixes trust funds with their own and makes withdrawals, they are deemed to spend their own money first.

Key Term: Re Oatway presumption The equitable principle allowing beneficiaries to trace their money into an asset purchased from a mixed fund by a trustee, even if the trustee's own money was sufficient to cover the purchase, especially if the remaining funds are dissipated.

Key Term: Lowest Intermediate Balance The rule limiting a proprietary claim against a mixed bank account to the lowest balance recorded after the claimant's money was paid in but before any subsequent deposits by the wrongdoer.

Worked Example 1.2

A trustee mixes £20,000 of trust money with £10,000 of their own in a bank account (Total £30,000). The trustee then withdraws £15,000 to buy antique furniture (now worth £18,000). Later, they withdraw £10,000 which they spend on an expensive holiday (dissipation). £5,000 remains in the account. What can the beneficiaries claim?

Answer: The beneficiaries can use the rules against the trustee. Re Hallett would suggest the trustee spent £10,000 of their own + £5,000 trust money on the furniture, and £10,000 trust money on the holiday, leaving £5,000 trust money in the account. This is not the best outcome. Re Oatway allows the beneficiaries to trace into the profitable asset. They can claim that £15,000 of trust money went into the furniture. They can claim a proprietary interest in the furniture proportionate to their contribution (15/15ths initially, meaning full beneficial ownership if the trustee's £10k is deemed spent first on the holiday, or perhaps 15/35ths if the full £30k withdrawal is considered from the £40k mixed fund before dissipation rules apply - the better view under Re Oatway is that the profitable asset is secured first). They can claim the furniture (worth £18,000) and the £5,000 balance (Total £23,000), exceeding the original £20,000.

Mixing Funds of Two Trusts / Trust + Innocent Volunteer

When a trustee mixes funds from two different trusts, or when trust funds become mixed with the funds of an innocent volunteer (someone who received the trust property without giving value and without notice of the breach), the rules are designed to achieve fairness between the innocent parties:

1. Clayton's Case Rule (FIFO - First In, First Out): The traditional rule presumed that money withdrawn from an active bank account was withdrawn in the same order it was deposited. This rule is often criticised as arbitrary and is now frequently displaced.
2. Pari Passu (Proportionate Sharing): The preferred modern approach, particularly where FIFO is impractical or unjust, is to share the remaining funds, or any asset acquired from them, rateably (pari passu) in proportion to the contributions made by the innocent parties (Barlow Clowes v Vaughan).

Key Term: Innocent Volunteer A person receiving trust property (or its traceable proceeds) without providing consideration (value) and without having notice of the breach of trust.

Key Term: Clayton's Case rule The traditional (often displaced) common law rule for mixed bank accounts that money is presumed to be withdrawn in the order it was deposited ('First In, First Out').

Key Term: Pari Passu Meaning 'on equal footing'; a method of distributing assets or losses proportionally among parties based on their initial contribution or claim size.

Worked Example 1.3

A trustee wrongly takes £6,000 from Trust A and £4,000 from Trust B, paying both sums into a new account (Total £10,000). The trustee withdraws £5,000 to buy shares. £5,000 remains. How might the funds/shares be allocated between the trusts?

Answer: Clayton's Case (FIFO) would suggest the £5,000 shares were bought entirely with money from Trust A (first in), leaving the £5,000 balance belonging £1,000 to Trust A and £4,000 to Trust B. The more likely modern approach (pari passu) would allocate the shares and the remaining cash proportionately. Trust A contributed 60%, Trust B 40%. Therefore, Trust A gets 60% of the shares and 60% of the cash (£3,000 + £3,000 = £6,000). Trust B gets 40% of the shares and 40% of the cash (£2,000 + £2,000 = £4,000).

Defences to Equitable Tracing Claims

The right to trace in equity can be lost or defended against:

1. Bona Fide Purchaser for Value Without Notice (BFPFVWN): If legal title to the asset (or its traceable product) passes to a BFPFVWN, the equitable interest is destroyed. Tracing stops. This is the strongest defence.
2. Dissipation: As noted, if the property or its value ceases to exist in any identifiable form, tracing is impossible.
3. Inequitable Result: Equity will not permit tracing if it would produce an unjust outcome, particularly against an innocent volunteer (e.g., forcing the sale of a home improved with traced funds, Re Diplock).
4. Change of Position: An innocent volunteer who, acting in good faith, irreversibly changes their circumstances relying on the receipt may have a defence against a restitutionary claim based on tracing (Lipkin Gorman v Karpnale). This defence requires more than just spending the money; it needs a demonstrable, detrimental change linked to the receipt.

Key Term: Bona Fide Purchaser for Value Without Notice An innocent party who purchases legal title to property for valuable consideration without any notice (actual, constructive, or imputed) of prior equitable claims.

Key Term: Change of Position A defence in restitution law available to an innocent recipient who has detrimentally changed their position in reliance on the receipt, making full repayment inequitable.

Associated Remedies

If tracing successfully identifies property or its value, the claimant can seek proprietary remedies from the court, including:

• An order declaring the claimant owns the asset (or a proportionate share).
• An equitable charge or lien over the asset for the value traced.
• An order that the defendant holds the asset on constructive trust for the claimant.

Summary

The table below summarises the key differences between the two tracing methods.

Key Point Checklist

This article has covered the following key knowledge points:

• Tracing is a process to identify property, not a remedy.
• Common law tracing follows specific assets but is usually defeated by mixing, especially of money.
• Equitable tracing requires a fiduciary link and an equitable interest.
• Equity allows tracing through mixed funds and into substitute assets.
• Specific rules apply depending on who mixed the funds (trustee vs. innocent parties).
• Re Hallett presumes trustees spend their own money first from a mixed fund.
• Re Oatway allows beneficiaries to claim assets purchased from a mixed fund.
• The lowest intermediate balance rule limits claims against mixed bank accounts.
• Between innocents, Clayton's Case (FIFO) is often displaced by proportionate (pari passu) sharing.
• Tracing is defeated by dissipation or transfer to a BFPFVWN.
• Defences like Change of Position or inequitable result may protect innocent volunteers.
• Successful tracing enables proprietary remedies (eg, charge, constructive trust).

Key Terms and Concepts

• Tracing
• Following
• Fiduciary Relationship
• Equitable Proprietary Interest
• Dissipation
• Mixed Fund
• Re Hallett's Estate presumption
• Re Oatway presumption
• Lowest Intermediate Balance
• Clayton's Case rule
• Pari Passu
• Bona Fide Purchaser for Value Without Notice
• Innocent Volunteer
• Change of Position