Tracing
General
Where assets have not become mixed but have been merely substituted and are held by another, common law tracing is available. Common law tracing is available while the asset retains its identity.
Tracing is an equitable remedy by which a claimant may claim assets which have become mixed with those of another or have changed their original form. Tracing is effectively a proprietary claim that the assets held belong to the claimant.
Tracing in equity is more flexible and allows for a change in the form of the asset. For example, when funds are mixed, the courts may allow tracing on an equitable basis.
Tracing allows for the identification of one asset and its proceeds with another asset. The proceeds can be traced in and out of a mixed fund.
The equitable remedy is not available as of right. It is at the court’s discretion. There are limitations to the exercise of discretion. For example, it will not be available if a third party’s interest is thereby unreasonably affected.
A critical aspect of tracing is that both at common law and in equity, it is a proprietary claim. This allows a claim which has priority over unsecured creditors in an insolvency. Commonly, it arises where there has been fraud or misappropriation, where the person who has misappropriated the assets is insolvent, so that the ability to assert a proprietary claim is critical to recovery.
Nature of Tracing
Tracing may be available under principles of restitution or constructive trust. There must be some basis for equitable intervention. This is commonly a proprietary interest or quasi-proprietary interest based on a breach of trust or on breach of a fiduciary relationship between the parties.
In one sense, tracing is the detection process itself. However, tracing in the equitable sense refers to a remedy which allows the claimant to assert equitable proprietary rights in the assets representing his claimant’s asset.
Tracing commonly involves identifying the property which represents or has been purchased with the proceeds of property, previously owned by the claimant. It allows the assertion of property rights against substituted property.
Tracing may involve the honest but mistaken use of another’s funds as well as fraudulent misappropriation. Commonly, there has been a breach of trust or fiduciary duties. It may also arise where funds are distributed in error, such as under a will which is later found to be invalid.
Although tracing is proprietary in nature, it extends beyond a proprietary interest in the strict sense. A bank account holder has no asset but is owed a debt owed by the financial institution. Tracing applies to funds of money which represent the original asset or property misappropriated. It applies to substitute assets and their proceeds of assets.
A right to trace is akin to an equitable charge over the assets held. The rights apply against subsequent recipients. However, if the asset or its monetary proceeds reach a bona fide purchaser for value or if it otherwise is inequitable or unfair, tracing may not be allowed.
Common Law v Equity
The common law equivalent of tracing , substitution, is less flexible. At its simplest, it may involve an action for detinue and the recovery of chattels /movables.
Common law tracing or substitution/ following may apply to substituted property and is not limited to the original property. Once the property becomes comingled, common law tracing or following is no longer possible. This may happen, for example, when monies are mixed in a bank account.
Tracing in equity allows assets to be traced through different types of assets and mixed funds. Tracing in equity requires a trust, fiduciary relationship or fraud.
Common law tracing is necessary where there is no such element. The common law claim to “following”, is effective for so long as the original money can be identified. Money or the proceeds of an asset may be transferred from one account to the other and remain identifiable.
Mixing Funds
Where the recipient mixes his funds with those of another, the whole fund may be treated as subject to tracing unless the person can adequately separate one from the other.
Generally, when a customer makes a payment to a bank account, he may decide to which account it should be credited. However, in the absence of a direction, the bank is free to appropriate the payment into whatever account it chooses. This may have significant implications where a person has a range of loan accounts and current/deposit accounts.
The Consumer Credit act provides for the appropriation of payments by consumers. The consumer has a right to appropriate the payment in order to pay or discharge the account of his choosing. If he does not do so, the lender must appropriate the payments in proportion to the loan balances due.
The so-called rule in Clayton’s case, which raises certain presumptions regarding money lodged in and withdrawn from a running account, is relevant to the context of tracing. The general principle is that the last payment discharges the earliest liability, i.e. “first in, first out”.
Payment to an account is deemed to pay interest first and then principal. These presumptions can be varied by agreement.
Mixing Trust Funds
In the case of trust accounts, the position which is most favourable to the beneficiaries is applied. Where the trustee mixes personal and trust monies, the presumptions are reversed when this is against the defaulting trustees’ interests.
He is deemed to withdraw his money first, where this is required to protect the beneficiaries. Where there are payments in and out, the trustee’s money is deemed to be withdrawn to the greatest extent. Payments out reduce the beneficiary’s money only when the trustee or fiduciary’s money has been reduced to nil.
There are limits to the principle. New monies, lodged later, are not presumed to be trust monies. The trust funds are limited to the lowest credit balance during the period. Where these monies are not sufficient to satisfy the claim, the court may trace into assets purchased with them.
The modern approach has been to seek to do justice without recourse to rigid “first in, first out” rules. Where trust funds are misappropriated (which are thereby held on trust for the persons entitled) and are sourced from various beneficiaries /persons entitled (commonly the victims of fraud) and mixed, the general presumption of “first in, first out” rule applies, may be more readily displaced.
In some cases, certain beneficiaries may have a superior claim, in which event they may be entitled to priority. In other cases, the courts have favoured a proportionate division where there are a number of beneficiaries persons entitled whose money has been separately misappropriated and mixed. A presumption of equal distribution to all account beneficiaries may be appropriate.
Mixed Funds Issues
Where two persons have contributed to a mixed account, the general principle is that they are each entitled to trace into it proportionately.
Where monies are wrongly received by a person who has not given value, such as by way of an inheritance under an invalid will, they may be traced by the real owners.
When money is placed into a bank account, the rule in Clayton’s case applies. This presumes a “first in, first out” approach where the monies of innocent parties have been mixed.
The effect of the “first in first” out presumption may have an arbitrary effect. Where monies are withdrawn from an account and invested in other assets which increase in value, the persons whose monies were lodged earlier may be entitled to the proceeds.
In recent years, the courts, in some cases, have sought to take a more equitable approach, which would leave the innocent parties in such cases, entitled to the full funds proportionately.
Where a person contributing to the mixed fund is in breach of trust, fiduciary duty or acts fraudulently, the position of the innocent beneficiary is protected. Each presumption is against the trustee or other person who has committed the breach of duty.
If funds are dissipated, they are assumed to belong to the trustees. If they are spent and used for profitable investments, they are presumed to belong to the beneficiary if there is a shortfall.
There are limits to the extent to which the beneficiary can be protected. If the account falls into deficits, the monies can no longer be traced into independent funds that are later lodged. They have left the account.
Equally, if the balance falls below the amount of money that is sought to be traced, the maximum which can be traced into that account is its lowest level. The monies may, of course, be traced into a further account.
Nature of Remedy
Once monies have been traced, there are a number of equitable remedies which may be applied. A constructive trust is where the court, as a matter of justice, declares a trust over particular funds.
A constructive trust may be applied, even though the person who holds the monies is innocent of wrongdoing. If he has not given value, such as when he receives a gift or inheritance, he is obliged to repay the funds to the true owner.
An equitable charge may be given in portion to the claimant’s share. The charge secures the payment of money equal to the value lost to the claimant (e.g. trust). If the money is not paid, the claimant may enforce payment on foot of the charge to the value of the amount owed.
A lien may be granted by way of equitable remedy. A lien entitles the holder to apply to the court, requiring the amount due to the claimant to be paid. A lien may be appropriate in respect of securities.
Subrogation is the right to stand in the shoes of another. The right may arise where monies are used for the discharge of an obligation owed to a third party. The claimant may be subrogated to the rights owed to the third party, whose debt and security (where it was a secured debt) would be thereby revived.
Defences/ Limits
As with equitable remedies generally, there are limits to the extent to which they may be asserted against innocent third parties. Where an innocent person changes his position to his detriment, in reliance on the receipt of money, a court of equity may deem it inequitable to require repayment. It may take the view that the hardship to the innocent recipient outweighs the injustice of denying the reclaim of the money.
A recipient who claims to have changed his position and acted to his detriment in reliance on receipt of funds must satisfy the requirement for estoppel. He must have acted in good faith. Where a third party acquires an asset for value and without notice of the invalidating circumstances, the right to trace will usually be lost.
Where a representation has been made to the recipient, whether innocently or intentionally, to him and the claimant knows the representation would be acted on, then to the extent that he has acted to his detriment in reliance, there may be a total of partial defence to tracing.
Where a payer pays money by mistake, it is generally recoverable from the recipient on the basis of unjust enrichment. Where, however, the recipient of the money has changed his position bona fide, the payer may not be able to recover to the extent that it would be unjust to do so. The defendant must have changed his position in reliance on the receipt.
If a bank over-credits a customer and the customer, believing that he has more money than he is, in fact, entitled to, has spent in reliance, the bank is likely to be estopped, at least to this extent. However, the mere fact that the money has been spent does not necessarily mean that the defence of change of position is available. Monies spent in the normal course of things would not necessarily constitute a change of position.